Topic 4

Theory of Absolute Advantages

This theory was established by Adam Smith in 1776. In this theory he said, since different countries are
efficient in producing different products so the countries should export only those products that they are
efficient in producing and they should import those products that they cannot produce efficiently.

Costa Rica America

Coffee (efficient) Coffee (inefficient)
Wheat (inefficient) Wheat (efficient)
According to this theory of A7YUUYUJUUUUUUUUUUdam Smith, Costa Rica will only produce coffee
and export to America because America is inefficient in producing coffee and Costa Rica should import wheat
from America because America is efficient in producing wheat but Costa Rica is not.

Arguments in favor of Absolute advantage theory:

Labor could be more skilled because of doing the same work again and again.
Labor would not lose time in switching from one task to another task.
It would provide incentives for the development of more effective working method.

Arguments against Absolute advantage theory:

There are no central institutions that can decide which country should export which product and
import which product.
The amount of imports will be greater than exports
It is not possible to produce only few products and imports all other products.
What if a country has no absolute advantage?
 Theory of Comparative Advantages
This theory was established by David Ricardo in 1817. He said that any country can produce a product
more efficiently than others so they should produce it and export it to other countries.

Costa Rica America

Coffee (efficient)
Wheat (inefficient)
- 100 units resource
- 10 units to produce a ton of wheat
- 10 units to produce a ton of coffee.
Coffee (inefficient)
Wheat (efficient)
- 100 units resource
- 4 units to produce a ton of wheat
- 5 units to produce a ton of coffee

Comparison between trading and without trading:

Without Trade: when there is no foreign trade, each country gets half of its resources for each product. Costa-
Rica can produce 5 tons of coffee (50/10) and 5 tons of wheat (50/10) whereas, America can produce 10 tons of
coffee (50/5) and 12.5 tons of wheat (50/4). So total 15 tons of coffee produced (10+5) and 17.5 tons of wheat
(12.5+5).

With Trade:

Let the combined production of wheat is unexchanged, America will alone produce the total 17.5 tons of wheat
by using 70 units (17.5x4) and with the remaining 30 units America will produce 6 tons of coffee (30/5). On
the other hand Costa-Rica will use its total resource to produce coffee which is 10 tons (100/10). So the
combined production of wheat may remain same but the coffee production has increased by 1 ton.

Let the combined production of coffee is unexchanged, Costa-Rica will produce 10 tons of coffee with all of its
resources (100/10) and the remaining 5 tons will be produced by America using 25 units (5x5). The remaining
75 units will be used to produce wheat, so they can produce a total of 18.75 tons of wheat (75/4). Again, the
combined production of coffee may remain same but the production of wheat has been increased by 1.25 tons.