An Assignment

On
The Absolute advantage theory of international business by Adam smith

Course Title: International Business

Course code: BUS- 421

Submitted for
Ashutosh Roy
Assistant Professor
Department of Business Administration

Submitted By
Pinto Chandra Bhowal
ID: 18100072
Department of Business Administration

Date of submission
December 05, 2021

RANADA PRASAD SHAHA UNIVERSITY

Contents
What Is Absolute Advantage? .............................................................................. 3
Understanding Absolute Advantage........................................................................ 3
1. Lack of Mobility for Factors of Production ............................................................. 3
2. Trade Barriers ............................................................................................ 3
3. Trade Balance ............................................................................................ 3
4. Constant Returns to Scale ................................................................................ 4
Absolute Advantage vs. Comparative Advantage ......................................................... 4
Example of Absolute Advantage ........................................................................... 4
What Is Absolute Advantage?
Absolute advantage is the ability of an individual, company, region, or country to produce a
greater quantity of a good or service with the same quantity of inputs per unit of time, or to
produce the same quantity of a good or service per unit of time using a lesser quantity of
inputs, than its competitors.

Understanding Absolute Advantage

The concept of absolute advantage was developed by 18th-century economist Adam Smith in
his book The Wealth of Nations to show how countries can gain from trade by specializing in
producing and exporting the goods that they can produce more efficiently than other
countries. Countries with an absolute advantage can decide to specialize in producing and
selling a specific good or service and use the generated funds to purchase goods and services
from other countries.

Smith argued that specializing in the products that they each have an absolute advantage in
and then trading the products, can make all countries better off, as long as they each have at
least one product for which they hold an absolute advantage over other nations.
Absolute advantage explains why it makes sense for individuals, businesses, and countries
to trade with each other. Since each has advantages in producing certain goods and services,
both entities can benefit from the exchange.
This mutual gain from trade forms the basis of Smith’s argument that specialization, the
division of labor, and subsequent trade lead to an overall increase in prosperity from which
all can benefit. This, Smith believed, was the root source of the eponymous "Wealth of
Nations."

The idea of absolute advantage rests on a number of assumptions on the part of Adam Smith.
While influential and insightful, the theory of absolute advantage is not always entirely
accurate because many of these fundamental assumptions are in fact not true in practice. Here
are the most significant of these assumptions:

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 goods. 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.

Absolute Advantage vs. Comparative Advantage

Both absolute advantage and comparative advantage are enormously significant concepts for
understanding how international trade works. Both nations and the firms residing within them make
many of their decisions about resource allocation (which goods should be allotted more or
fewer resources for production) based on assessments of absolute and comparative advantage.

The two concepts are undoubtedly related but are also distinct. Absolute advantage refers to situations
wherein one firm or nation can produce a given product of better quality, more quickly, and for higher
profits than can another firm or nation. Comparative advantage, by contrast, looks at international
trade more broadly—it accounts for the opportunity costs of choosing to manufacture multiple kinds
of products using finite resources.

Adam Smith had believed that absolute advantage was a necessity for beneficial trade. The theory
of comparative advantage was developed by David Ricardo, who built on Adam Smith’s work to
argue that, in fact, a country doesn’t have to have an absolute advantage for beneficial trade to occur.

Example of Absolute Advantage

Consider two hypothetical countries, Atlantica and Krasnovia, with equivalent populations and
resource endowments, with each producing two products: guns and bacon. Each year, Atlantica can
produce either 12 guns or six slabs of bacon, while Krasnovia can produce either six guns or 12 slabs
of bacon.
Each country needs a minimum of four guns and four slabs of bacon to survive. In a state
of autarky, producing solely on their own for their own needs, Atlantica can spend one-third of the
year making guns and two-thirds of the year making bacon, for a total of four guns and four slabs of
bacon.
Krasnovia can spend one-third of the year making bacon and two-thirds making guns to produce the
same: four guns and four slabs of bacon. This leaves each country at the brink of survival, with barely
enough guns and bacon to go around. However, note that Atlantica has an absolute advantage in
producing guns and Krasnovia has an absolute advantage in producing bacon.

If each country were to specialize in their absolute advantage, Atlantica could make 12 guns and no
bacon in a year, while Krasnovia makes no guns and 12 slabs of bacon. By specializing, the two
countries divide the tasks of their labor between them.

If they then trade six guns for six slabs of bacon, each country would then have six of each. Both
countries would now be better off than before, because each would have six guns and six slabs of
bacon, as opposed to four of each good which they could produce on their own.