Absolute Advantage Theory in the Trading Process

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Table of Contents

Discussion of the Theory
Historical Background
Three Instances
Conclusion
Works Cited

Discussion of the Theory

The theory of absolute advantage explores the processes of trading from the perspective of the abilities of some parties to produce a certain volume of goods or services with higher efficiency than a different party. In this context, what is referred to as “efficiency” is the ability of one party to use lesser amounts of resources in producing certain goods or services than it would be needed to another party to produce the same goods or services? Therefore, the issue of resources is the key element of the theory.

A party can be a company or an individual; however, when the theory originated, it was initially applied to the context of international trade, and parties examined under the theoretical perspective of absolute advantage were entire countries. The theory was proposed by Adam Smith, and according to the way it was described in the 18th century, the very notion of absolute advantage, as opposed to the modern concept of comparative advantage, suggested that a country could produce certain goods or services in a way that essentially undermined the competitiveness of the same goods or services produced in a different country (Schumacher 55).

However, since it is impossible to have an absolute advantage for all the goods and services or even a considerable portion of goods and services out of all proposed internationally, international trade did not assume the form of a system where particular countries dominate in terms of having absolute competitive advantages; instead, different countries had different absolute advantages, which is why the trade among them went on.

To examine the concept of absolute advantage, it is necessary to assess what criteria the theory’s inventor—Adam Smith—took into consideration when establishing the absolute advantage of a particular country. It is established above that resources were the main consideration, but it is important to understand that what Smith meant by resources was not the mere availability of natural raw materials.

Countries have natural geographical and climatic differences, which is why some countries have access to certain resources on their territories, while other countries are deprived of such access. For example, a certain country may have deposits of fossil fuels, and a different country may have good typical weather conditions that enable growing various fruits that other countries would like to buy all year long. However, these conditions do not solely constitute an absolute advantage because the notion of absolute advantage does not refer to what a country has but to what it can supply to other countries.

Having access to certain minerals, fertile soils, or other valuable resources missing from other countries is not a sufficient condition for having an absolute advantage. Instead, what enables an absolute advantage is the ability of a country to produce something and supply it to foreign buyers. Therefore, a major consideration in the theory of absolute advantage is the resource that is needed for making something a country has access to into a product, i.e. the resource of labor. Labor was the only input used by Smith in his analysis (Yang and Ng 5), and the criteria of labor costs and labor productivity were primarily used in establishing the absolute advantage for producing certain goods or services.

From the perspective of the theory of absolute advantage, as it was initially described in the context of international trade, absolute advantage is a requirement for any country to participate in trading with other countries. Based on Smith’s understanding, no country can trade unless it has an absolute advantage for at least one good or service. Therefore, absolute advantage is not regarded as a side phenomenon of processes of economic relations among countries but as an underlying feature of those processes and a prerequisite for them.

At the same time, since the labor costs and labor productivity are the main elements of a country’s absolute advantage, it is possible from the perspective of this theory that a country has no absolute advantage, in which case it does not participate in international trading. It is believed that almost any country has an absolute advantage in terms of producing certain goods or services. If a country can produce something with a cost of production that is significantly lower than that of other countries, the country will have an explicit competitive advantage.

Why the costs of production are low is a different issue: it can be due to the country’s history, geographic location, social and political development, type of government and societal structures, labor culture, or demographic situation.

It is important to realize that absolute advantage for a particular good or service (if it is posited that having an absolute advantage is a positive factor for a country) often cannot be achieved through the efforts of politicians or society. It may be rooted in the history of a country, and history may turn out to be a factor that is as strong as a geographical location. Therefore, the absolute advantage of a country is examined by theorists as a result of economic settings that are not initiated by a country’s government or promoted according to a certain political position of the country’s leaders but as a result of complex historical processes.

Historical Background

The general concept of absolute advantage was proposed by Adam Smith in his 1776 work An Inquiry into the Nature and Causes of the Wealth of Nations, which is considered to a be one of the most influential works in the history of economic thought and a major source of understanding the processes of capitalism. Smith proposed a perspective from which world nations were regarded as subjects of economic relations that both supply goods and services to other nations and buy other goods and services from them. Therefore, one country’s export is another country’s import, which is why the two cannot become wealthy at the same time (Aspromourgos 167).

However, through trading based on their absolute advantages, the countries could gain simultaneously, which is why it is important to acknowledge the notion of absolute advantage and use it extensively in managing the national economy of a given country and its international economic connections. For this, it is necessary to identify the production cost of which is significantly lower for a given country than the cost of this product in a different country.

However, within almost 250 years since the publication of An Inquiry into the Nature and Causes of the Wealth of Nations, many concepts discussed in it have been reconsidered due to the advancements in international economic relations. First of all, it has been recognized that the gains from trading based on comparative advantage may not be mutually beneficial. To address the issue of mutual benefits, an alternative concept was proposed known as a comparative advantage (Cuñat and Melitz 225).

From this theoretical perspective, a country (or a different subject of economic relations) has a comparative advantage in trading if it can produce certain goods or services at a lower relative opportunity cost. The concept of opportunity cost was proposed in the early 20th century, and it is measured through identifying the value of the best alternative option in the process of making decisions and choosing among several mutually exclusive options. Comparative advantage is a more complicated economic construct in comparison with absolute advantage, and the perspective on international trade that it proposes is more insightful because it allows addressing the issue of mutual benefits.

In today’s world, however, there has been a shift toward post-industrial economies in which the classical understandings of capitalist processes may not be fully applicable. The quality of international economic relations has changed because many countries in the modern world are much more involved in the economies of one another than they were two centuries ago. However, it is still possible to regard the processes of international trade as a system where separate countries trade with each other, and the notion of absolute advantage can be applied to establish how they gain and how they build their national economies based on promoting the productions whose costs are lower than those in other countries.

Three Instances

A major example of absolute advantage that still plays a significant role in international trade is the absolute advantage of China and several other countries of the same region of the world. These countries have an absolute advantage of manufactured goods because they have low unit labor costs (Sun et al. 5). The reason for this advantage is the demographic situation. With its largest population in the world, China features a high supply of labor, which naturally correlated with the demand for labor and results in low prices for it, i.e. low wages.

Therefore, China can afford to have plants and factories where goods are manufactured in large quantities with the cost of labor that is significantly lower than that in Europe or the United States. Following the principle of optimization, under which it is recognized that any business strives for maximizing its profits by all legal means, productions from many countries have been transferred to China. Many global companies today that may be headquartered in Silicon Valley or other centers of the first world’s economy have their production in China, which shows how the absolute advantage helps this country gain.

Another example is Canada. As it has been established, an absolute advantage can be caused by various factors including demographical situations and geographical locations (see Discussion of the Theory). If China is an example of the former, Canada is the example of the latter.

The second-largest country of the world, Canada has vast spaces available for agriculture. The land is low-cost and undeveloped, unlike in Europe, which has approximately the same area, but this area is populated with approximately 20 times more people, and the land there, especially in the western and northern parts of Europe, has been extensively used for many centuries before Canada was colonized. Having access to its low-cost land, Canada can afford agricultural production with which other countries may be unable to compete.

Another possible example of absolute advantage in Sri Lanka, which is historically known for its production of tea. The climatic and natural conditions of the country allow it to produce tea, rubber, and coconut products at lower costs than in other countries (Sachithra et al. 52).

The conditions are also suitable for the production of other goods, e.g. wheat, but to switch to it, the country would need to reduce its production of tea (due to the issues of land use), which would significantly lower reliance on the product that currently provides Sri Lanka with an absolute advantage, which is why it is more beneficial for this country to trade, i.e. to sell its tea to other countries while purchasing crops from them, than it would be for both parties to strive for economic self-sufficiency.

Similar to the case of Canada, Sri Lanka has gained its absolute advantage due to its location and natural conditions and resources, but historical factors play a significant role in Sri Lanka’s case, too. The country could have had a different advantage, but its long-standing tradition of growing tea has resulted in the presence of all necessary elements of tea production, and it is not deemed necessary today to make a shift from that, which is why trading based on an absolute advantage remains a major component of Sri Lanka’s international economic relations.

Conclusion

For a country, having an absolute advantage means being able to produce certain goods or services at lower costs than other countries would need to incur for the same production. Proposed by Adam Smith in the 18th century, this theory heavily relies on the concepts of labor costs and labor productivity and describes international trading as the process of exchange among countries, each of which has an absolute advantage for at least one product or service.

Today, the concept may not be fully applicable because economic relations are more complex, and different theories have been proposed to examine them. However, some countries—like China with its low labor costs, Canada with its low costs of agricultural production, and Sri Lanka with its production of tea—remain examples of absolute advantage, which means that the theory can still apply to the modern international economic relations.

Works Cited

Aspromourgos, Tony. On the Origins of Classical Economics: Distribution and Value from William Petty to Adam Smith. Routledge, 2013.

Cuñat, Alejandro, and Marc J. Melitz. “Volatility, Labor Market Flexibility, and the Pattern of Comparative Advantage.” Journal of the European Economic Association, vol. 10, no. 2, 2012, pp. 225-254.

Sachithra, K. M. V., et al. “Comparative Advantage in Interntional Trade: A Study Based on Leading Exports in Sri Lanka.” Kelaniya Journal of Management, vol. 1, no. 2, 2014, pp. 51-85.

Schumacher, Reinhard. “Adam Smith’s Theory of Absolute Advantage and the Use of Doxography in the History of Economics.” Erasmus Journal for Philosophy and Economics, vol. 5, no, 2, 2012, pp. 54-80.

Sun, Sunny Li, et al. “A Comparative Ownership Advantage Framework for Cross-Border M&As: The Rise of Chinese and Indian MNEs.” Journal of World Business, vol. 47, no. 1, 2012, pp. 4-16.

Yang, Xiaokai, and Y-K. Ng. Specialization and Economic Organization: A New Classical Microeconomic Framework. Elsevier, 2015.

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