Absolute Advantage Theory (1776)

Absolute Advantage Theory [1776] (Adam Smith)

• The capability to produce more of a given product using less of a given resource than a competing entity.

• It is determined by a simple comparison of labor productivities, it is possible for a party to have no absolute advantage in anything; in that case, according to the theory of absolute advantage, no trade will occur with the other party.

• In this example, Brazil has an absolute advantage in producing Trucks (10 to 5).

• The US has an absolute advantage in producing cars.

• It may happen that a country is having absolute advantage in the production of both the products.

Output per worker Cars Trucks

US 10 5

Brazil 5 10

Assumptions

• No trade barriers, no tariff, no customs duties→ free movement of goods, and no transportation cost.

• Constant returns to scale.

• Perfect mobility of labour between sectors but not across international borders

• 2 Goods, 2 countries, and 1 factor

CRUX of Absolute Theory

Trade will take place when one country export that good in which it enjoys an absolute advantage to the second country for importing the other good in which the latter is having an absolute advantage

Specialization of labour → Higher Labour productivity → Lower Cost of Production → Absolute Advantage

Absolute Advantage Types:

• Natural Advantage→ Due to climatic conditions

• Acquired Advantage → Due to technology and skill set