Welcome to the World of Education.

Adam Smith, the Scottish economist observed some drawbacks of existing Mercantilism Theory of International trade and he proposed a new theory i.e. Absolute Cost Advantage theory of International trade to remove drawbacks and to increase trade between countries.

Drawbacks of Mercantilism theory

Adam Smith observed following drawbacks of Mercantilism and Neo-mercantlism  theory.

1. Mercantilism weakens a country.

2. Restriction on Free Trade decreases country’s wealth

Adam Smith’s Theory (1776)

1. This theory is based on principle of division of labour

(division of labor  the separation of a work process into a number of tasks, with each task performed by a separate person or group of persons.)

2. Free trade among countries can increase a country’s wealth.

3. Free trade enables a country to provide a variety of goods and services to its people by specializing in the production of some goods and services and importing others.

4. Every country should specialize in producing those products at the cost less than that of other countries and exchange these products with other products produced cheaply by other countries.

5. When one country produces one product at less cost and another country produces another product at less cost, both can exchange required quantity and can enjoy benefit of absolute cost advantage.

Advantage of Skilled labour and specialization

1. ABSOLUTE COST ADVANTAGE: Reasons for Absolute Cost Advantage

A. SPECIALIZATION: Specialization of labour leads to higher productivity and less labour cost per unit of output

B. SUITABILITY: Suitability of the skill of the labour of the country in producing certain products

C. ECONOMIES OF SCALE: Economies of scale helps to reduce the labour cost per unit of output.

2. NATURAL ADVANTAGE

Climatic conditions

Natural resources

Example: Indian Climate- Production of Rice, Wheat, Sweet Mangoes, Grapes, Tea, Coconuts, Cashew nuts, Cotton etc.

Sri Lanka: Production of Tea, Rubber

USA: Production of Wheat

3. ACQUIRED ADVANTAGE

Technology

Skill development

Examples: Japan: advantages in steel production through the imports of both iron and coal (Labor saving and material saving technology)

England: production of textiles,

France: Wine

Assumptions of the Theory

Trade is between two countries

Only two commodities are traded

Free Trade exists between the countries

The only element of cost of production is labour

Numerical Example

Output per one day of labour
India Japan
Pens 90 30
Mobiles 3 9

Production Possibilities: Ability of labour to produce different goods/services in a day

India Japan
One labour per day can produce either 90 pens or 3 Mobiles One labor per day can produce either 30 Pens or 9 Mobiles
Absolute advantage in the production of Pens Absolute advantage in the production of Mobiles

If India and Japan will exchange these products, both will get advantage.

India will export 60 Pens to Japan

Japan will export 6 Mobiles to India

So, 60 Pens for 6 Mobiles

2 days of Japanese labour needed to produce 60 pens

and only 0.67 days of labor is enough to produce 6 Mobiles

Japan can save 1.33 days of labour

Similarly India can save 1.33 days of labour

Thus both countries can get benefit of trade and can save labour as well as cost per unit

Implications (Significance) of Absolute Advantage Theory

1. More quantity of both products

2. Increased standards of living of both countries

3. Increased production efficiency

4. Increase in global efficiency and effectiveness

5. Maximization of Global productivity and other resources productivity

Criticism

No absolute advantages for many countries

Country size varies

Country by country differences in specialization

Deals with labour only and neglects other factors (Variety of resources)

Neglected Transport cost (It plays significant role)

Scale economies (Large scale economies reduces the cost of production and forms a part of absolute advantages, this theory neglects it)

Absolute advantage for many products

Share This