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. Below is the information about Adam Smiths International Trade Theory, it’s evolution and practibality.
Drawbacks of Mercantilism theory
Adam Smith observed following drawbacks of Mercantilism and Neo-mercantilism theory.
1. Mercantilism weakens a country.
2. Restriction on Free Trade decreases the country’s wealth
Adam Smith’s Theory (1776)
1. This theory is based on the principle of division of labour
(a division of labour 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 the required quantity and can enjoy the 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 the cost of production is a 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: One labour per day can produce either 90 pens or 3 Mobiles
Japan: One labour per day can produce either 30 Pens or 9 Mobiles
India: Absolute advantage in the production of Pens
Japan: Absolute advantage in the production of Mobiles
If India and Japan will exchange these products, both will get an 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 labour 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 the benefit from 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 in 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 a significant role)
Scale economies (Large scale economies reduce the cost of production and form a part of absolute advantages, this theory neglects it)
the absolute advantage for many products. Adam Smith, the Scottish economist observed some drawbacks of existing Mercantilism Theory of International trade.
This is all about Adam Smiths International Trade Theory.