Theory of Absolute Cost Advantage

Theory of Absolute Cost Advantage

MERCANTILISTS' VERSION

Mercantilism stretched over nearly three centuries, ending in the last quarter of the eighteenth century. It was the period when the nation-states were consolidating in Europe. For the purpose of consolidation, they required gold that could best be accumulated through trade surplus. In order to achieved trade surplus, their governments monopolized trade activities, provided subsidies and other incentives for export, and restricted imports. Since most European countries were colonial powers, they imported low cost raw material from their colonies and exported high cost manufactured goods to the colonies. They also prevented colonies from producing manufacturing. All this was done in order to generate export augmentation and import restriction lay at the root of the mercantilist theory of international trade. However, the later versions of the mercantilist doctrine explained that trade surplus was not an overlasting phenomenon. A positive trade balance led to an increase in the commodity prices relative to other countries. The increase in commodity prices caused a drop in export and, thereby, erosion in the surplus of the trade balance. Moreover, the exponents of this theory ignored the concept of production efficiency through specialization. In fact, it is production efficiency that brings in gains from trade (Heckscher, 1935).

CLASSICAL APPROACH

Classical economists refuted the mercantilist notion of precious metals and specie being the source of wealth. They thought domestic production was the prime source of wealth; and thereby assumed productive efficiency to be the motivating factor behind trade. Two of the classical theories need to be mentioned here: one propounded by Adam Smith and the other propounded by David Ricardo.

Theory of Absolute Cost Advantage

Adam Smith was one of the forerunners of the classical school of thought. He propounded a theory of international trade in 1779, which is known as the theory of absolute cost advantages. He was of the opinion that productive efficiency differed among different countries because of diversity in the natural and acquired resourced possessed by them. The difference in natural advantages manifests in varying climate, quality of land, availability of minerals, water and other natural resources; while the difference in acquired resources manifests in different levels of technology and skills available. A particular country should specialize in producing only those goods that it is able to produce with greater efficiency that is at lower cost; and exchange those goods with other goods of their requirement from a country that produces those other goods with greater efficiency, or at lower cost. This will lead to optimal utilization of resources in both the countries. Both countries will gain from trade insofar as both of them will get the two sets of goods at the least cost.

Adam Smith explains the concept of absolute advantages in a two-commodity, two-country framework. Suppose Bangladesh produces one kilogram of rice with 10 units of labour or it produces one kilogram of wheat with 20 units of labour. On the other hand, Pakistan produces the same amount of rice with 20 units of labour and produces the same amount of wheat with 10 units of labour. Each of the countries has 100 units of labour. Equal amount of labour is used for the production of two goods in the absence of trade between the two countries.

In the absence of trade, Bangladesh will be able to produce 5 kilogram of rice and 2.5 kilogram of wheat. At the same time, Pakistan will produce 5 kilogram of wheat and 2.5 kilogram of rice. But when trade is possible between the two countries, Bangladesh will produce only rice and exchange a part of the rice output with wheat with Pakistan. Pakistan will produce only wheat and exchange a part of the wheat output with rice from Bangladesh. The total output in both the countries will rise because of trade. Bangladesh, which was producing 7.5 kilogram of food grains in the absence of trade, will now produce 10 kilogram of food grains. Similarly in Pakistan 10 kilogram of food grains will be produced instead of 7.5 kilogram.

The theory of absolute cost advantage explains how trade helps increase the total output in the two countries. But it fails to explain whether trade will exist if any of the two countries produces both of goods at lower cost. In fact, this was the deficiency of this theory, which led David Ricardo to formulate the theory of comparative cost advantage (Haberler, 1950).

Theory of Absolute Cost Advantage

Amount of Production in Absence of Trade Amount of Production after Trade

Rice Wheat Rice Wheat

Bangladesh

Pakistan

Total output in two countries: 5 kg

2.5 kg

15 kg 2.5 kg

5 kg Bangladesh

Pakistan

Total output in two countries: 10 kg

Nil

20 kg Nil

10 kg

Theory of Comparative Cost Advantage

Ricardo focuses not on absolute efficiency but on relative efficiency of the countries for producing goods. This is why his theory is known as the theory of comparative cost advantage. In a two-country, two-commodity model, he explains that a country will produce only that product which it is above to produce more efficiently.

Suppose Bangladesh and India, each of the two has 100 units of labour. One half of the labour force is used for the production of rise and the other half is used for the production of wheat in the absence of trade. In Bangladesh, 10 units of labour are required to produce either one kilogram of rice one kilogram of wheat. On the contrary, in India, 5 units of labour are required to produce one kilogram of wheat and 8 units of labour are required for producing kilogram of rice. If one looks at this situation from the viewpoint of absolute cost advantage, there will be no trade as India possesses absolute cost advantages in the production of both commodities. But Ricardo is of the view that from the viewpoint of comparative cost advantages, these will be trade because