Adam Smith's Theory of Adam Smith's Absolute Cost Advantage Theory

Absolute Cost Advantage: Meaning, Theory, Example, Assumptions, and Criticisms

What is Absolute Cost Advantage?

Absolute cost advantage can be defined as the ability of the nation to produce more products with lower costs and resources more efficiently than the other nation. Absolute advantage is achieved when a nation has the capacity to produce more of a good than another nation with the same amount of input.

It is Adman Smith, the father of economics, who endeavored to destroy mercantilism by introducing the concept of free trade in 1776, in his classic book “The Wealth of Nations”. He is the first introducer of formal international trade theory by introducing the theory of absolute cost advantage, which is what we call today Adam Smith’s International Trade Theory.

By criticizing the concept of mercantilist theorists, Smith introduced free trade (laissez-faire policy), whereas in mercantilism state-controlled economy prevailed. He also destroyed the concept of a zero-sum game and introduced a positive-sum game.

Smith argued government intervention should be reduced in a trade instead should encourage trade and exports, and the individual companies should be free to trade as they see fit. The concept of free trade policy is an effective means to increase international trade or businesses. He further added the government is not efficient in producing more, making more exports, and more money than the individuals (private industries).

Adam Smith explained efficient specialization produces goods and services and helps the nation to increase output and wealth as well. A nation’s real wealth consists of the goods, services, and facilities its citizens have to produce more efficiently than other nations.

He further added that a nation’s advantage would be in terms of natural or acquired. The natural advantage is one that considers climate and natural resources and the acquired advantage considers management skills and technology through human resources and creations. Division of labor is a significant matter of efficiency in production.

Example of Absolute Cost Advantage

As discussed above, further in simple terms, absolute cost advantage is the nation’s capacity to have specialization and greatness in production than other nations. For such, a nation is not dependent on any other nations.

The following example will further make it simple to understand what the actually the concept of absolute cost advantage theory.

Table Showing Absolute Cost Advantage

Let’s suppose, there are two countries Ghana and South Korea, both have the same amount of resources. For Ghana to produce 1 ton of Cocoa would cost 10 resources, in the same way, it would cost 20 resources to produce 1 ton of rice.

Similarly, South Korea would cost 20 resources to produce 1 ton of Cocoa and 10 resources for 1 ton of Rice.

It clearly represents that Ghana would get an absolute cost advantage in the production of Cocoa and South Korea get in the production of Rice.

According to Smith, countries should specialize in the production of goods for which they have an absolute cost advantage and then trade these goods for those produced by other countries. According to this theory, Ghana should specialize in the production of Cocoa, while South Korea should specialize in the production of Rice.

Ghana Could get all the rice it needed by selling its cocoa to South Korea and South Korea selling rice and buying cocoa from Ghana. Thus, absolute cost advantage theory explains trade takes place when one nation can produce a good at a lower cost than another nation can.

Key Points/Assumptions of Absolute Cost Advantage

The key points or assumptions of Adam Smith’s absolute cost advantage theory can be pointed out and mentioned below.

Two Countries and Two Products

This theory states that there exist only two countries and two products in international trade. As we stated in the above example, countries Ghana and South Korea & products Cocoa and Rice are the only factors of international trade according to this theory.

Free Trade

Smith emphasized there should be free trade in the economy. There is no need for government intervention in trade and international commerce, the government’s role is only of regulator and facilitator.

He added, let the market forces determine the volume, pattern, composition, and direction of trades. Individuals and society are more efficient in production and have the capacity to generate more output and economy-making activity than the state.

Perfect and Free Competition

In absolute advantage theory, there also exists perfect and free competition. Companies are free to involve in any business, and exit from the business without any barriers, market information is shared, and customers are more informed.

This is influenced by no government intervention policy, where demand and supply determine the prices, and the market runs without government intervention.

Specialization in Production

This theory emphasised a nation to specialize its production in the goods and services that it produces more efficiently which gives it more production at low cost and resources. Due to different factors such as climate, natural resources, capital & labor force availability of any country, specialization occurs and its level differs across countries.

Smith suggested production specialization is the means to get absolute cost advantage and which is a means of exports and source of income. A country should never produce goods at home that it can buy at a lower cost from other countries. By specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade.

In addition, a country should export some of such goods in which it has specialized and make payments for import of goods produced by other countries more efficiently.

Through specialization and free trade, a nation would get benefits like,

  • Labor will be more efficient resulting in more productivity.
  • Creates an incentive to develop a more effective production process or technique.
  • Production or output itself will increase.
  • Excess production could be exported to buy more important requirements.

No Transportation Cost

This theory assumes there is no transportation cost between two countries i.e. it is not taken as a cost.

Positive Sum Game

Adam Smith attacked the mercantilism concept of a zero-sum game which means between two countries a country’s trade surplus is equal to the loss of another country.

He introduced the concept of the positive-sum game, which is the opposite of a zero-sum game – which means when engaging in trade both countries would get benefits. The benefit may be higher in one country than in another and vice versa.

Critical Review of Absolute Cost Advantage Theory

Although this theory talks about and gives various ways to flourish in international trades, it can also be criticized in many ways.

  • This theory argues that there exist only two countries and two products but in reality the world is big. In fact, today international trade refers to trade between many countries and transactions of many products not only two products and two countries.
  • It is not possible to assume that there does no exist transportation cost in international trades.
  • Free trade or no government intervention policy may adversely affect the nation when private sectors become so powerful and try to exploit natural resources and set trade direction for their personal benefits only.

Furthermore, Smith explained in this theory that under the conditions of free trade and perfect competition, trade takes place between nations that have an absolute cost advantage in the manufacture of specific items.

He did not, however, offer any solutions to countries that face an absolute cost disadvantage in producing both items. Thus a question will be raised “Will trade takes place if a country has an absolute disadvantage in the production of both products?”.

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