Adam Smith and Absolute Advantage (the Concept of Absolute Advantage). Part 1.

Adam Smith and Absolute Advantage (the Concept of Absolute Advantage). Part 1.

According to Adam Smith (1723-1790), nations gain by each specializing in the production of the commodity of its absolute advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage.

For instance, Japan is efficient in producing cars but inefficient in producing computers; on the other hand, the USA is efficient in producing computers but inefficient in cars. Thus, Japan has an absolute advantage over the USA in producing cars but an absolute disadvantage in producing computers. The opposite is true for the USA. Under these conditions both nations would benefit if each specified in the production of the commodity of its absolute advantage and then traded with the other nation. Japan would specialize in producing cars and would exchange some of the cars for computers produced in the USA. As a result, both more cars and computers would be produced, and both Japan and the USA gain. Through free trade, resources are mostly efficiently utilized and output of both commodities will rise. Smith thus argued that all nations would gain from free trade and strongly advocated a policy of laissez-faire. Under free trade, world resources would be utilized mostly efficiently and world welfare would be maximized.

To explain the concept of absolute advantage, we assume that the world consists of two countries (for instance, England and Portugal). There are two commodities (cloth and wine) and a single factor (labor) of production. Technologies of the two countries are fixed. Assume that the unit cost of production of each commodity (expressed in terms of labor) is constant. Assume that a labor theory of value is employed, that is, goods exchange for each other at home in proportion to the relative labor time embodied in them. Let us assume that the unit costs of production of cloth and wine (units for cloth and wine are, for instance, yard and barrel) in terms of labor are respectively 2 and 8 in England; while they are respectively 4 and 6 in Portugal. Applying the labor theory of value, we see that 1 unit of wine is exchanged for 4 units of cloth in England when England does not have trade with Portugal. The ratio is expressed as 1/ 4 units of cloth/per wine. The ratio is the relative quantities of labor required to produce the goods in England and can be considered as opportunity costs. The ratio is referred to as the price ratio in autarky. Similarly, 2 units of wine is exchanged for 3 units of cloth in Portugal ( 3 / 2 units of cloth/per wine). England has an absolute advantage in the production of cloth and Portugal has an absolute advantage in the production of wine because to produce one unit of cloth needs less amount of labor in England than in Portugal and to produce one unit of wine needs more amount of labor in England than in Portugal. Adam Smith argued that there should be mutual benefits for trade because each country has absolute advantage in producing goods. For instance, if the two countries have free trade and each country specified in producing the good where it has absolute advantage.

In this example, England is specified in producing cloth and Portugal in producing wine. Also assume that in the international market, one unit of wine can exchange for 3 units of cloth. In England in open economy one can obtain one unit of wine with 3 units of cloth, while in the autarky system one unit of wine requires 4 units of cloth, we see that trade will benefit England. Similarly, in Portugal in open economy one can obtain one unit of cloth with 1/3 unit of wine instead of 2 / 3 unit of wine as in autarky system, trade also benefits Portugal. In this example, we fixed the barter price in open economies with one unit of wine for 3 units of cloth. Mutual gains can occur over a wide range of barter prices.

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