Theories of Absolute and Comparative Advantage: by Sirish Shrestha

[Year]
THEORIES OF
ABSOLUTE AND
COMPARATIVE
ADVANTAGE
BY SIRISH SHRESTHA
MBA 2ND SEMESTER
FEBRUARY 2019, INTAKE
INTERNATIONAL TRADE
 Exchange of goods and services between countries is called international

trade.
 The importance of international trade was recognized early on by political
economists like Adam Smith and David Ricardo
 It helps citizens of one nation to consume and enjoy the possession of
goods produced in some other nation.
 The aim of international trade is to increase production and to raise the
standard of living of the people
INTERNATIONAL TRADE THEORIES
To understand the pattern in international trade, Different trade

theories are postulated. Some famous trade theories are:
1. Mercantilism
2. Absolute Advantage Theory
3. Comparative Advantage Theory
4. Hecksher-Ohlin Factor endowment Theory
5. Product Life Cycle Theory
6. New Trade Theory
7. Porter’s Diamond Theory for competitive advantage
ABSOLUTE ADVANTAGE THEORY
 Adam Smith,’ An Enquiry into the Nature and Causes of the Wealth
of Nations’, 1776.
 In economics, the principle of absolute advantage refers to the
ability of a party (an individual, or firm, or country) to produce a
greater quantity of a good, product, or service than competitors.
 A country with an absolute advantage can sell the good for less than a
country that does not have the absolute advantage.
 In economics, principle of absolute advantage refers to the ability of a
party(an individual, or firm, or country) to produce more of a good or service
than competitors, using the same amount of resources
ABSOLUTE ADVANTAGE THEORY: ASSUMPTIONS
 Two countries (A & B ), both producing two products (X & Y).

 Labour is the only factor of production and its productivity remains
the same.
 Perfect mobility of labour between the sectors within a country.
 No mobility of labour between the countries.
 Assumes perfect competition
 No transportation cost
 No restrictions on the movement of goods between the countries
(free trade).
ACHIEVING ABSOLUTE ADVANTAGE
An absolute advantage is achieved through low-cost production.

In other words, it refers to an individual, company, or country
that can produce at a lower marginal cost. Such an advantage is
established when (compared to competitors):
 Fewer materials are used to produce a product
 Cheaper materials (thus a lower cost) are used to produce a
product
 Fewer hours are needed to produce a product
 Cheaper workers are (in terms of hourly wage) used to produce
a product
ABSOLUTE ADVANTAGE THEORY: LIMITATIONS
 Explains the causes of trade only when both the countries enjoy
absolute advantage in the production of at least one product.
 Country by country differences in specialization.
 Neglected transport cost.
 Theory is based on an assumption that exchange rates are stable
and fixed.
 Deals with labor only and neglects other factors of production.
 Perfect mobility of labor between sectors – labor may be mobile
within the country
COMPARATIVE ADVANTAGE THEORY
 The theory of comparative advantage, first developed by
English economist David Ricardo in 1817, is a theory that refers
to an economy's ability to produce goods and services at a lower
opportunity cost than that of trade partners.
 A comparative advantage gives a company the ability to sell
goods and services at a lower price than its competitors and
realize stronger sales margins.
 Comparative advantage is a fundamental tenet of the argument
that all actors, at all times, can mutually benefit from cooperation
and voluntary trade.
COMPARATIVE ADVANTAGE THEORY:ASSUMPTIONS
 The world consists of two countries.
 Two factors of production: Capital and Labor.
 Labor is the only input.
 Labor can move freely among industries within a country, but is
incapable of moving between nations.
 No transportation costs.
 Both goods uses both factors and the relative factor intensities are
the same for each good in the two countries
COMPARATIVE ADVANTAGE THEORY: LIMITATIONS
 Only two countries engaged in production .

 It has consumptions of just two commodity.
 No consideration for Learning Theory.
 Assumption of Perfect Competition.
 Labor is perfectly mobile between sectors but immobile between
countries.
 Driven only by maximization of production and consumption.
 Thus, there is a deviation from the expected and actual gain from
trade.
ABSOLUTE ADVANTAGE VS COMPARATIVE
ADVANTAGE THEORY
ABSOLUTE ADVANTAGE THEORY COMPARATIVE ADVANTAGE THEORY
 It refers to lowering production cost of a  It refers to lowering the opportunity cost

production of a specific goods in
specific goods in comparison to competitors.
comparison to competitors.
 Countries having absolute advantage of  Countries with comparative advantage
producing a good, produces higher volume of takes into account the production of
that good with the same available resources. multiple goods in country while deciding
 It may not always be mutually beneficial for
the production of a specific good and
both countries the involved in the trade resource allocation for the same.
transaction.
 It may be mutually benefited for both
countries the involved in the trade
transaction because of comparative
advantage each others.

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[Year]

 Exchange of goods and services between countries is called international

To understand the pattern in international trade, Different trade

 Two countries (A & B ), both producing two products (X & Y).

An absolute advantage is achieved through low-cost production.

 Only two countries engaged in production .

ABSOLUTE ADVANTAGE THEORY COMPARATIVE ADVANTAGE THEORY

 It refers to lowering production cost of a  It refers to lowering the opportunity cost

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