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
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
Examples: Japan: advantages in steel production through the imports of both iron and coal (Labor saving and material saving technology)
England: production of textiles,
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
|Output per one day of labour|
Production Possibilities: Ability of labour to produce different goods/services in a day
|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
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