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Book No. – 3 (Economics)
Book Name – Principles of Microeconomics (HL Ahuja)
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1. The Theory of Absolute Advantage: Basis of International Trade
2. Comparative Advantage or Comparative Cost Theory
2.1. Comparatitve Cost Theory: Opportunity Cost Approach
2.2. Constant Opportunity Costs and Gain from Trade
2.3. Comparative Cost Theory and Gain from Trade: Varying Opportunity Costs
3. Critical Appraisal of Comparative Cost Theory
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International Trade: Absolute Advantage Theory and Comparative Cost Theory
Chapter – 44
Adam Smith, in The Wealth of Nations, emphasized division of labour as a means to increase labour productivity; by concentrating on specific tasks, individuals develop greater expertise and efficiency in their work.
Division of labour involves dividing the work required for producing a good among different individuals or groups according to their respective abilities in performing different tasks.
The full gains from division of labour are realized when individuals or groups specialize in activities where their relative productivity is higher than that of others.
The principle of division of labour and specialization was extended from domestic production to international trade through Smith’s Absolute Advantage Theory of International Trade.
In 1817, David Ricardo further applied the principle of specialization to international trade through his Comparative Advantage Theory, arguing that:
Trade between two countries is mutually beneficial.
Countries should concentrate their resources on producing goods that they can produce at relatively lower costs or in which they possess a comparative advantage.
The goods produced through such specialization should be exchanged through trade between nations.
Modern economies are characterized by mutual interdependence among nations, making international trade an essential feature of the global economic system.
A completely closed economy is difficult to find in the contemporary world; almost all economies have become open economies, although the degree of openness varies across countries.
No country in the modern world is completely self-sufficient, reflecting the growing importance of international specialization, exchange, and economic interdependence.
The Theory of Absolute Advantage: Basis of International Trade
Adam Smith’s Absolute Advantage Theory states that international trade arises because different countries possess absolute advantages in producing different goods, enabling them to produce certain commodities more efficiently than others.
In the given example:
Production of 1 unit of wheat requires 3 man-hours in the U.S.A. and 10 man-hours in India, giving the U.S.A. an absolute advantage in wheat.
Production of 1 unit of cloth requires 6 man-hours in the U.S.A. and 4 man-hours in India, giving India an absolute advantage in cloth.
A country has an absolute advantage when it can produce a good with fewer labour hours (lower cost) than another country.
Adam Smith argued that both countries can increase total output if they specialize in the goods in which they possess absolute advantage and then trade with each other, making international trade mutually beneficial.
Illustration of specialization:
If the U.S.A. withdraws 6 man-hours from cloth production and reallocates them to wheat production:
Loses 1 unit of cloth.
Gains 2 units of wheat.
Net change: +2 wheat, –1 cloth.
If India withdraws 10 man-hours from wheat production and reallocates them to cloth production:
Loses 1 unit of wheat.
Gains 2.5 units of cloth.
Net change: –1 wheat, +2.5 cloth.
Combined effect on world output:
Wheat: +2 units (U.S.A.) –1 unit (India) = net gain of 1 unit of wheat.
Cloth: –1 unit (U.S.A.) +2.5 units (India) = net gain of 1.5 units of cloth.
Transfer of labour resources toward goods in which countries enjoy absolute advantage increases total global production.
The additional output generated through specialization can be shared between countries through voluntary exchange, allowing both countries to benefit from trade.
International division of labour and trade expand world output and wealth even when there is no increase in total productive resources, because resources are allocated more efficiently.
According to Adam Smith, under conditions of perfect competition within industries and free trade between countries, market forces automatically promote specialization and trade according to each country’s absolute advantage.