Absolute Advantage Definition: Absolute advantage is an economic idea that refers to a person’s, firm’s, nation’s, or country’s higher manufacturing capabilities. It refers to the capability to manufacture a particular commodity or better quality than a competitor.
The early thoughts of international trade are viewed as classical thoughts of International Trade. It includes the absolute advantage theory and comparative advantage theory. Adam Smith presented the absolute advantage theory in 1776. David Ricardo, in 1819, presented the comparative advantage theory. These ideas developed in the great Brittan during the 18th and 19th centuries.
After reading this lesson, you would be able to:
- The theory of absolute advantage
- The idea of absolute advantage theory
- The productivity of the inputs
- Assumptions of absolute advantage theory
- Example of absolute advantage
- Limitations of absolute advantage theory
The theory of absolute advantage
The theory was presented by Adam Smith in 1776. In the eighteenth century, the influence of trade spread throughout the world. Observing that impact, Smith said the trade limits proposed by traders would limit world production, consumption, and public welfare.
Therefore, he advised promoting free trade among nations. He further said that trade should improve by specializing in products that have the absolute advantage of trading partners.
Absolute Advantage Definition: The idea of absolute advantage theory
The main idea of Smith’s absolute advantage theory was international division of labor. It means a specialization in the production of only a few goods by nations will increase efficiency and output.
By observing the absolute cost differences among countries, Smith said that autarky level price differences would lead to international trade. He said that an increase in production by the division of labor in individual countries would increase the international division of labor and production. And also thereby surplus products could divide among countries through international trade.
The productivity of the inputs
The main factor determining the cost of production is the productivity of the inputs. Smith mentioned they base on natural and acquired (man-made) advantages.
The natural advantage refers to natural resources such as climate, land, soil, and locations, etc. Man-made resources refer to special abilities and human skills of nations.
Thus, Smith said that, given the natural or acquired advantages in producing goods, a country could produce the own good at a lower cost, becoming more competitive than the trading partner.
Labor theory of value
Smith’s concept based on the labor theory of value. It assumed that labor has the following qualities.
- Labor is the only factor of production. It is homogeneous (no quality difference)
- The cost or the price of goods depends on the amount of labor.
For example, as shown in the table below.
USA could produce soya using less number of labor units than the UK. Therefore, the USA has the cost-efficiency in producing soya than the UK.
Smith’s trading principle is the principle of absolute advantage.
In a two-country, division of labor and specialization would gain to the nation when it has an absolute cost advantage in producing one commodity. Similarly, another country would also have a similar advantage when it has a cost advantage for another product.
Thus, for the world to benefit from the international division of labor, each country must have a good that has absolute cost advantage than his trading partner. Accordingly, the country will export the good which has an absolute advantage and will import the commodity which has absolute cost disadvantage.
Assumptions of absolute advantage theory
The absolute advantage theory base on the following assumptions.
- There are only two countries and two goods.
- Agents and individuals exhibit rational behavior.
- In each nation, labor is the only input.
- No money illusion (consider only relative prices, not the nominal money values.
- Perfect competition prevails in all markets.
- Labour can move freely among industries but cannot move between countries.
- The level of technology is fixed for both nations. Though nations have different technologies, each nation utilizes a common production method.
- No barriers to trade.
- Export must pay for imports.
- Production exhibits constant returns between labor and output.
- Transportation costs are zero.
Example of absolute advantage
Smith’s idea of this theory can show in the below table 1. According to two countries and two goods model, there are two countries.
The USA and UK produce two goods, such as soya and textile. Thus the USA spend 3 hours making one unit of soya and 6 hours to make one unit of textile while the UK spends 12 and 4 hours to one unit of soya and textiles, respectively.
|Good||Hours to make 1 unit|
|Hours to make 1 unit|
Accordingly, the USA has the absolute advantage in producing soya (3<12), and the UK has an absolute advantage for making textiles (4>6).
It reflects that the USA could specialize soya since its cost is relatively lower than in the UK. Similarly, the UK has the least cost advantage for specializing textiles. Hence both countries can get the benefits of trade by specializing in the least cost item.
If the USA declines its production of textiles by 1 unit and uses its six units of labor for soya production, it could produce two units of soya instead of making one unit of textiles.
Eventually, the world soya production could be increased by 1 unit by specializing in the USA’s only soya. Similarly, textile production could increase by two units if the UK specializes in textiles by reducing 1 unit of soya and using it for textiles (see table 2).
|Country||In production of soya||In production of textile|
Gains from Specialization
Market prices of respective products in two countries are determined as follows.
Hence, PS/PT in USA is = (WA x 3)/ (WA x 6) = 3/6 = 1/2
Similarly prices in UK is; Ps=WA x Hours=WA x 12, Pt = WA x 4
Hence PS/PT in UK = (WB x 12)/ (WB x 4) = 12/4 = 3
Accordingly, ½ units of soya require to buy one unit of textile in the USA while 3 units of textile require to buy one unit of soya in the UK. It implies that Soya is chief in the USA and textile is less cost in the UK.
Once trade allows by two countries, consumers in country A will buy its textile from country B. And also consumers in country B will buy its soya from country A because the cost of producing textile is expensive in USA and similarly cost of soya is expensive in United kingdom.
Thus as a result of autarky price differences in the two countries the USA will specialize and export its cost-effective product of soya by reducing textile. Similarly, the UK will specialize and export textile by reducing its expensive product of soya.
Limitations of absolute advantage theory
However, the theory of absolute advantage was criticized due to following limitations.
- Unrealistic assumptions such as labor theory of value, perfect competition, and fixed technology are not match with the real world.
- The theory was not answered for the situation of countries which have the absolute advantage for more than one products
Absolute Advantage Definition: Conclusion
In this article, you learn about the fundamentals of absolute advantage theory presented by Adam Smith in 1776. I think this article has given you a full understanding of the absolute advantage theory. Let me know what you think.