COMPARATIVE ANALYSIS: ADAM SMITH’S ABSOLUTE COST ADVANTAGE THEORY AND DAVID RICARDO’S COMPARATIVE ADVANTAGE THEORY

COMPARATIVE ANALYSIS: ADAM SMITH’S ABSOLUTE COST ADVANTAGE THEORY AND DAVID RICARDO’S COMPARATIVE ADVANTAGE THEORY

AUTHOR:

ANANAYA CHAUHAN AND AMAN TIWARI

INTRODUCTION:

“Adam Smith is known as the Father of the Modern Economics and also the first and well known supporter of Free Trade.” However, his theory related to International Trade, on the other side is less known to the public or valued. The absolute advantage hypothesis is quickly abandoned in favor of a “Comparative Advantage Theory, which is linked to David Ricardo.”

David Ricardo expanded Smith’s concept on absolute advantage in 1817. Ricardo created the idea of international trade based on the Principle of Comparative Advantage, which he improved upon Adam Smith’s explication (Cost). Theory of Comparative Costs was presented by the famous economist “David Ricardo in his book, Principles of Political Economy and Taxation (1817) and by Torrens in a brochure titled, An Essay on the External Corn Trade (1815).” The theory is also called Theory of Comparative Advantage.

Smith’s publications, on the other hand, provide a more sophisticated theoretical approach to international trade than is credited to him in textbooks. His narrative, in particular, demonstrates that unrestrained trade and open international competition benefit a nation more than the mercantilist economic policies that existed in many regions of Europe throughout the 18th century.

With the rise of economists like “John Locke and David Hume”, the Theory of Mercantilism, relevant during the era of 16^th and 18^th century, came as an important theory. Mercantilism, believed to be “National Economic Policy” aiming to increase the gold and money reserved of the country. It was growing popularly in Britain and Portugal during the colonial times, until “Adam Smith and later David Ricardo” came into picture and developed their own theories.

KEY TAKEAWAYS OF ADAM SMITH THEORY:

• Smith first introduced this theory and he argued to back up his “laissez-faire” views. In his book, “The Wealth of Nations”, policies, which favored one-business, drain the resources away from another industry where they can be more efficiently used due to the concept of opportunity cost.

• Adam Smith applies the concept of opportunity cost to the people in the society. To better understand this he cites an example of a shoemaker, who will never ear the shoe he will make, as by doing so it would be a waste of his own resources. Hence, every person pays attention to the goods in which they have competitive advantage.

• Smith also apply the same concept of opportunity cost as well as specialization concept to international trade and polices. He states that when a country imports items from rest of the countries it is more efficient as the importing country can focus more on its resources and give productive goods. Hence, he creates tension that difference between the states related to technology are known to be the fundamental determinant of trade worldwide.

KEY TAKEAWAYS OF DAVID RICARDO THEORY:

• “The capacity of an economy to produce a certain item or service at a lower opportunity cost than its trade counterparts is referred to as comparative advantage.

• The notion of comparative advantage presents opportunity cost as a consideration to consider when deciding between several production possibilities.

• According to comparative advantage, countries will participate in commerce with one another, exporting commodities in which they have a comparative advantage.

• Focusing only on a country’s comparative advantages, which can exploit the country’s workforce and natural resources, has drawbacks.

• Absolute advantage refers to a country’s undeniable ability to manufacture a certain item more efficiently.”^[1]

ABSOLUTE ADVANTAGE: WHAT IT IS?

“When a country can manufacture a thing more effectively than other countries, it has an absolute advantage in the production of that good. The capacity of a country to manufacture an item more effectively than other countries is referred to as absolute advantage. To put it another way, a country with an absolute advantage can create a product with a lower marginal cost (fewer materials, cheaper materials, in less time, with fewer workers, with cheaper workers, etc.). Comparative advantage refers to a country’s capacity to create particular items at a lower opportunity cost. Absolute advantage, on the other hand, refers to a country’s ability to produce specific goods at a lower opportunity cost.”[2]

“The notion of absolute advantage was also utilized by Smith to describe the benefits of free trade in the worldwide market. He postulated that nations’ absolute advantages in certain commodities would enable them to gain simultaneously through exports and imports, highlighting the need of unfettered international trade in the global economic framework. Smith proposed for a capitalist symbiosis between states in The Wealth of Nations (published in 1776). He noted that while various nations had absolute advantages in particular industries, no country had an absolute advantage in all industries. As a result, Smith promoted international commerce so that one country’s exports may become the imports of another.”[3]

We can take the example of rum, which was a popular beverage in both Europe as well as Americas throughout Smith’s time. Rum contains sugar that has been fermented, and sugar grows best in warm areas. As a result, the warm, tropical islands of the Caribbean, which were just recently colonized by Europeans, had an unbeatable edge in sugar manufacture. Although, they lacked the necessary gear to properly uproar sugar, store it in a bottle, and export it all over the world. Because European countries had such gear and infrastructure, they had an absolute advantage in the actual rum processing once the raw ingredients were available.

COMPARATIVE ADVANTAGE: WHAT IT IS?

The country, which has the best natural advantage in terms of production of a commodity, is similar to how one who is expert in trade has more upper hand. A nation may produce a variety of items at once, but in the making of various products (for example, jute or tea), it may have comparative advantage and it will specify in said items

Likewise, a different nation might create things in which it has a competitive advantage (for example, engineering goods and machines, as in UK or US.) If these two nations create items based on their respective comparative advantages, each one will be capable to create the commodities at the lower rate, and each nation will benefit as of trade. The comparative advantage concept is based on this.

Comparative cost theory asserts that when the proportions of comparative cost of manufacturing commodities vary, international commerce occurs between two nations, and then every nation would focus in making the item with a comparative advantage

ADAM SMITH: DIVISION OF LABOR

Division of labour, stated in Smith’s theory serve as the foundation for his international trade theory. According to Smith, it leads to “the greatest advance in labor’s productive capacities.” More production can be generated with the same quantity of labour because of more advanced division of labour. He uses his famous pin factory example to demonstrate how the labour division results in an “increase of the quantity of work that the same number of workers are capable of performing.”

Then he outlines three factors that have led to this development:

“First, an improvement in dexterity in each individual worker; second, the reduction of time lost in transitioning from one type of work to another; and third, the advent of a large number of machines that assist and abridge labour, allowing one man to accomplish the job of many.”

This method of division of labour helps to improve the quality as well as the quantity of the production. This translates to advanced output, enhanced technical development, and upgraded worker expertise and output. As a result, economic development and national wealth are boosted. “The greater specialization, the more growth,” as the saying goes.

The primary constraint on the division of labour is “exchanging power,” or “market extent.” As a result, if the market is extended, a greater division of labour will be available, resulting in increased economic growth and profit. International trade must be taken into account in this regard.

DAVID RICARDO: DIVERSITY OF SKILLS

Wages help people to understand their comparative advantages. It also motivates them to take up occupations in which their interest lies, and they excel. If a mathematician is earning good money as an engineer rather than as a teacher, everyone around him trading with him will gain benefit from engineering.

If labour is arranged effectively, the gaps in the opportunity cost helps to achieve higher level of output. There is an advantageous trade through comparative advantage if more people with skills are engaged.

Let us look at an example of the famous athlete, Michael Jordan who is a basketball as well as a baseball player. His physical abilities are more than most of the players. Along with the talents he is also blessed with unbelievable height which help him to paint his house easily.

If we assume that he can paint his entire house in eight hours, he can also spend the same 8 hours in some television advertisement, which will pay him Rs. 70,000. Similarly, his neighbour can paint his house at 10 hours. He can earn Rs. 500 by working at a restaurant for 10 hours.

Therefore, if we look at these situations even though Michael is able to paint the house faster, his neighbor has more comparative advantage than he does. The ideal deal for both would be that Joe will paint the houses and Michael will film in a television advertisement. This deal is bonus for Michael till the time he receives the amount and on the other hand his neighbor earns more than Rs. 500. They both will find this as the best arrangement and earn a mutual benefit because of their talents.

BENEFITS DERIVED FROM INTERNATIONAL TRADE: ADAM SMITH THEORY

• International trade, according to Smith, benefits countries since it provides worth to their excesses by trading them for anything else that may fulfill a portion of their demands and augment their satisfactions. “The narrowness of the domestic market is overcome by it, allowing the division of labour in any given discipline of art or production to be carried out to the utmost level of excellence. It stimulates people to enhance their creative capacities and to augment their yearly yield to the fullest, so increasing the actual revenue and wealth of the society, by providing a more broad market for whatever part of their labor’s result may exceed home consumption.” [4]Smith ties international trade to his beliefs about the division of labour in this passage. Because the international market is larger than the local market alone, expanding the division of labour will be conceivable if commerce with another country is created. International trade benefits a country because it improves the division of labour, resulting in a rise in “the exchangeable worth of the yearly output of the country’s land and labour.” This raises the nation’s actual wealth as well as its population.

• To summarize, international trade takes use of the quantitative and qualitative advantages of a more extensive division of labour. International trade promotes specialization, which boosts productivity via technological and organizational improvements. As a result, with the same amount of labour, more things may be produced overall. As resources are mobilized and industry is promoted, this increases economic development.  Smith’s idea of (international) trade is obviously “closely linked with his theory of economic progress.” In Smith’s perspective, trade and development are inextricably linked. The division of labour binds them together. The benefits of international trade are bolstered by the greater competition faced by home firms. Another advantage is that international trade reduces the chances of home monopolies. Smith claims that free competition is always advantageous to the public, even if it is not always in the producers’ best interests.

• Smith also adds another advantage of international trade: it allows for the transfer of knowledge and technology across countries. The adoption and implementation of new production processes leads to increased productivity and, as a result, economic progress and profit. These benefits, according to Smith, might be even more valuable to a country than access to a larger market, especially for a large country. He speaks about this in relation to China. China already has a huge domestic market; therefore, free trade with Europe would largely benefit China by gaining access to its technologies rather than by expanding its market.

• Overall, international trade benefits both individual countries and the wider world. Smith is enthusiastic about economic growth and advancement. He never cites a limit to the division of labour, and his theory allows for infinite expansion. The extent of the market limits the division of labour, yet the extent of the market is not restricted in this theory. Rather, division of labour determines the size of the market, and an expansion of division of labour leads to expansion of the size of the market.

• Smith’s goal is to demonstrate that, International Trade benefits all countries, which are involved in it. He does admit, however, that nations do not always profit equally: “trade that is naturally and regularly carried on between any two locations, without coercion or restraint, is always favorable, though not always equally so, to both. International trade is not equally advantageous to all nations, just as domestic trade is not equally helpful to all areas within a country.”[5] Trade can also magnify inequalities between them, particularly if their income levels differ. Smith connects the trade interactions between rich and poor people to the trade relations between a developed and underdeveloped nation in his Lectures on Jurisprudence, which supports this viewpoint.

• Smith’s ‘Vent for Surplus’ philosophy is an intriguing component of his trade analysis. According to him, a country’s excess output above what can be absorbed in the internal market can be sold on the international market. It was because of this aim that Mercantilists and later thinkers placed such a high value on international trade.

• The ‘Vent for Surplus’ philosophy asserts that international specialization is irreversible and a necessary component of any country’s growth process. Furthermore, this idea indicates that international commerce maximizes the utilization of idle productive capacity that would otherwise exist if trade did not exist. This inference deviates significantly from the comparative cost approach’s premise that resources are fully used even before trade. Trade allows for a more efficient distribution of resources.

BENEFITS DERIVED FROM INTERNATIONAL TRADE: DAVID RICARDO THEORY

• David made a significant demonstration on how specialization and trade based on Comparative Advantage will benefit both the countries. If we look at the situation of England and Portugal, Portugal was able to produce wine whereas England was able to produce fabric at low cost. He anticipated that both the countries would understand these facts and quit striving to manufacture products, which are more expensive. However, after some time England stopped producing fabric and Portugal stopped producing wine. Both nations realized that it was beneficial for both of them to stop producing these commodities and trade with each other for importing and exporting it.

• If we look at the recent time, we can look at China Comparative advantage over the United Nation at the low cost of labour. China produces simple goods at lower opportunity cost whereas United States has specialization in capital-intensive goods, due to which is have a completive advantage. America produces sophisticated goods at low opportunity cost. Hence, specialization as well as trading between nations is sometimes mutually beneficial.

• If we look at the notion of this theory, Protectionism is ineffective. People following this method think that the countries, which participate in international trade, might have sorted with the partners of comparative advantage.

• If a country decided to withdraw itself from the International trade Agreement, and if government applies tariffs, it will lead to establishment of new industries and new employment opportunities. This will however not benefit in a long-term situation. The country involved will find itself as disadvantage in comparison to other neighbouring countries, who already produce these goods at low opportunity cost.

ASSUMPTIONS OF THE THEORY: ADAM SMITH

Adam Smith’s concept of absolute advantage is on a number of assumptions. While important and insightful, the idea of absolute advantage is not always right since many of its simple assumptions are not constantly true in practice. Below mentioned are some of the most important assumptions:

1. Factor of Production lacks mobility

Factors of production, according to Adam Smith, cannot be transferred among countries. This assumption also suggests that after the transaction, the “Production Possibility Frontier” of each country will remain the same or unchanged.

2. Barriers to Trade

When, exchange of good take place between the countries, there are no restriction on the movement of the trade. These barriers are not restricting the exporting or importing of trade between the countries.

3. Balance of Trade

Smith thinks that exports and imports must be equal. Because of this premise, it is believed that there is no difference in the balance of trade; there are no deficit balance or surplus balance. Imbalance in trade happens when a country exports more and imports less.

4. Constant Scale Returns

As the production increases, Adam Smith expects that we would earn constant returns, believing that there is no “economies of scale”. If a country named A, takes 3 hours to produce one good, it will take 6 hours to produce two goods in another country named B. Hence, producing four such goods will take 12 hours for a country. Economies of scale, on the other hand, would make it cheaper for these countries to continue manufacturing the same good as they produced more of it.

ASSUMPTIONS OF THE THEORY: DAVID RICARDO

“Theory of Comparative Costs is based on the following assumptions:

1. There are only two countries and they produce two goods.
2. Labour is the only factor of production and cost of production is measured in terms of the input of labour.
3. All units of labour are homogeneous.
4. A situation of constant returns prevails in the economy.
5. Factors of production are perfectly mobile within the country but are immobile between two countries.
6. There is no cost of transportation.
7. International trade is free from all government controls.
8. There is full employment in countries engaged in international trade.
9. There is perfect competition in goods market as well as in factor market.

Ricardo was worried regarding a situation in which one nation might manufacture every product for a fraction of the true cost of another. In this scenario, he advised that each country focus on the items where it had the greatest comparative advantage.”[6]

CRITICISM: ADAM SMITH THEORY

• According to this theory, it is assumed that only two states can trade with each other, and only two goods are traded between the states. When growth took place in trade along with the requirements of the nation, this notion was questioned. Therefore, this theory failed to acknowledge trade between more than two countries.

• It is also assumed that the states involved in trade are in free trade agreements. There was no consideration of the protectionist measures that were implemented by other countries. Protectionist Measures involved trade barriers, restriction on trade, environmental protection and Quantitative limits.

• Most developing nations, with poor labour and machinery, may not have an absolute competitive edge in any field. As a result, the theory of absolute cost advantage is unable to give a thorough and satisfying explanation of the grounds on which international commerce takes place.

• Adam Smith succinctly stated the essential foundations of international trade. The absolute cost advantage had failed to investigate the elements that influence commerce between two or more nations in any depth.

• Adam Smith’s ‘Vent for Surplus’ idea is not entirely adequate. This concept may have major negative consequences for developing nations’ prosperity. These countries do not sell their surplus produce on international markets, but are compelled to export despite internal shortages in order to balance their budget deficits.

CRITICISM: DAVID RICARDO THEORY

• In the real world, determining which items nations have a comparative cost advantage is significantly more difficult. This is due to the vast number of PRODUCTs and nations involved.
• In actuality, the pattern of comparative advantage changes. A country can acquire a competitive edge by increasing its factor productivity (labour productivity) or adopting trade restrictions, such as an import tariff. Therefore, contrary to what Ricardo believed, “comparative advantage is a dynamic idea, not a static one.”
• The implications of transportation costs are ignored in the hypothesis. England may be known for its textiles, whereas Portugal is known for its wine. Any competitive advantage, however, may be lost if transportation expenses are included in.
• According to the hypothesis, if Portugal wishes to specialize by introducing more wine, it may do so easily by moving production components to wine production. However, transferring these elements from fabric to wine production may be challenging. Furthermore, textile workers may be unaware of how to make wine.

CONCLUSION:

To summarize this, “Adam Smith’s theory of International Commerce” is dynamic in the way that this theory is incorporated into the wider economic structure of division of labour. It takes into account the economic growth, which is arisen and influenced by International Trade.  “Absolute production cost advantages” and the distribution of trade profits are not set in stone. Rather, trade causes them to evolve and emerge endogenously. Comparative advantage is a fundamental concept in economics. This theory explains economics as to why people, governments, & enterprises may experience higher collective advantages through trade and exchange than they can create alone. However, the concern of the economics of modern era is that these advantages can only benefit one country and lead to exploitation of other country.

 

[1]Comparative Advantage, available at: https://www.investopedia.com/terms/c/comparativeadvantage.asp#toc-diversity-of-skills  (Last Visited on 19-05-2022)

[2] Reading: Absolute Advantage, available at: https://courses.lumenlearning.com/suny-internationalbusiness/chapter/reading-absolute-advantage/ (Last visited on 19-05-2022)

[3] What is Absolute Advantage? Available at: https://corporatefinanceinstitute.com/resources/knowledge/economics/what-is-absolute-advantage/ (Last visited on 20-05-2022)

[4] Reinhard Schumacher, “Adam Smith’s theory of absolute advantage and the use of doxography in the history of economics” Volume 5, Erasmus Journal for Philosophy and Economics, 6.

[5] Reinhard Schumacher, “Adam Smith’s theory of absolute advantage and the use of doxography in the history of economics” Volume 5, Erasmus Journal for Philosophy and Economics, 8.

[6] Theory of International Trade, available at: http://www.drbrambedkarcollege.ac.in/sites/default/files/Chapter%2011_compressed.pdf (Last Visited on 20-05-2022)

Author: Ananaya Chauhan and Aman Tiwari,
DELHI METROPOLITAN EDUCATION, NOIDA AFFILIATED TO GURU GOBIND SINGH INDRAPRASTHA UNIVERSITY, DELHI, 4th Year