According to this theory Trade between Nations took place if the traders saw an absolute cost advantage in buying a particular good from a foreign country rather than buying the same good domestically. This means that a country specialises in the production of those goods only in which it experiences an absolute cost advantage and the other goods are acquired by it through import.
This can be illustrated through the following example –
The above table shows units of labour required to produce Shoes and Computer in 2 countries – India and USA.
India can produce Computer with 100 units of labour while USA can produce the same quantity of Computer with 50 units of labour. Clearly USA can produce Computer in a more efficient manner than India. India would therefore import Computer from USA.
Further assuming that both countries have the same currency (say Rs.) and same wage rates (say 1 Re. per unit of labour) – It can be seen that the cost of production of Computer in India would be Re. 100 while that of producing the same quantity of Computer in USA would be Rs. 50. It would thus be advantageous for Indians to buy Computer from USA at anything less than Rs. 100. The Englishmen will also be happy to sell Computer to Indians at anything more than Rs. 50
Thus we see that both countries stand to gain if India imports Computer from USA.
An exactly reverse logic can be applied to Shoes where it can be shown that India would end up exporting Shoes to USA.
The trade here takes place because India enjoys a clear and absolute advantage in producing Shoes (50 units of labour as against 100 unit required in USA) and vice versa as regards production of Computer.
Assumptions of Absolute Cost Advantage Theory –
- 2 countries, 2 commodity model
- Labor as the only input
- Single currency assumed thereby eliminating effects of exchange rate changes
- Homogeneous factors of production – All labor units are of same type.
- Units of production are divisible in compact units.
- All factors of production are fully employed.
- No government restrictions on free trade.
Criticisms of Absolute Advantage Theory –
Most of the criticisms from absolute advantage theory would arise because of the unrealistic nature of its assumptions.
However, an important incompleteness in the theory was the fact that it addressed only a situation wherein one country enjoyed an absolute advantage in production of a commodity over another country. It was pointed out that such situations are rare. Quite often the advantage is not an absolute advantage but a comparative one as would be clear from the Ricardian Theory of Comparative Cost Advantage.