Question

1. What is the theory of absolute advantage? Explain

Answer 1

According to Adam Smith, the theory of absolute advantage as the idea of foreign exchange, under such situations exchange of goods or services will take place between the two countries or business and only if each of the two countries or business can produce one commodity at an absolutely lower production cost than the other country.
Any entity of particular country with an absolute advantage can produce a product or services at a lower absolute cost per unit using a smaller number of inputs or a more efficient process than another entity producing the same goods. For example- India has an absolute advantage in running call centres compared to the running call centres in the Philippines because of the availability of low cost of labour and abundant labour force.

However, the theory of absolute advantage is not always accurate because many of these basic assumptions are not true in practice. Following are the signs of these assumptions.

1. As per admin, smith factors of productions cannot change between countries. These assumptions also express that the production possibility frontiers of each country will not change after the trade.
2. This theory assumes that there are no trade barriers to the exchange of goods. Government implement trade barriers on countries to discourage the importation and exploration of specific goods.
3. According to smith exports must be equal to imports. There is not having a trade imbalance. Trade imbalances arise when exports are higher than imports.
4. This theory assumes that we will get constant returns as production scales, it means there are no economic of scales but if there were economic of the scale then it would become less expensive for countries to maintain producing the same good as it produced more of the same good..

Example of absolute advantage theory-
Suppose to produce one unit of wheat in USA 3 labour hours and in India 10 labour hours required. Similarly, for the production of one unit of cloth, USA required 6 man-hours and in India required 4 man-hours as a result that the USA can produce wheat efficiently whereas India can produce cloth efficiently.
It means the USA has an absolute advantage in the wheat production while India has an absolute advantage in the cloth production, therefore, the USA and India would benefit and world output will increase if the two countries specialized in the production of goods or services wherein they have got an absolute advantage and exchanged with each other.