International Finance

International Finance

Absolute advantage

In 1776, Adam Smith, father of modern economics developed the concept of absolute advantage. According to him all nations can gain simultaneously if they carry out free trade and focus in accordance with their absolute advantage. In other words, a country should export those goods and services in which it is efficient or more productive whereas, it should import those goods and services in which other countries are more efficient or productive.

 

Country A

Country B

Product A (units/hour)

6

1

Product B (units/hour)

4

5

Specialization and distribution of labour occupy a major place in Smith's model. Above table shows how the labour distribution should be, as the country A has an absolute advantage in manufacturing product A and country B has an absolute advantage in manufacturing product B. According to Smith's theory, country A should produce a product A and country B should produce product B. Both the countries would gain if they export their specialized product.

If they trade 6A for 6B, then the gain of the country A is ½ hour's work, which is required to produce the additional 2B that it is importing through trade with country B. Because country B halts the production of product A, the 6A it imports from country A will save six hours of labour time with which 30 additional units of B can be produced. After trading 6B out of 30B, country B is left with 24B, which is almost equivalent to five labour hours' time. The countries can produce a number of goods of their absolute advantage with the labour time they save through international trade.

Comparative Advantage

In 1817, David Ricardo proposed the theory of comparative advantage, which is determined, not by absolute values of labour output but by labour output ratios. The theory states that the country should produce and export those goods and services in which it is comparatively more efficient than the other countries where as, it should import those goods and services in which other countries are comparatively more efficient or productive. Comparative advantage incorporates the idea of opportunity cost, value of what is given up to get the good.

The basis of labour efficiency ratios comes from Ricardo's labour theory of value. According to Ricardo, the lone source of value is the labour and all the other factors of production are also produced by labour. So, the value (V) of a commodity is equal to the rate of wage (W) times the labour (L) spent in production, divided by output (Q) as profit is zero in a competitive market. V= (WL)/Q because the average output of labour is A=Q/L, V=W/A. If the labour market is competitive then the rate of wage paid to the labours will be same in all industries. Therefore, the ratio between the value of product A (VA) and the value of product B (VB) will be equal to the ratio between average output of labour in product B (AB) and average output of labour in product A (AA).

[VA/VB] = [AB/AA]

This makes a direct connection between comparative advantage and relative ...