Module 9

MODULE 9
ABSOLUTE AND COMPARATIVE ADVANTAGE THEORY

3.1 INTRODUCTION

International trade refers to the sale and exchange of goods and services from a domestic
seller to an international buyer. The process of international trade has developed to mean
different things from various standpoints. Economies like to indulge in international trade due
to the multiple benefits that are associated with this form of trade such as greater profits,
increase in standards of living, greater choice to the buyers, more availability of products,
better production in home markets etc.- naturally, as trade developed, several theories that
pose as a guide to the various economies of the world tend to act as a rough guide to enable a
nation to determine which form or theory off trade to follow. Nations may indulge in the
professing of one trade theory or may seek to practice a combination of these trade theories.
Each theory has its merits and drawbacks, however, there is no hard and fast rule as to what
should be applied where. This is primarily because no two nations are the same, similarities
amongst them though, may exist. Therefore, these theories of trade, even if applied, may not
result in the specific outcome they suggest which then is a criticism of these theories.
Broadly, trade theories are classified into Classical theories and Modern Theories.
The classical trade theories, developed before the twentieth century are from the
perspective of a country as compared to modern theories that are from the perspective of the
firm. The shift in the outlook is in coherence with the economic shift that took place in the
mid twentieth century that gave rise to the modern theory. Both of these theories have sub
sets. The classical theory consists of Mercantilism, the Heckscher-Ohlin theory, Absolute
Advantage theory and the Comparative Advantage theory. The Modern theory comprises of
Country Similarity, Product Life Cycle, Global Strategic Rivalry and Porter’s National
Comparative Advantage. A detailed analysis of these theories was given in Module I. This
Module focuses on the Absolute Advantage Theory and the Comparative Advantage theory
which are forms of the classical school and have gained popularity because of their
adaptability across various types of nations. These theories largely influence how resources
are allocated optimally to ensure optimal production.

3.2 ABSOLUTE ADVANTAGE

Adam Smith, gave to the world the Absolute Advantage Theory in his book ‘The Wealth of
Nations. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations’ in
1776. This theory focused on the ability of a country to produce a product with greater
efficiency than another nation. Trade should be performed by taking into consideration what
can be produced at ease in one country may not be produced with equal ease in another.
Therefore, exports should comprise of all those goods and services that are produced at ease
in the nation and imports should comprise of those that are difficult to produce. This process
should take place according to the free flow of the market forces. Gold and silver therefore
are disregarded as the nation’s wealth, the focus should be on market forces that directly
affect the people instead.

3.3 ASSUMPTIONS OF THE THEORY OF ABSOLUTE ADVANTAGE

The underlying philosophy of this theory is the efficiency of production. The focus of a
country should therefore be on goods that it has utmost efficiency in producing, or absolute
advantage in producing. There are certain assumptions upon which this theory rests. Smith
states that in order for Absolute Advantage to work, the factors of production cannot be in
motion. This suggests that the factors of production are constant within a country. This
assumption excludes the possibility of any such factor of production: land, labor, capital is
subject to movement and therefore disregards the presence of multinational corporations,
or/and migration movements.

Adam Smith was critical of the theory of Mercantilism which focused on the wealth of the
nation being proportional to the gold and silver reserves. He believed that the true wealth of
the nation rests in its people. Thus, trade should be an activity which benefits the people and
their standard of living in a positive manner. He was critical of the theory of protectionism
which enforced trade barriers. A forerunner in the advocacy of free trade, another assumption
of this theory is the absence of any trade barriers which results in a smooth flow of trade.

Until this theory was instituted, to have a trade surplus was the ultimate aim of nations. Trade
deficits were indicative of a weak economy and nations moved towards creating a situation
wherein they would be in a position of surplus. This was an impossible task for poorer
countries and often led to massive wars and even bankruptcy of nations. Smith advocated the

Balance of Payments or an economy situation wherein exports are equal to imports. This
assumption reiterates the absence of any trade surplus or a deficit.

Another assumption that this theory is based on is the factor of production. This theory
assumes that labor is the only factor that is relevant to production. As mentioned earlier,
Smith advocated that welfare and the living of the people should be the primary goals of the
nation’s indulging in trade. Therefore, the only factor of production that this theory assumes
to be relevant is that of labor.

Constant returns to scale relates to the imposition of technology in the production process. It
signifies the relationship between input and output being proportional. Therefore, if
technological changes are made in all inputs, it would result in a change in all outputs. This is
another assumption of this theory.

3.4 FEATURES OF ABSOLUTE ADVANTAGE

The two main features of this theory relate to productivity and cost. Productivity is the
measure of the efficiency of production. Often expressed as a ratio of aggregate output to a
single unit input, it can be measured in terms of the amount of input used to measure a single
unit of output as well. Labor productivity, capital and material productivity are three broad
classifications. The absolute advantage theory relates to labor productivity and focuses on
how many units of output can be produced by one unit of labor in a nation. The other feature
of this theory is that of cost.

The value of money that has been used to produce something or deliver a service and is
therefore unavailable for use thereafter relates to cost. This theory concerns itself with the
cost of production and therefore signifies that the cost of production of a unit should be
optimal or at the best price possible in order to be efficient.

Therefore, a country has an absolute advantage on producing a good or service if it can
produce more of that output with the same or lesser level of input as compared to other
countries. Examples of the use of this theory can be seen across the world. The extraction of
oil from Saudi Arabia, Colombia for its coffee etc.

3.5 COMPARATIVE ADVANTAGE

Comparative Advantage, a challenge to the theory of Absolute Advantage, proposed by
David Ricardo focused on the possibility that a country may have an advantage at producing
more than one good whilst another may not have the advantage at producing any good. David
Ricardo embodied this principle in his book titled “On the Principles of Political Economy”
in 1819. He sought to incorporate the theory in order to solve issues of pertinence such as the
need for trade and the reasons why countries perform the trading function. His theory was
formulated on the basis of mutual exhaustion of needs between nations as a mutually
beneficial activity. Therefore, the exchange then should be in accordance to the cost of
production and factors of production. Relative productivity is the focus of comparative
advantage as compared to absolute advantage that focuses on absolute productivity. The
benefits of production are the gains from trade. This principle highlights the opportunity cost
of production. This theory however, was also based on the free trade principle.
The theory of comparative advantage takes relative factors into consideration. Therefore, if
one country is relatively better at producing outputs at the same level of inputs, it is said to
have a comparative advantage. Relative magnitudes are the basis for consideration.

3.6 ASSUMPTIONS OF COMPARATIVE ADVANTAGE
Comparative advantage measures the efficiency in production in terms of factors that are
relative in nature. The assumptions of this theory relate to the resources of a nation being
limited. Their technological knowhow and resource allocation is thus limited to the
knowledge prevalent.

The comparative advantage theory is based on the assumption of opportunity cost associated
with the production of one good compared to another. The opportunity cost relates to the loss
of other alternatives when one is chosen.

The factor of production taken into consideration is that of labor. This supply of labour is
unchanged and not influenced by other factors. The labour factor is also homogeneous and is
prevalent in equal measure in both countries. The cost of labor is the cost that is associated
with the production of these commodities and therefore determines the price of the product.

Another assumption is that these countries that are considered are sole market players and
produce the same products the consumer tastes and knowledge are similar in both these
countries. Technological knowledge also remains the same and remains unchanged in both
these countries.
The comparative advantage theory disposes the existence of trade barriers and believes that
the movement or restriction of trade in the economy is absent. Transportation costs are also
not considered and the exchange ratio for the two commodities is the same as it is assumed
that the countries are trading in the barter system.

3.7 FEATURES OF COMPARATIVE ADVANTAGE

Comparative Advantage fills the void left behind by Absolute Advantage as the latter did not
take the cost factor into account. Opportunity cost relates to economic cost or that which is
borne due to a choice made. Therefore, this theory takes the opportunity cost into
consideration and rests on a more relative term than that of absolute advantage. Another key
feature of this theory is that though a country may have an absolute advantage at producing
multiple or all goods, the possibility of it having a comparative advantage is far lesser or
negligible even. This is due to the difference in opportunity costs that exist in the countries.
The benefits of specialization form the basis of this theory and the market is assumed to be
perfectly competitive driven by the forces of demand and supply.

Diminishing returns are ignored and transport costs are assumed to not be in existence. The
comparative advantage of a country may have might change from time to time. The advent of
technology and renewability of resources plays a major part in this. Certain resources are
non-renewable and can run out thereby increasing the costs of production and therefore the
consequent but severe reduction in the gains from trade in that particular area. Countries may
even develop a new Comparative Advantage. Such as the case of Vietnam and coffee
production witnessing a major increase over the past few decades from just 1% in 1985. The
global world set up has far more than just two players in the market, the multiple players
therefore, make it a more complex trading arena than what is assumed under this model.

3.8 DIFFERENCES BETWEEN ABSOLUTE ADVANATAGE AND COMPARATIVE
ADVANTAGE THOERY

The differences between these trade theories are glaring. A country has an absolute advantage
if it produces a quantity of goods with the same resources as provided to another country.
Comparative advantage on the other hand relates to the production of a greater number of a
particular product with the same relative factors of production. The latter relates to
opportunity cost and the former with that of absolute cost.

Absolute Advantage does not operate on the abstract of mutual benefits. It does not provide
for a system of barter or trade in commodities so as to increase the benefits from such a trade
mutually, whereas comparative advantage supposes the existence of a system where mutual
benefit arises from the trading of commodities.

The theoretical aspects of both these theirs are immense, however, the actual and practical
approach might differ. Therefore, several theories have developed to be more suited in the
modern day approach as mentioned earlier.

FACTORS OF DIFFERENTIATION IN NUTSHELL

Absolute Advantage Comparative Advantage

Concept

It occurs when a country produces better goods and It occurs when a country produces
services better than its competitors using the same goods and services at a lower
amount of resources. opportunity cost than its competitors.

Trade

It represents a condition wherein the trade between 2 It represents a condition wherein the
countries is not mutually beneficial. trade between two countries
definitely gives rise to mutual
benefits.

Cost

While cost is an essential point here and this term Its significant factor is the lowering
manifests its efficiency with reduced costs, it is of opportunity costs. Opportunity

important to note that it does not involve opportunity cost refers to the amount you have to
costs. It considers only productivity of goods, no pay in order to obtain something.
measure concerning cost is used.

Economic Nature

It is not mutual or reciprocal. It is mutual and reciprocal.

REFERENCES

1. (What Is International Trade Theory?)
<https://saylordotorg.github.io/text_international-business/s06-01-what-is-
international-trade-th.html> accessed June 26, 2019
2. “Comparison between Classical Theory and Modern Theory of International Trade”
(PreserveArticles.com: Preserving Your Articles for EternityDecember 29, 2010)
<http://www.preservearticles.com/international-trade/comparison-between-classical-
theory-and-modern-theory-of-international-trade/350> accessed June 26, 2019
3. OpenStax (Principles of Economics)
<https://opentextbc.ca/principlesofeconomics/chapter/33-1-absolute-and-
comparative-advantage/> accessed July 3, 2019
4. James M. Buchanan (2008). "Opportunity cost". The New Palgrave Dictionary of
Economics Online (Second ed.). accessed July 3,2019
5. Harrington, James W. "International Trade Theory". Geography 349 Absolute
advantage. University of Washington. accessed July 3,2019
6. Bruce Bueno de Mesquita (2013), Principles of International Politics, SAGE,
pp. 329–330
7. Bernhofen, Daniel M.; Brown, John C. (2004). "A Direct Test of the Theory of
Comparative Advantage: The Case of Japan". Journal of Political Economy. 112 (1):
48–67.
8. A. O'Sullivan & S.M. Sheffrin (2003). Economics. Principles & Tools.