BBA SEM 5 [ABSOLUTE ADAVNTAGE TRADE THEORY]

According to Adam Smith, who is regarded as the father of modern economics, countries should
only produce goods that they have an absolute advantage in.
A country is said to have an absolute advantage if the country can produce a good at a lower cost
than another. Furthermore, this means that fewer resources are needed to provide the same
amount of goods as compared to the other country. This efficiency in production creates “an
absolute advantage,” which allows for beneficial trade.

Assumptions in Absolute Advantage

1. Lack of Mobility for Factors of Production

Adam Smith assumes that factors of production cannot move between countries.
This assumption also implies that the Production Possibility Frontier of each country will not
change after the trade.

2. Trade Barriers
There are no barriers to trade for the exchange of good. Governments implement trade barriers to
restrict or discourage the importation or exportation of a particular good.

3. Trade Balance
Smith assumes that exports must be equal to imports. This assumption means that we cannot
have trade imbalances, trade deficits or surpluses. A trade imbalance occurs when exports are
higher than imports or vice versa.

4. Constant Returns to Scale

Adam Smith assumes that we will get constant returns as production scales, meaning there are
no economies of scale. For example, if it takes 2 hours to make one loaf of bread in country A,
then it should take 4 hours to produce two loaves of bread. Consequently, it would take 8 hours
to produce four loaves of bread.
However, if there were economies of scale, then it would become cheaper for countries to keep
producing the same good as it produced more of the same good.

Example of Absolute Advantage

In our Absolute Advantage example, we assume that there are two countries, which are
represented by a blue and red line, Blue Country and
Red Country respectively.
To keep things simple, we also assume that only two
goods are produced, Good A and Good B. From the
table below, we can determine how many hours it takes
to create one product.
Consider this table, which gives hours required to
produce one unit of Good A and Good B by Blue and
Red country:

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 BBA SEM 5 [ABSOLUTE ADAVNTAGE TRADE THEORY]

The Blue country has an Absolute Advantage in the production of Good A (2 hours). Blue
County has an absolute advantage because it takes fewer hours to produce a unit of Good A than
Red country, which takes 10 hours.

Red Country takes fewer hours to produce Good B (4 hours). Therefore Red Country has an
Absolute Advantage in the production of Good B.
As a result, Blue Country will be better off if it specializes in the production of Good A.
Red Country will be better off if it specializes in Good B.
As you can see from our example, it makes sense from businesses and countries to trade with one
another. All countries engaged in open trade benefit from lower costs of production.

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