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Unit 3 : Free Trade Theory — Absolute Advantage, Comparative Advantage and Opportunity Cost

Imagine for the sake of simplicity that we have a world of only two countries and two commodities. Notes
Malaysia and India are two such countries. Rubber and textiles are the two commodities. Assume
further that in the production of these two goods in the two countries there are constant returns to
scale conditions i.e. there are constant marginal opportunity cost conditions in both countries in
respect of both the goods. Assume further that the production possibilities are such that both countries
can produce both the goods if they wish. Finally assume that both the countries are endowed with
“x” amount of factors of production such that (a) With x factors of production, Malaysia can produce
either 100 units of rubber or 50 units of textiles, or any other mix of rubber and textiles, conditioned by
the opportunity cost ratio of 2:1 (This means that if Malaysia wants to produce 1 more unit of textiles
it will have to give up the opportunity of producing 2 units of rubber; or alternatively, by giving up
the opportunity of producing 1 unit of textiles, Malaysia can produce 2 units of rubber) (b) With x
factors of production India can produce either 50 units of rubber or 100 units of textiles; or some other
combination of rubber and textiles subject to the opportunity cost ratio of 1:2 (This means that India
has to give up producing 1 unit of rubber in order to produce 2 units of textiles; or alternatively, India
has to give up the opportunity of producing 2 units of textiles in order to produce 1 more unit of
rubber).

The vagueness in Mill’s principle of what is called as Reciprocal Demand was later
removed in the 19th century, first by F.Y. Edgeworth and later by Alfred Marshall.

From the above production possibilities (or supply conditions) it is quite clear that Malaysia has an
absolute advantage in the production of rubber, and India has the absolute advantage in the production
of textiles. This means there is symmetrical factor distribution between the two countries so that
there is scope for specialization in production and also a scope for establishing mutually beneficial
trade between the two countries. Let us see how that happens.
First, in a situation of autarky or no trade between the two countries, each country can produce and
consume independent of the other country, a combination of rubber and textiles as shown in the
following table :

Table 1 : Production and Consumption Levels with Zero Trade

Commodities Total Output
Countries Rubber Textiles or GNP
(units) (units) (units)

Malaysia 50 25 75
India 25 50 75

World 75 75 150

Let us now examine the second possibility, i.e. when the two countries “open” their economies to
foreign trade. Opening up of trade gives the two countries an opportunity to specialize in production.
Malaysia would specialize in the production of rubber, because in this line of production it has an
absolute advantage over the other country, India. And India will specialize in the production of
textiles, because she has absolute advantage over Malaysia in this particular line of production. Note
carefully that in this case there is a scope for complete specialization in production in both the countries.
The effect of opening trade between the two countries is shown in the following table :

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