Question

6) Differentiate the Modern Theory of International Trade (The Generalized Comparative Advantage) from the Pure Theory of International trade in the way they handle the issues of:
A) The Basis for Trade. [4 Marks]
B) The gains from trade.

Answer 1

INTERNATIONAL TRADE THEORY

The theory of international trade is that branch of economic theory concerned with trade between nations and, more broadly, with all aspects of the economic relations between nations.

Absolute vs. Comparative Advantage: An Overview

Absolute advantage and comparative advantage are two important concepts in economics and international trade. They largely influence how and why nations and businesses devote resources to the production of particular goods.

In isolation, absolute advantage describes a scenario in which one entity can manufacture a product at a higher quality and a faster rate for a greater profit than another competing business or country can accomplish.

Comparative advantage differs in that it takes into consideration the opportunity costs involved when choosing to manufacture multiple types of goods with limited resources.

The differentiation between the varying abilities of companies and nations to produce goods efficiently is the basis for the concept of absolute advantage. Absolute advantage looks at the efficiency of producing a single product.

This analysis helps countries avoid the production of products that would yield little or no demand, leading to losses. A country’s absolute advantage, or disadvantage, in a particular industry, can play an important role in the types of goods it chooses to produce.

Comparative Advantage

Comparative advantage takes a more holistic view, with the perspective that a country or business has the resources to produce a variety of goods. The opportunity cost of a given option is equal to the forfeited benefits that could have been achieved by choosing an available alternative in comparison.

In general, when the profit from two products is identified, analysts would calculate the opportunity cost of choosing one option over the other.

ADAM SMITH helped to originate the concepts of absolute and comparative advantage in his book, An Inquiry into the Nature and Causes of the Wealth of Nations. Smith argued that countries should specialize in the goods they can produce most efficiently and trade for those goods they can't produce as well.

Smith described specialization and international trade as they relate to absolute advantages. He suggested that England can produce more textiles per labor hour and Spain can produce more wine per labor hour so England should export textiles and import wine and Spain should do the opposite.

Following Adam Smith's research, British economist David Ricardo built on his concepts by more broadly introducing comparative advantage in the early 19th century.

Ricardo has become well-known throughout history for his musings on comparative advantage. Building on research from Adam Smith along with Robert Torrens, Ricardo explains how nations can benefit from trading even if one of them has an absolute advantage in producing everything.

In other words, countries must choose to diversify the goods and services they produce which requires them to consider opportunity costs.