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Adam Smith’s International Trade Theory of Absolute
cost advantage
Adam Smith, the Scottish economist observed some drawbacks of existing Mercantilism Theory of International trade and he proposed a new theory i.e. Absolute Cost Advantage theory of International trade to remove drawbacks and to increase trade between countries.
Drawbacks of Mercantilism theory Adam Smith observed following drawbacks of Mercantilism and Neo-mercantilism theory.
- Mercantilism weakens a country.
- Restriction on Free Trade decreases country’s wealth
Adam Smith’s Theory (1776)
- This theory is based on principle of division of labour
(division of labor the separation of a work process into a number of tasks, with each task performed by a separate person or group of persons.)
- Free trade among countries can increase a country’s wealth.
- Free trade enables a country to provide a variety of goods and services to its people by specializing in the production of some goods and services and importing others.
- Every country should specialize in producing those products at the cost less than that of other countries and exchange these products with other products produced cheaply by other countries.
- When one country produces one product at less cost and another country produces another product at less cost, both can exchange required quantity and can enjoy benefit of absolute cost advantage.
Advantage of Skilled labor and specialization
- ABSOLUTE COST ADVANTAGE: Reasons for Absolute Cost Advantage A. SPECIALIZATION: Specialization of labour leads to higher productivity and less labour cost per unit of output
B. SUITABILITY: Suitability of the skill of the labour of the country in producing certain products
C. ECONOMIES OF SCALE: Economies of scale helps to reduce the labour cost per unit of output.
2. NATURAL ADVANTAGE
Climatic conditions
Natural resources
Example: Indian Climate- Production of Rice, Wheat, Sweet Mangoes, Grapes, Tea, Coconuts, Cashew nuts, Cotton etc.
Sri Lanka: Production of Tea, Rubber
USA: Production of Wheat
- ACQUIRED ADVANTAGE Technology
Skill development
Examples: Japan: advantages in steel production through the imports of both iron and coal (Labor saving and material saving technology)
England: production of textiles,
France: Wine
Assumptions of the Theory Trade is between two countries
Only two commodities are traded
Free Trade exists between the countries
The only element of cost of production is labor
Implications (Significance) of Absolute Advantage Theory
- More quantity of both products
- Increased standards of living of both countries
- Increased production efficiency
- Increase in global efficiency and effectiveness
- Maximization of Global productivity and other resources productivity
Government therefore thought that in order to increase the wealth of nations it was important to encourage exports and discourage imports. This was the Mercantilist thought on International Trade.
Criticisms – It was pointed out that with the above logic, a nation will never be able to perpetually increase its wealth –
An increase in exports would lead to inflow of gold. In a Gold standard this would lead to an
increase in money supply. An increase in Money supply would lead to inflation.
Due to inflation exports would become costlier and hence non- competitive. On the other hand
people would prefer imported goods as they would be cheaper compared to domestic goods.
This would lead to fall in exports and rise in imports and thus an outflow of Gold – thereby
reversing the cycle.
Critics therefore pointed out that y the mercantilist logic the country would keep oscillating
between being a bullion surplus and a bullion deficit country.
This is not observed in real life. Therefore a revision was necessary in the understanding of International Trade.
Comparative cost theory of international trade
This theory is developed by a classical economist David Ricardo. According to this theory, the international trade between two countries is possible only if each of them has absolute or comparative cost advantage in the production of at least one commodity. This theory is based upon following assumption
- There are only two countries and two commodities
- There is no governmental intervention in export and import
- Only labor is factor of production. Quantity of labor used gives cost of production
- There is perfect mobility of labor within the country but not between the countries
- There is no cost of transportation between the countries
- The law of constant returns to scale operates in production.
- The units of labor is homogeneous
- The units of each commodity in both countries are homogeneous
Complimentary trade theory, Stolper–Samuelson
theorem
It describes the relationship between relative prices of output and relative factor rewards— specifically, real wages and real returns to capital.
The theorem states that—under specific economic assumptions (constant returns, perfect competition, equality of the number of factors to the number of products)—a rise in the relative price of a good will lead to a rise in the return to that factor which is used most intensively in the production of the good, and conversely, to a fall in the return to the other factor.
The Stolper-Samuelson theorem demonstrates how changes in output prices affect the prices of the factors when positive production and zero economic profit are maintained in each industry. It is useful in analyzing the effects on factor income, either when countries move from autarky to free trade or when tariffs or other government regulations are imposed within the context of a H-O model.
Derivation
Considering a two-good economy that produces only wheat and cloth, with labour and land being the only factors of production, wheat a land-intensive industry and cloth a labour-intensive one, and assuming that the price of each product equals its marginal cost, the theorem can be derived.
The price of cloth should be:
(1)
with P ( C ) standing for the price of cloth, r standing for rent paid to landowners, w for wage levels and a and b respectively standing for the amount of land and labour used.
Similarly, the price of wheat would be:
(2)
with P ( W ) standing for the price of wheat, r and w for rent and wages, and c and d for the respective amount of land and labour used.
If, then, cloth experiences a rise in its price, at least one of its factors must also become more expensive, for equation 1 to hold true, since the relative amounts of labour and land are not affected by changing prices. It can be assumed that it would be labour—the factor that is intensively used in the production of cloth—that would rise.
