THEORIES OF INTERNATIONAL TRADE: COMPARATIVE ADVANTAGE VS.

ABSOLUTE ADVANTAGE

BAL3.4 Economics-I

Academic Year: 2024 – 25

Semester III

Submitted by:

Teesha Shrivastava

UG23-149

Submitted to:

Mr. Mayur Garud

Assistant Professor of Economics

MAHARASHTRA NATIONAL LAW UNIVERSITY, NAGPUR

RESEARCH DESIGN AND TABLE OF CONTENTS WILL BE HERE.
INTERNATIONAL TRADE THEORIES

International trade theories are frameworks designed to explain the principles governing trade
across borders. Trade is fundamentally the exchange of goods and services between
individuals or entities. When this exchange crosses national boundaries, it becomes
international trade. Entities engage in such exchanges because they anticipate advantages,
such as fulfilling a need or satisfying a desire for certain goods or services. While the concept
may appear straightforward, international trade involves complex theories, policies, and
strategies that shape its practice globally.

To better understand the development of contemporary global trade, it is imperative to

examine how trade between nations evolved over time. Economists have historically devised
theories to explain how global trade functions. These theories are broadly of two types:
classical and modern. Initially, these theories viewed trade from a national or country-based
standpoint, these were known as classical trade theories. However, in the mid-20th century
the focus shifted and new theories emerged to explain trade from the perspective of firms
rather than nations, giving rise to firm-based, modern theories. These two groups, classical
and modern, encompass a variety of theories that collectively enhance our understanding of
international trade.1

In this paper we would be mainly discussing two of the classical international trade theories:
Absolute Advantage theory and Comparative Advantage theory.

EVOLUTION OF INTERNATIONAL TRADE THEORIES

To understand how theories of Absolute and Comparative advantage emerged, we need to

understand how economic thought evolved from mercantilist ideas, which emphasized
national wealth through trade surpluses, towards more liberal views that valued efficiency
and mutual benefits in trade between nations.

MERCANTILISM

Mercantilism developed in the sixteenth century. It represented one of the earliest attempts to
construct an economic theory. According to this theory, a nation's wealth was measured by
the quantity of its gold and silver reserves. Mercantilists argued that a country should try to
increase its gold and silver holdings by encouraging exports and limiting imports. Simply put,
1
Pankaj Kumar Sharma, INTERNATIONAL BUSINESS AND TRADE,
https://dspmuranchi.ac.in/pdf/Blog/INTERNATIONAL%20BUSINESS%20AND%20TRADE%20UNIT-2.pdf
(Visited on October 25,2024).
if other nations buy more goods from you (exports) than they sell to you (imports), they must
compensate you with the difference in gold and silver. Each nation’s goal was to maintain a
trade surplus, meaning the value of exports would exceed the value of imports, while
avoiding a trade deficit, where imports would surpass exports. 2
A closer look at world history from the 1500s to the late 1800s helps explain why
mercantilism flourished. The 1500s marked the rise of new nation-states, whose rulers
wanted to strengthen their nations by building larger armies and national institutions.
By increasing exports and trade, these rulers were able to amass more gold and wealth
for their countries. One way that many of these new nations promoted exports was to
impose restrictions on imports. This strategy is called protectionism and is still used
today.

Nations historically expanded their wealth by exploiting their colonies to control trade and
gather riches (gold and silver). The British colonial empire is a prime example, they tried to
grow their wealth by sourcing raw materials from regions like the Americas and India. Other
nations such as France, the Netherlands, Portugal, and Spain also succeeded in building
expansive colonial empires that generated substantial wealth for their homeland economies.

Although mercantilism is an ancient trade theory, we can still see its use in today’s economic
strategies. Countries like Japan, China, Singapore, Taiwan, and Germany favour exports over
imports by practicing a form of neo-mercantilism. This modern approach combines
protectionist policies, trade restrictions, and subsidies for domestic industries. Virtually every
country, at some stage, has enacted protectionist measures to protect essential industries in its
economy.

Export-focused companies often back protectionist policies that advantage their specific
sectors or businesses; however, these policies tend to negatively impact other industries and
consumers. Government subsidies for certain exports result in higher taxes for taxpayers who
ultimately bear the cost. Restrictions on imports drive up prices, causing consumers to pay
more for foreign-made goods and services. Proponents of free trade emphasize that open
trade benefits all members of the global economy, while the protectionist policies of
mercantilism benefit only selected industries, often at the cost of consumers and other
businesses.3

2
MERCANTILISM, https://www.scribd.com/document/363516425/Mercantilism (Visited on October 26,2024).
3
Supra. at 1.
To combat the challenges of the mercantilist theory, the theory of Absolute trade advantage
emerged.

THEORY OF ABSOLUTE TRADE ADVANTAGE

In 1776, Adam Smith questioned the leading mercantile theory of the time in ‘The
Wealth of Nations’.

Adam Smith is highly regarded as the father of modern economics. Though his work on
international trade theory is not as widely acknowledged, despite this, he was one of the
earliest and most notable proponents of free trade. Smith stands as the first classical
economist to explore both the benefits and direction of free trade. His objective was to
illustrate that free trade along with capitalism in general, was a far more effective system than
the dominant mercantile model of the time, which retained strong ties to its feudal past. 4

When a country or individual is significantly more efficient at producing a particular good

than another country or individual, it is said that they possess an absolute advantage in
producing that particular good.5 “A country is said to absolute advantage over another
country if it uses fewer resources to produce any given good.”

Absolute trade advantage theory emphasizes a nation's capacity to produce a good more
effectively than another. Smith argued that trade between nations should not be controlled or
limited by government policies or interference. He believed trade should occur freely, driven
by market forces. In a hypothetical world with two countries, if Country A could produce a
good at a lower cost or more quickly than Country B, then Country A would hold the
advantage and could concentrate on specializing in the production of that good. Likewise, if
Country B was more efficient at producing another good, it could also focus on that good’s
specialization. Through specialization, countries would create efficiencies, as their workforce
would gain expertise by consistently performing the same tasks. Production would also
become more streamlined, as there would be a strong incentive to develop quicker and more
effective production techniques to enhance specialization.6

For instance, extracting oil in Saudi Arabia is largely a matter of "drilling a hole." In contrast,
producing oil in other nations may involve significant exploration and expensive technologies

4
Reinhard Schumacher, FREE TRADE AND ABSOLUTE AND COMPARATIVE ADVANTAGE, 2012, p. 13.
5
ABSOLUTE AND COMPARATIVE ADVANTAGE,
https://www.shivajicollege.ac.in/sPanel/uploads/econtent/5102deeb71d6bf56ea33c90352cf73dc.pdf. (Visited on
October 26, 2024)
6
Supra. at 1.
for drilling and extraction, if they even have oil resources at all. The United States boasts
some of the most fertile farmland globally, making the cultivation of corn and wheat easier
than in many other countries. Guatemala and Colombia possess climates that are particularly
favourable for growing coffee. Chile and Zambia are home to some of the richest copper
mines in the world. In these cases, these countries hold an absolute advantage in producing
the specified goods. According to Smith, these countries should concentrate on producing the
goods for which they possess this absolute advantage.7

Let us understand this through a numerical example:

Country Table (I unit) Shoes (I unit)

A 4 7
B 8 5
Table 1.1 How many labour hours it takes to produce table and shoes.

Table 1.1 shows the unit cost of production of the two commodities in labour hours.

We can see from the above table that by spending 4 units of labour, country A can produce I
unit of table, whereas country B needs to spend 8 units of labour to produce I unit of table.
Here, tables can be produced more cheaply in Country A. Therefore, country A has absolute
advantage in producing tables. Similarly country B has absolute advantage in producing
Shoes.

According to the absolute advantage theory, country A should utilise its entire labour for
producing Tables, henceforth country A will have surplus production for table. Similarly
country B will have surplus production in shoes. By doing this, the world production of shoes
and table would also increase. Country A can export tables in return of shoes from country B
or vice-versa. There would be an increase in supply, which will lead to more affordable prices
and will ultimately lead to increased welfare of both the countries.

LIMITATIONS OF ABSOLUTE ADVANTAGE THEORY

 Labor is considered the only relevant factor of production, meaning other factors such
as capital, land, and entrepreneurship are not considered in this theory.

7
Erik Dean, et al., PRINCIPLES OF ECONOMICS: SCARCITY AND SOCIAL PROVISIONING, 2nd ed.
2016.
  It focuses solely on bilateral trade, implying trade of only 2 commodities between two
countries at a time, which limits the scope of its application in the real-world context
where multiple countries trade simultaneously.
 The theory assumes that factors of production are homogeneous, meaning that they
are interchangeable and identical across different industries, which does not reflect the
actual diversity of skills and resources available in various sectors.
 Additionally, it assumes that factors of production cannot move between countries.
This exclusion disregards the potential for migration or the presence of multinational
companies, which facilitate the movement of labour and capital across borders in
today’s globalized world.
 It also assumes that there are no barriers to trade in goods, which overlooks the
influence of tariffs, quotas, and other trade restrictions that can significantly impact
global trade.
 If a country only produces the goods in which it has an absolute advantage, this could
lead to a heavy dependence on other nations for essential goods, including those
critical to its survival and economic stability.
 Lastly, there’s a possibility that a country might not have an absolute advantage in
producing any of the goods. In such a scenario, question arises as to how such a
country should engage in trade and whether it could still benefit from it in any
meaningful way?8

COMPARARIVE TRADE ADVANTAGE

As discussed above, one of the biggest limitations of absolute advantage theory was that what
if a country has no absolute advantage in producing any of the goods? To put in other way,
what if one country has absolute advantage over both the products? What about the other
country?

To deal with this issue, David Ricardo came up with the ‘Comparative Advantage’ theory.
Comparative advantage refers to an economy's ability to produce a specific good or service at
a lower opportunity cost than its trading partners. In the context of international trade, it
highlights the products that a country can produce more cheaply or efficiently than other
countries.

8
Supra at 5.
This theory suggests that countries can gain from trading by specializing in producing the
goods they are most efficient at making, while purchasing goods they are less efficient at
producing from other nations. It is founded on the concept that each country has distinct cost
structures and opportunity costs (cost of the next best alternative forgone). By concentrating
on their areas of strength, countries can produce more efficiently. Ricardo’s research showed
that even if one country is more efficient in producing every good compared to another,
international trade can still be both possible and advantageous.9

Comparative advantage arises when a country cannot produce a product more efficiently than
another, but it can produce that product more efficiently than it does other goods. The
difference between comparative and absolute advantage is subtle: comparative advantage
focuses on relative productivity differences, while absolute advantage looks at overall
productivity.

Let us consider a simplified hypothetical example to highlight the distinction between the two
principles. Miranda is a Wall Street lawyer who charges ₹700 per hour for her legal services.
It turns out that Miranda types faster than the administrative assistants in her office, who are
paid ₹200 per hour. Despite having an absolute advantage in both legal work and typing,
should she do both tasks? No. For every hour she spends typing instead of practicing law, she
sacrifices ₹500 in potential income. Her productivity and income will be highest if she
specializes in legal services and hires the most qualified administrative assistant, who may
type a bit slower but is still highly capable. By having both Miranda and her assistant focus
on their respective tasks, their overall productivity as a team increases. This is comparative
advantage, in which one does a task they are relatively better in.10

Examples of country with comparative advantage:

Oil-producing countries have a comparative advantage in producing chemicals because their

locally sourced oil offers a cheap raw material for chemical production, making it more cost-
effective compared to countries that lack such resources. For example, nations like Saudi
Arabia, Kuwait, and Mexico produce and provide low-cost chemicals with a low opportunity
cost.

Another example is India’s call centres. U.S. companies often outsource this service to India
because it is more affordable than establishing call centres in the United States.
9
Montevirgen Karl, COMPARATIVE ADVANTAGE, https://www.britannica.com/money/comparative-
advantage (Visited on October 28, 2024).
10
Supra. at 1.
Let us understand this using a numerical example:

Country Table (I unit) Shoes (I unit)

A 5 10
B 20 20
Table 1.1 How many labour hours it takes to produce table and shoes.

Here we can see country B has absolute cost advantage in both the products.

But let us take a look at the opportunity cost of the following goods:

In country A:

Opportunity cost of producing 1 unit table is – 2 shoes

Opportunity cost of producing 1 unit of shoes is – 0.5 table

In country B:

Opportunity cost of producing 1 unit of table is – 1 shoe

Opportunity cost of producing 1 unit of shoes is – 1 table

Here we can see that country B has absolute cost advantage in producing both the goods, but
according to the comparative trade advantage theory, a country should focus on producing the
goods with lower opportunity cost. In the given scenario, country A has a lower opportunity
cost in producing shoes and hence has a comparative advantage in producing shoes. Whereas
country B has a lower opportunity cost in producing tables and hence has a comparative
advantage in producing the same.

Country A and B can engage in exchange of books and shoes to fulfil their respective
demands, Additionally, both countries would have a surplus in the production of their
specialized goods, which could boost consumption levels, as the increased supply may lead to
lower, more affordable prices, ultimately enhancing overall welfare. Alternatively, the surplus
goods can be exported to other countries, generating additional revenue. Ultimately, each
country benefits by specializing in the production of the good in which it has a comparative
advantage, allowing them to trade and mutually improve their overall economic efficiency
and resource allocation.
LIMITATIONS OF COMPARATIVE TRADE ADVANTAGE THEORY

The comparative advantage theory, while more nuanced than the absolute advantage theory,
inherits several of its limitations. For instance, both theories are grounded in the concept of
bilateral trade, which assumes that trade takes place exclusively between two countries and
only for 2 commodities.

Another limitation lies in the assumption of homogeneous labour, labour is considered to be

immobile within different industries or countries.

Furthermore, comparative advantage theory also considers labour as the only factor of
production, overlooking the role of capital, technology, and other resources that contribute to
production efficiency.

Finally, the theory's acceptance of dependence on other countries for essential commodities
presents another drawback.

In essence, while comparative advantage theory adds depth to the understanding of

international trade, there are still many limitations that reveal the need for more
comprehensive models that better reflect the diverse factors influencing trade and production
in the modern world.11

11
Indu Kumari, COMPARATIVE COST THEORY OF INTERNATIONAL TRADE,
https://bncollegebgp.ac.in/wp-content/uploads/2020/05/comparetive-cost-theory-of-international-Trade.pdf
(Visited on November 3, 2024).