The Theory of Absolute Advantage

Adam Smith postulated that each country should specialize in those commodities she can produce at the lower absolute cost than other countries. He made this assertion when he was writing about Division of labour and specialization in international trade in his “Wealth of Nations” in 1776. Adam Smith argued for free trade by comparing nations to households. Since every household finds it prudent to produce only some of its needs and buy others with products it can sell, the same should apply to nations. Adam Smith, assuming a two-good and a two-country world, concluded that trade is mutually beneficial if one nation has an absolute advantage in the production of one good and the other nation has absolute advantage in the production of the second good.

Illustration:

Assume a two-nation (Nigeria and Ghana) two-good (Crude Oil and Cocoa) model. Assume again that only one factor of production (Labour) is used and each nation has the same amount of labour. Now, suppose that each nation devotes half of its limited resources (Labour) to the production of Crude Oil and the other half to the production of Cocoa. The production totals without trade are shown in the table below.

Table 21.1: Production and Consumption Totals before Trade

In Table 21.1, Nigeria produces 20 units of Crude Oil combined with 10 units of cocoa. Ghana, on the other hand, produces 10 units of Crude Oil combined with 20 units of Cocoa. From the table, Nigeria has an absolute advantage in Crude Oil production because, given the same labour resources, more crude oil is produced in Nigeria. Ghana has an absolute advantage in cocoa production because, given the same resources, more cocoa can be produced in Ghana than Nigeria. According to the theory of Absolute Advantage, specialization and trade would be beneficial to Nigeria and Ghana. Nigeria should specialize completely in Crude Oil production while Ghana should specialize completely in cocoa production. The production totals after specialization are depicted in the table below.

Table 21.2: Production and Consumption Totals after specialization

Table 14.2 shows the production totals after specialization. Nigeria now produces 40 units of Crude oil and zero units of Cocoa. Ghana, after specialization, produces zero of Crude oil and 40 units of cocoa. Total world output increased after specialization based on the theory of absolute advantage.

Some of the assumptions underlying the theory of Absolute Advantage are:

1. Factors of production are perfectly mobile within each nation and they can be instantly switched between industries. However, factors are immobile between countries, though final goods and services can be traded.
2. There are constant returns to scale and constant average costs of production in both industries.
3. The limited resources and factors of production in each nation are fully employed.
4. There are no transport costs between the two countries.
5. The theory assumes value in real magnitude entirely different from monetary phenomenon i.e. in units of crude oil and cocoa.