Economics · Ch 7 — International Economics
Theories of International Trade — Absolute and Comparative Cost Advantage
Theories of International Trade — Absolute and Comparative Cost Advantage
Absolute Cost Advantage (Adam Smith): a country has an absolute advantage in a good if it can produce that good using fewer resources (or less labour time) than another country. Smith argued each country should specialise in the good(s) where it has an absolute advantage, and trade for the rest — both countries gain since each avoids producing goods it makes inefficiently.
Comparative Cost Advantage (David Ricardo): Smith's theory leaves an important case unanswered — what if one country is absolutely MORE efficient at producing every good than the other? Ricardo showed that mutually beneficial trade is still possible in this case, provided each country specialises in the good where its relative (opportunity-cost) advantage is greatest, even if it holds no absolute advantage at all.
Worked illustration (labour hours needed per unit):
| Cloth (per unit) | Wheat (per unit) | |
|---|---|---|
| India | 4 hours | 2 hours |
| Country B | 6 hours | 5 hours |
India needs fewer hours for BOTH goods — so India has an absolute advantage in both, and by Smith's theory alone, there would seem to be no basis for trade (Country B looks inefficient at everything). But look at the opportunity cost of each good in each country:
- Opportunity cost of 1 unit Cloth = (hours for Cloth) ÷ (hours for Wheat)
- India: 4 ÷ 2 = 2 units of Wheat given up per unit of Cloth
- Country B: 6 ÷ 5 = 1.2 units of Wheat given up per unit of Cloth
- Opportunity cost of 1 unit Wheat = (hours for Wheat) ÷ (hours for Cloth)
- India: 2 ÷ 4 = 0.5 units of Cloth given up per unit of Wheat
- Country B: 5 ÷ 6 ≈ 0.83 units of Cloth given up per unit of Wheat …