INTERNATIONAL

BUSINESS-Absolute
Advantage
Session 4 : International Trade Theory
(a) Purpose of Trade Theory
(b) Mercantilism
(c) Absolute Advantage
(d) Comparative Advantage

Business Case 7 : Indian Foundries Limited

Video : Alan Rugman on NAFTA - an interesting

Regional Agreement
(a) Mercantilism :

The first theory of international trade emerged in England

in the mid-16th century.
In mercantilism principle, gold and silver were considered
as national wealth and essential to vigorous commerce.

At that time, gold and silver were the currency of trade

between countries;

A country could earn gold and silver by exporting

goods.

Importing goods from other countries would result in

an outflow of gold and silver to those countries.
The main tenet of mercantilism was that it was in a
country's best interests to maintain a trade surplus, to
export more than it imported.

This theory recommended policies to maximize exports

and minimize imports.

To achieve this, imports were limited by tariffs and

quotas, while exports were subsidized.
Illustration :
According to Hume, if England had a balance-of-trade
surplus with France (it exported more than it imported)
the resulting inflow of gold and silver would swell the
domestic money supply and generate inflation in
England.
In France, however, the outflow of gold and silver would
have the opposite effect. France's money supply would
contract, and its prices would fall.
This change in relative prices between France and
England would encourage the French to buy fewer
English goods (because they were becoming more
expensive) and the English to buy more French goods
(because they were becoming cheaper). The result
would be a deterioration in the English balance of trade
and an improvement in France's trade balance, until the
English surplus was eliminated.
This change in relative prices between France and England would
encourage the French to buy fewer English goods (because
they were becoming more expensive) and the English to buy
more French goods (because they were becoming cheaper).

The result would be a deterioration in the English balance of

trade and an improvement in France's trade balance, until the
English surplus was eliminated.
Hence, according to Hume, in the long run no country
could sustain a surplus on the balance of trade and so
accumulate gold and silver as the mercantilists had
envisaged.
The flaw with mercantilism was that it viewed trade as a
zero-sum game. (A zero sum game is one in which a
gain by one country results in a loss by another.)

Adam Smith and David Ricardo - approach and to

demonstrate that trade is a positive-sum game, or a
situation in which all countries can benefit.
(b) Absolute Advantage Theory : Adam Smith

In his 1776 landmark book The Wealth of Nations, Adam

Smith attacked the mercantilist assumption that trade
is a zero-sum game.

Smith argued that countries differ in their ability to

produce goods efficiently.

In his time, the English, by virtue of their superior

manufacturing processes, were the world's most
efficient textile manufacturers.
Due to the combination of favorable climate, good soils,
and accumulated expertise :

English - absolute advantage - production of textiles,

French - absolute advantage - production of wine.

Thus, a country has an absolute advantage in the

production of a product when it is more efficient than
any other country in producing it.
According to Smith,
countries should
specialize in the
production of goods for
which they have an
absolute advantage
and then trade these for
goods produced by
other countries.
Smith's basic argument, therefore, is that you
should never produce goods at home when you can
buy at a lower cost from other countries.

Smith demonstrates that by specializing in the

production of goods in which each has an absolute
advantage, both countries benefit by engaging in
trade.
 Country Specialization
• Under the concept of absolute advantage
countries could increase efficiency
because:
• Labor could become more skilled by repeating the
same tasks
• Labor would not lose time in switching from the
production of one kind of product to another
• Long production runs would provide incentives for
the development of more effective working methods
 Natural Advantage
• Countries have inherent advantages
– Climate
– Natural resources
– Labor forces
• Two countries that have opposite
natural advantages should favor trade
with one another
 Acquired Advantage
• Most contemporary trade is
manufactured goods and services
rather than agricultural goods or
natural resources
• Countries with an acquired advantage
produce manufactured goods and
services competitively
– Product technology
– Process technology
 Consider the effects of trade between Ghana and South Korea

The production of any good (output) requires resources

(inputs) such as land, labor, and capital.

Assume that Ghana and South Korea both have the same
amount of resources and that these resources can be used to
produce either rice or cocoa.

Assume further that 200 units of resources are available in

each country.
 10 R 1 Ton Cocoa
Ghana
20 R 1 Ton Rice

Thus, Ghana could produce :

(a) 20 tons of cocoa and no rice,

(b) 10 tons of rice and no cocoa, or
(c) some combination of rice and cocoa between these two
extremes.
 40 R 1 Ton Cocoa
South Korea
10 R
1 Ton Rice

South Korea could produce :

(a) 5 tons of cocoa and no rice,

(b) 20 tons of rice and no cocoa, or
(c) some combination between these two extremes.
The Theory of Absolute Advantage
Thus, as a result of specialization and trade, output of both
cocoa and rice would be increased, and consumers in both
nations would be able to consume more.

Thus, we can see that trade is a positive-sum game;

it produces net gains for all involved.

(c) Comparative Advantage : David Ricardo
(Also called Comparative Cost)

According to Ricardo, a country can have certain

advantages in the production of certain goods and
services.

The advantage may be due to the availability of

natural resources or due to the skills and aptitudes
of the people.

By advantages, Ricardo means, a country can

produce certain goods and services at
comparatively lower costs than others.
Ricardo argues that different countries should specialize
in the production of those commodities in which they
have comparative cost advantage or comparatively
lesser production costs.

After specialization, they should exchange or trade

their surplus among themselves.

Thus, Ricardo presents a general theory of international

trade based on the comparative cost advantage
principle.
Assumptions of the Theory :

1. Production costs are measured in terms of labour costs

only.

2. Labour is assumed to be mobile within a country and

immobile between countries.

3. The average cost of production does not change as output

changes. (assumes constant costs).

4. There are no changes in technology or methods of

production.

5. The theory assumes free trade.

6. Trade is carried on by barter.
7. Ricardo's theory is a two country, two commodity model.
 Statement of the Theory :
Ricardo's theory can be explained with the help of an
example as follows:

Portugal has comparative cost advantage over England in the

production of wine because between two advantages greater
advantage is comparative advantage.
England has absolute cost disadvantage in the production of both
wine and cloth. But her disadvantage is lesser in cloth than wine.
Hence, England has comparative cost advantage over Portugal in
the production of cloth because between two disadvantage, lesser
disadvantage is comparative advantage.
Under such conditions, the two
countries should specialize in
accordance with comparative
cost advantage principle.

Portugal should produce wine

and England should produce
cloth and they exchange their
surplus with each other.
Benefits of Specialization and Trade :

In the absence of international trade, the rate of exchange

between wine and cloth in Portugal would be one unit of wine
against 0.88 units of cloth (1W = 0.88C).

In England the rate of exchange would be one unit of wine

against 1.2 units of cloth (1W = 1.2C).
Let us assume that after specialization and trade Portugal and
England exchange wine and cloth in the ratio of 1W = 1C.

It is certainly profitable for Portugal to export wine to England

and import cloth because now 1 unit of wine secures 1 unit of
cloth, whereas, in her own country 1 unit of wine gets only 0.88
units of cloth.

So, Portugal gets more cloth for her wine after specialization
and trade. Similarly, it is profitable for England to export cloth
and import wine from Portugal because now she can secure 1
unit of wine for 1 unit of cloth.
But in her own country, 1 unit of wine costs 1.2 units of cloth.
So, England gets a unit of wine for lesser cloth and both the
nations benefit from specialization and trade.
Thus, according to Ricardo, international trade arises because
of comparative differences in costs.

The general conclusion of the theory is that

1. Different nations should specialize in the production of only

those commodities in which they have comparative cost
advantage or comparatively lower costs.

2. After specialization they can trade their surplus among

themselves.

Such specialization and free trade lead to the efficient use of

resources, maximization of output and income and benefits
the trading nations.
Criticisms of the Theory :

1. Based on the assumption of the labour theory of value. It

measures production costs in terms of labour costs only
which is unrealistic.

2. The assumption that the labour is immobile between

countries is not correct.

3. The assumption of constant costs is unrealistic because the

average cost of production may increase or decrease as
output expands.

4. Ricardo assumes free trade, but at present international

trade is subject to a number of restrictions.
5. The assumption of constant technology is questionable because in
the modern dynamic world techniques of production change
continuously.
6. The theory assumes barter exchange which is very rare.
7. Ricardian theory is a two country, two commodity model. But
international trade is a multilateral phenomenon and involves many
commodities and countries.
8. Ricardo explains international price differences in terms of cost
differences only. He considers the supply side of international trade
but takes no account of the demand side. Hence, Ricardian theory is
criticized as one-sided theory of international trade.
9. The classical theory advocates that a country should produce only
those commodities in which it has cost advantage. But a country may
produce a commodity even without cost advantage for various
reasons like industrial development, national defense and self-
reliance. The economic principle of comparative cost advantage may
be sacrificed by a country to achieve certain national objectives.
10. It is pointed out that complete specialization on the part of two
countries is difficult.
11. The socialists criticize the theory on ideological grounds. They
argue that if international specialization and trade takes place in
accordance with the principle of comparative cost advantage, the
developed nations produce industrial goods and
underdeveloped countries only agricultural products. It is not
favourable to underdeveloped countries because they cannot
develop their industries. It leads to the exploitation of poor nations by
rich nations through trade.