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Theory of absolute
advantage
In 1776, ADAM SMITH
Theory of absolute
advantage
Absolute Advantage
An Absolute Advantage exists if one
Example 1
Country A
Country B
Super comp.
10 hrs of
labour
15 hrs of
labour
Aircraft
20 hrs of
labour
10 hrs of
labour
1 S
produces
Germany
5 S
produces
So, Germany can
produce more
steel for equal
sacrifices of food.
1F
1F
Produces:
20
S+1F
TOTAL OUT PUT=
22 S + 3F = 25
units (tons)
Argentina
Produces:
2S
+ 2F
Suppose each
nation decides to
specialize:
Germany only
Steel, Argentina
only food.
Germany
Argentina
produces= 40 S +
0F
TOTAL OUT PUT
= 40 S + 4 F = 44
UNITS (tons)
produces= 0 S + 4
F
By specializing
according to
absolute
advantage the
increase in total is
19 tons, but it
masks the reason
why nations trade.
Theory of comparative
advantage
In 1817, DAVID
theory.
Opportunity Cost
The decision to produce any goods or service has an
Theory of comparative
advantage
Says, trade is possible as long as the
Principle of Comparative
Adv.
Nations can increase output by producing those
Produces: 20 S +
4F
2S+2F
Germanys greater
TOTAL OUT PUT= 22
comparative adv. is
S + 6 F= 28 tons
steel and Argentinas
smallest comparative
disadvantage is food.
When nations
specialize in the product of their comparative
advantage and have increasing opportunity
cost, they go in for international trade.
Country B
1 unit of steel
5 lab hrs
15 lab hrs
1 unit of cement
10 lab hrs
20 lab hrs
Country B
Steel
120 units
40 units
Cement
60 units
30 units
Lessons:
A should produce steel.
B should produce cement
Two countries can benefit by trading with
Demand lag
Demand lag is the difference between the
Imitation lag
Imitation lag is the difference between the
Lessons:
If imitation lag is less than demand lag,
Different stages:
In the first stage, the product is producted
I. Tariff barriers
Import duty
Export duty
Transit duty
Advantages of International
Trade
Additional output from the exchange of goods
Income levels & living standards go up through
CULTURAL DYNAMICS:
UNITED STATES: People and