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Absolute Advantage Theory
 This theory introduced by Adam Smith in 1776
 He was of the view that productive efficiency differed
among different countries because of diversity in the
natural and acquired resources possessed by them.
 Definition:
 It explains that a country having absolute cost advantage
in the production of a product on account of greater
efficiency should specialise in it production and export.
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Cont.
 A particular country should specialise in producing
only those goods that is able to produce with greater
efficiency, that is at lower cost
 And exchange those goods with other goods of their
requirement from a country that produce those other
goods with greater efficiency or at lower cost.
 This will lead to optimal utilisation of resources in
both the countries.
 Both the countries will gain from trade because both
of them will get the goods at the least cost.
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Cont.
 In following example; both the countries has 100 units
of labour.
 One half of labour used for rice and 2nd half for wheat
in absence of trade.
 In Bangladesh, 10 units of labor are required to
produce 1 kg of rice and 20 units for producing 1 kg
wheat.
 In Pakistan, 20 units of labor are required to produce 1
kg of rice and 10 units of labor for producing 1 kg
wheat.
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Cont.
Amount of production in absence of Trade
Countries
Units of
Labour
Rice
Wheat
Bangladesh
100 ( 50 + 50)
5 kg
2.5 kg
Pakistan
100 ( 50 + 50)
2.5 kg
5 kg
Total Output in two countries : 15 Kg
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Cont.
Amount of production after Trade
Countries
Rice
Wheat
Bangladesh
Units of
Labour
100 (50 + 50)
10 kg
Nil
Pakistan
100 (50 + 50)
Nil
10 kg
Total Output in Two Countries: 20 Kg
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Conclusion
 This theory explains how trade helps increase the total
output in the two countries.
 But it fails to explain whether trade will exist if any of
the two countries produces both the goods at lower
cost.
 In fact, this was the deficiency of this theory, which led
David Ricardo to formulate the theory of comparative
cost advantage.
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Comparative Cost Advantage
Theory
 This theory introduced by David Ricardo.
 This theory focuses not only on absolute efficiency but
on relative efficiency of the countries for producing
goods.
 In a two country and two commodity model, he
explains that a country will produce only that product
which it is able to produce more efficiently.
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Cont.
 Definition:
 This theory explains that a country should
specialise in the production and export of that
commodity in which it possesses a greatest
relative advantage.
 This theory introduced in order to remove the limitation
of previous theory, called Absolute Advantage Thoery.
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Cont.
 In following example; both the countries has 100 units
of labour.
 One half of labour used for rice and 2nd half for wheat
in absence of trade.
 In Bangladesh, 10 units of labor are required to
produce either 1 kg of rice or 1 kg wheat.
 In India, 5 units of labor are required to produce 1 kg
of wheat and 8 units of labor for producing 1 kg rice.
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Cont.
Amount of Output in Absence of Trade
Countries
Rice
Wheat
Bangladesh
Units of
Labour
100 (50 + 50)
5 kg
5 kg
India
100 (50 + 50)
6.25 kg
10 kg
Total Output in two countries: 26.25 kg
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Cont.
Amount of Output after Trade
Countries
Rice
Wheat
Bangladesh
Units of
Labour
100 (50 + 50)
10 kg
Nil
India
100 (50 + 50)
Nil
20 kg
Total Output in two Countries: 30 kg
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GAINS FROM TRADE
 Static Gain:
 Static gain manifest in the increase in the trading
country’s real income, based on efficient international
resource allocation.
 If output and consumption increases as a result of trade
the increase is called gains from trade.
 Static gain is short term in nature.
 Organizations get gains from trade by producing goods
at greater efficiency and export to another country.
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GAINS FROM TRADE
 Dynamic Gains:
 The increase in output and consumption is not once
over, rather its is a continual phenomenon manifesting
in higher rate of growth in income over a period of time.
 This type of continuity indicates dynamic gains from
trade.
 Widening the market and the resultant improvement in
the process of production indicated dynamic gains.
 Free trade leads to better efficiency so better use of
resources leads to reducing real cost per unit. So this
reduction also dynamic gains from trade.
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TERMS OF TRADE
 Based on “ What you get for what you give”
 Net barter terms of trade index:
 (export price index / import price index) * 100
 Gross barter terms of trade index:
 ( Export qty index / import qty index) * 100
 Income terms of trade index:
 Net barter terms of trade index * export size index
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