Absolute advantage theory

 Adam Smith proposed the theory of absolute advantage

 He showed that how all countries would be better off without making anyone worse off.
 Smith’s model of world trade is one of harmony of interest among countries where free trade,
like honesty, would come out as the best policy for al.

Assumption of Smith’s Absolute advantage theory:

1. Imagine a world of only two countries and two commodities. Malaysia and Indira re the two
countries and Rubber and Textiles are the two commodities.
2. Production of these two goods in two countries are constant returns to scale. That is, there are
constant marginal opportunity cost conditions in both the countries in respect of both the
goods.
3. Both countries can produce both the goods if they wish.
4. Both countries are endowed with “X” factors of production.

For example, With “X” Factors of production, Malaysia can produce either 100 units of rubber or 50
units of textiles, or any other mix of rubber and textiles, conditioned by opportunity cost ratio of 2:1.

Alternatively, with “X” factor so production India can produce either 50 Units of Rubber or 100 Units of
textiles, or some other combination of rubber and textiles subject to the opportunity cost ratio of 1:2.

From the above production possibilities (or Supply Conditions), it is evident that Malaysia has an
absolute advantage in Rubber production and India has absolute advantage in textile production. This
means that there is symmetrical factor distribution between the two countries so that there is scope for
specialization in production and also a scope for establishing mutually beneficial trade between two
countries. Let us see what happens.

First, in a situation of autarky or no trade between two countries, each country can produce and
consume independent of the other country, a combination of rubber and textiles as shown in the
following table:

Table I: Production and consumption levels with zero trade

Countries Rubber Textiles Total output or GNP

(Units)
Malaysia 50 25 75
India 25 50 75
World 75 75 150
Second, when the two countries open their economies to foreign trade. Opening up of trade gives the
two countries an opportunity to specialize in production.

Malaysia would specialize in rubber and India would specialize in textiles.

Table II: Production levels after international trade

Countries Rubber Textiles Total output or GNP

(Units)
Malaysia 100 0 100
India 0 100 100
World 100 100 200

As a result of trade, you will notice, the GNP in the two countries went up; means that both countries
became richer after trade as compared to before trade. World GNP also increased from 150 units to 200
units.

Now, what about consumption gain?? Have the consumers in the two countries been happier as a result
of their countries becoming richer and more specialized in terms of production??

This depends on how the gains from production are distributed between two countries. In other words,
the consumption gains to the two countries depend upon the terms of trade I,e. how many units or
rubber exchange for one unit of textiles between India and Malaysia.

1. Suppose the terms of trade are fixed at 1:1

Table III: Consumption shares after international trade

Countries Rubber Textiles Total output or GNP

(Units)
Malaysia 60 40 100
India 40 60 100
World 100 100 200

Both countries consumption gain is 25 units compare to before trade (see table I)

2. Let us assume that international terms of trade are 2:1 (two units of rubber are exchanged for 1
units of textiles in the international market.).

Table IV: Consumption shares after international trade

Countries Rubber Textiles Total output or GNP

(Units)
Malaysia 50 25 75
India 50 75 125
World 100 100 200
Here, Malaysia’s consumption of rubber and textiles, before or after trade remained the same, though
Malaysia has 25 units production gain.