Theories of international trade Theories of Absolute Advantage Theories of Comparative Advantage Trade Country A vs Country B

2. 2
• Theory of Absolute advantage
• Theory of Comparative advantage

3. 3
• Adam Smith and David Ricardo gave the
classical theories of international trade.
• According to the theories given by them, when
a country enters in foreign trade, it benefits
from specialization and efficient resource
allocation.

4. 4
• There are two countries producing two goods.
• The size of economies of these countries is
equal.
• There is perfect mobility of factors of
production within countries.
• Transportation cost is ignored.
• Before specialization, country’s resources are
equally divided to produce each good.

5. 5
• In response to Mercantilism, Adam Smith
offered his own theory of Absolute Advantage.
• This theory believed that a nation should
specialize in producing those goods that it can
produce at a cheaper cost than that of other
nations.
• These goods should be exchanged with other
goods that are being cheaply produced by the
other nations.

6. 6
• Country A has absolute advantage in
producing tea as it can produce 1 ton of tea
by using less laborers as compared to
country B.
• On the other hand, country B has absolute
advantage in producing coffee as it can
produce 1 ton of coffee by employing less
laborers in comparison to country A.
Country A
(Labor )
Country B
(Labor )
Tea 10 25
Coffee 20 5

7. 7
• There is no trade between these countries and
resources (in this case there are total 200
laborers) are being used equally to produce tea
and coffee, country A would produce 10 tons
of tea and 5 tons of coffee and country B
would produce 4 tons of tea and 20 tons of
coffee.
• Thus, total production without trade is 39 tons
(14 tons of tea and 25 tons of coffee).
Country A
(in tons)
Country B
(in tons)
Tea 10 4
Coffee 5 20

8. 8
• If both the countries trade with each other and
specialize in goods in which they have absolute
advantage, the total production would be higher.
• Country A would produce 20 tons of tea with
200 units of laborers; whereas, country B
would produce 40 tons of coffee with 200 units
of laborers.
• Thus, total production would be 60 units (20
tons of tea and 40 tons of coffee).
Country A
(in tons)
Country B
(in tons)
Tea 20 0
Coffee 0 40

9. 9
• Absolute Cost Advantage -
• Absolute Cost Advantage will exist because
of specialization of labor that would in turn
lead to higher productivity and less cost
of labor.
• Economies of Scale will also exist as one
country would produce one type of goods
at a large scale. This will significantly
reduce the cost of the goods.

10. 10
• Natural Advantage – A country would produce
those goods that are naturally favoring its
climatic conditions.
• The type of goods produced would also depend
upon the availability of natural resources.
• Presence of plenty of natural resources would
significantly provide advantage to such a
country while producing the goods.

11. 11
• Acquired Advantage – This would include
advantage in technology and level of skill
development.

12. 12
• This theory assumed that only bilateral trade
could take place between the nations and only
in two commodities that are to be
exchanged. This assumption was significantly
challenged when the trade as well as needs
of a nation started increasing. Thus this
theory did not take into account the multi-
lateral trade that could take place between the
countries.

13. 13
• This theory also assumed that free trade
exists between the nations. It did not take
into account that protectionist measures that
are adopted by the nations. These protectionist
measures were in many forms and included
quantitative restrictions, technical barriers
to trade, and restrictions on trade on
account of environment protection or
public policy.

14. 14
• Another criticism of this theory is that it
considered labor as the only cost of
production in manufacturing goods. It
neglected other significant elements like
transportation costs, technological costs
etc. Also, it became hard for countries to have
absolute advantage for many products.

15. 15
• In 1817, famous Economist, David Ricardo
introduced his theory of Comparative
Advantage.
• As per this theory if a country had absolute
advantage in two or more products or in no
product, specialization and trade could still
occur between the countries.

16. 16
• As per this theory, Comparative Advantage
exists when a country is able to produce a
commodity better and more efficiently than
it does other commodities.
• This theory focuses on the relative
productivity difference, whereas Absolute
Advantage theory focused only on absolute
productivity.

17. 17
• Suppose there are two countries A and B,
producing two commodities Tea and Coffee
with labor as the only factor of production.
• Now assume that both the countries have 200
laborers and they use 100 laborers to
produce Tea and 100 laborers to produce
Coffee .
Country A
(in tons)
Country B
(in tons)
Tea 20 15
Coffee 40 10

18. 18
• Country A can produce 20 units; whereas,
country B can produce 15 units of Tea by
using 100 laborers.
• In addition, country A can produce 40 units;
whereas, country’ B can produce 10 units of
Coffee by employing 100 laborers.
Country A
(in tons)
Country B
(in tons)
Tea 20 15
Coffee 40 10

19. 19
• Country A has absolute advantage in
producing both the products. As already
discussed, country A employs same number of
laborers (100 laborers in production of each
good) in producing both tea and coffee; however,
the production of coffee is more than the
production of tea.
• Country A has comparative advantage in
producing coffee.
Country A
(in tons)
Country B
(in tons)
Tea 20 15
Coffee 40 10

20. 20
• Country B also employs same number of
laborers (100 laborers in production of each
good) in producing tea and coffee; however,
its production of tea is more than the
coffee.
• It indicates that country B has comparative
advantage in producing tea.
Country A
(in tons)
Country B
(in tons)
Tea 20 15
Coffee 40 10

21. 21
• Country A has decided to produce 60 units
of coffee by employing 150 laborers.
• It uses 50 laborers to produce 10 units of tea.
• On the other hand, country B has decided to
use all the 200 laborers to produce 30 units
of tea.
• It would not produce any unit of coffee.
Country A
(in tons)
Country B
(in tons)
Tea 10 30
Coffee 60 0

22. 22
• Now, country A exchanges 14 units of tea
with 14 units of coffee produced by country
B.
• Both the countries have gained from trade.
• Before trade, country A has 20 units of tea
and 40 units of coffee; however, after trade,
country A has 24 units of tea and 46 units of
coffee.
Country A
(in tons)
Country B
(in tons)
Tea 24 16
Coffee 46 14

23. 23
• On the other hand, country B has 15 units of
tea and 10 units of coffee before trade;
however, it has 16 units of tea and 14 units of
coffee after trade.
• Therefore, comparative advantage explains that
trade can create benefit for both the countries
even if one country has absolute advantage in
the production of both the goods.
Country A
(in tons)
Country B
(in tons)
Tea 24 16
Coffee 46 14

24. 24
• This theory demonstrates that trade between
two countries is possible even when a country
is able to produce all its goods at a cheaper
cost than other countries. This is possible
when the cost advantage is comparatively
more in some goods than in the others. The
country is compensated more by focusing its
skill and knowledge on producing those goods
in which it has a better cost advantage.

25. 25
• This theory also has the potential to
incorporate costs other than labour. Thus it
can take more complex situations into account
than the absolute advantage theory.
• It also takes into account the ‘Opportunity Cost’
of producing the goods. A lower opportunity
cost than another country would signify
comparative advantage available to a
particular country.

26. 26
• This theory assumes that the internal
economies of countries are competitive.
However, this is not true. Most of the countries
have industries that are monopolistic in
nature.
• This theory also assumes the existence of
constant returns. This is quite utopian as
change in availability of resources and other
such dimensions directly affect the economic
structure of a country.

27. 27
• This theory like Absolute Advantage again
assumes existence of free trade between the
countries. It fails to take into account factors
like quantitative restrictions, public policy,
protectionist measures, export subsidies
etc.