H.

P NATIONAL LAW UNIVERSITY, SHIMLA

ASSIGNMENT OF ECONOMICS

TOPIC :- THEORY OF ABSOLUTE COST

ADVANTAGE

SUBMITTED TO :- SUBMITTED BY:-

Mr. Hari Chand Shashwat Srivastava

B.A.LL.B(3 Sem)

ENROLLMRNT NO. :- 1020171828

 Acknowledgement

I am using this opportunity to express my gratitude to everyone who supported me

throughout the course of this assignment. I am thankful for their aspiring guidance,
invaluably constructive criticism and friendly advice during the project work. I am sincerely
grateful to them for sharing their truthful and illuminating views on a number of issues
related to the project.

I would also like to thank my faculty of the subject Mr. Hari Chand and all the people who
provided me with the facilities being required and conductive conditions for my assignment
making.

Thank you,

Shashwat Srivastava
 CONTENT

 Introduction
 International Economics
 Adam Smith’s Theory of Absolute Cost Advantage
 Criticism
 Introduction
The main concept of absolute advantage is generally attributed to Adam Smith for his 1776
publication An Inquiry into the Nature and Causes of the Wealth of Nations in which he
countered mercantilist ideas. Smith argued that it was impossible for all nations to become
rich simultaneously by following mercantilism because the export of one nation is another
nation’s import and instead stated that all nations would gain simultaneously if they practiced
free trade and specialized in accordance with their absolute advantage. Smith also stated that
the wealth of nations depends upon the goods and services available to their citizens, rather
than their gold reserves. While there are possible gains from trade with absolute advantage,
the gains may not be mutually beneficial. Comparative advantage focuses on the range of
possible mutually beneficial exchanges.

In economics, principle of absolute advantage refers to the ability of a party (an individual, or
firm, or country) to produce more of a good or service than competitors, using the same
amount of resources. Adam Smith first described the principle of absolute advantage in the
context of international trade, using labour as the only input.

International Economics
International economics deals with the economic activities of various countries and their
consequences.

In other words, international economics is a field concerned with economic interactions of

countries and effect of international issues on the world economic activity.

International trade, economic transactions that are made between countries. Among the items
commonly traded are consumer goods, such as television sets and clothing; capital goods,
such as machinery; and raw materials and food. Other transactions involve services, such as
travel services and payments for foreign patents. International trade transactions
are facilitated by international financial payments, in which the private banking system and
the central banks of the trading nations play important roles.

International trade and the accompanying financial transactions are generally conducted for
the purpose of providing a nation with commodities it lacks in exchange for those that it
produces in abundance; such transactions, functioning with other economic policies, tend to
improve a nation’s standard of living. Much of the modern history of international
relations concerns efforts to promote freer trade between nations. 

Adam Smith’s Theory of Absolute Cost Advantage

Adam Smith’s theory of absolute cost advantage in international trade was evolved as a
strong reaction of the restrictive and protectionist mercantilist views on international trade.
He upheld in this theory the necessity of free trade as the only sound guarantee for
progressive expansion of trade and increased prosperity of nations. The free trade, according
to Smith, promotes international division of labour.

Every country tends to specialize in the production of that commodity which it can produce
most cheaply. Undoubtedly, the slogans of self- reliance and protectionism have been raised
from time to time, but the self-reliance has eluded all the countries even up to the recent
times. The free and unfettered international trade can make the countries specialise in the
production and exchange of such commodities in case of which they command some absolute
advantage, when compared with the other countries.

In this context, Adam Smith writes; “Whether the advantage which one country has over
another, be natural or acquired is in this respect of no consequence. As long as one country
has those advantages, and the other wants them, it will always be more advantageous for the
latter, rather to buy of the former than to make.”

When countries specialise on the basis of absolute advantage in costs, they stand to gain
through international trade, just as a tailor does not make his own shoes and shoemaker does
not stitch his own suit and both gain by exchanging shoes and suits.

Suppose there are two countries A and B and they produce two commodities X and Y. The
cost of producing these commodities is measured in terms of labour involved in their
production. If each country has at its disposal 2 man-days and 1 man-day is devoted to the
production of each of the two commodities, the respective production in two countries can be
shown through the hypothetical Table 2.1.
In country A, I man-day of labour can produce 20 units of X but 10 units of Y. In country B,
on the other hand. I man-day of labour can produce 10 units of X but 20 units of Y. It
signifies that country A has an absolute advantage in producing X while country B enjoys
absolute advantage in producing commodity Y. Country A may be willing to give up 1 unit
of X for having 0.5 unit of Y. At the same time, the country B may be willing to give up 2
units of Y to have I unit of X. If country A specialises in the production and export of
commodity X and country B specialises in the production and export of commodity Y. both
the countries stand to gain.

The absolute cost advantage of country A in the production of X and that of B in the
production of Y can also be expressed as below:

It is possible to explain the cost difference in two countries A and B concerning the
commodities X and Y geometrically through Fig. 2.1.
In Fig. 2.1, AA1 is the production possibility curve of country A. Given the techniques and
factor endowments, if all the resources are employed in the production of X commodity, it
can produce OA1quantity of X. On the contrary, if all resources are used in the production of
Y, country A can produce OA quantity of Y. BB 1 is the production possibility curve of
country B.

In case of this country, if all resources are employed in the production of X commodity,
OB1 quantity can be produced. Alternatively, if all the resources are used in the production of
Y, it is possible to produce OB quantity of Y. The slope of production possibility curve is
measured by the ratio of labour productivity in X to labour productivity in Y in each country.

Slope of AA1 = LXA/LYA

Slope of BB1 = LXB/LYB

Since slope of AA1 is less than the slope of BB1, it signifies that country A has absolute cost
advantage in the production of X commodity, while country B has the absolute cost
advantage in the production of Y commodity.
Adam Smith also emphasised that specialisation on the basis of absolute cost advantage
would lead to maximisation of world production. The gains from trade for the two trading
countries can be shown through Table 2.2.

Before trade, Country A produces 20 units of X and 10 units of Y. After trade, as it

specialises in the production of X commodity, the total output of 40 units of X is turned out
by A and it produces no unit of Y. Country B produces 10 units of X and 20 units of Y before
trade. After trade it specialises in Y and produces 40 units of Y and no unit of X. The gain is
production of X and Y commodity each is of 10 units. The gain from trade for country A is
+20 units of X and -10 units of Y so that net gain to it from trade is +10 units of X. Similarly,
net gain to country B is +10 units of Y.

An interesting aspect of Smith’s analysis of trade has been his ‘Vent for Surplus’ doctrine.
According to him, the surplus of production in a country over what can be absorbed in the
domestic market can be disposed of in the foreign markets. It was basically this desire that
led Mercantilists and subsequent theorists to place much emphasis on the international trade.

The ‘Vent for Surplus’ doctrine implies that the international specialisation is not reversible
and that it is an integral part of the development process in any country. In addition, this
doctrine implies that the foreign trade results in the fullest utilisation of the idle productive
capacity that is likely to exist in the absence of trade. This implication makes a clear
departure from the assumption held in the comparative cost approach that the resources are
fully employed even before trade. What trade does is to bring about a more efficient
allocation of them.

Criticism
Adam Smith, no doubt, provided a quite lucid explanation of the principle of absolute cost
advantage as the basis of international transactions, yet his theory has certain weaknesses.

Firstly, this theory assumes that each exporting country has an absolute cast advantage in the
production of a specific commodity. This assumption may not hold true, when a country has
no specific line of production in which it has an absolute superiority. In this context Ellsworth
says “Smith’s argument is not very convincing as it assumed without argument that
international trade required a producer of exports to have an absolute advantage, that is, an
exporting country must be able to produce with a given amount of capital and labour a larger
output than any rival. But what if a country has no line of production in which it was clearly
superior.”

Most of the backward countries with inefficient labour and machinery may not be enjoying
absolute advantage in any line of activity. So, the principle of absolute cost advantage cannot
provide complete and satisfactory explanation of the basis on which trade proceeds among
the different countries.

Secondly, Adam Smith simply indicated the fundamental basis on which international trade
rests. The absolute cost advantage had failed to explore in any comprehensive manner the
factors influencing trade between two or more countries.

Thirdly, the ‘Vent for Surplus’ doctrine of Adam Smith is not completely satisfactory. This
doctrine can have serious adverse repercussions on the growth process of the backward
countries. These countries do not sell their surplus produce in foreign markets but are
constrained to export despite domestic shortages for the reasons of neutralising their balance
of payments deficit.

A more detailed and satisfactory explanation concerning the basis of international trade has
been provided by David Ricardo and J.S. Mill.
 References
 www.economicsdiscussion.net
 International Economics- K. C. Rana & K. N. Verma