Page 37 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

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

textiles and rubber at the constant opportunity cost ratio of 1:2 i.e. Malaysia has to give up the Notes
opportunity of producing 2 units of rubber in order to produce 1 unit of textiles, or alternatively it
has to give up half a unit of textiles, in order to produce 1 unit of rubber. Notice here that the internal
cost ratios in the two countries are not the same. To produce 1 unit of rubber or textiles, India has to
give up 1 unit of the other alternative commodity foregone. The cost of producing a unit of either
commodity is the same in India. In the case of Malaysia, however, the cost of producing the two
commodities is not the same. Because, to produce 1 unit of rubber, Malaysia has to give up half a unit
of textiles; but to produce 1 unit of textiles, it is necessary to give up 2 units of rubber. This means that
the unit cost of producing rubber is less than the unit cost of producing textiles, when we measure
unit costs in terms of the units of alternative commodity foregone. And as long as the internal cost
ratios in the two countries are different, there is scope or potential of gains from international trade
between the two countries.
In Table 6 you will notice that India has absolute advantage over Malaysia in the production of both the
goods, and Malaysia has absolute disadvantage in respect of both the goods. This is as far as absolute
advantage and disadvantage is concerned. In terms of relative or comparative advantages and
disadvantages, we have the following things to say, viz, (a) India’s comparative advantage over Malaysia
is greater in the production of textiles (3:1) as compared to rubber (1.5:1). Therefore, India should specialize
in the production of textiles rather than rubber, although India can produce both the goods equally
efficiently (at a cost ratio of 1:1); (b) Malaysia’s comparative disadvantage, in relation to India, is lower
in the production of rubber (1:1.5) as against textile (1:3). In addition, Malaysia can produce rubber at a
far lower cost of production than textiles (at a cost comparisons of 1 unit of rubber = ½ unit of textiles
and 1 unit of textiles = 2 units of rubber). Hence, Malaysia should specialize in the production of rubber,
not because it has absolute advantage over India in this line but because its comparative disadvantage
is less in this line of production than in the other line of production (viz, textiles).
The theory of comparative advantage suggests that a country should specialize in the production
and export of those goods in which either its comparative advantage is greater or its comparative
disadvantage is less : and it should import those goods, in the production of which its comparative
advantage is less or comparative disadvantage is greater. Thereby, a country would be able to maximize
its production (GNP) and its consumption (economic welfare).
We have already indicated that India should specialize in the production and export of textiles, because
her comparative advantage is greater in that line of production, and that Malaysia should specialize
in the production and export of rubber; because Malaysia’s comparative disadvantage is smaller in
rubber production. Before we examine the gains from trade for the two countries arising out of such
specialization, let us consider what would the GNP and welfare levels be, for the two countries, in
the absence of trade. Table 7 below represents this equilibrium under conditions of autarky.
Table 7 : Production and Consumption under Autarky
Commodities Total Production
Countries Textiles Rubber and Consumption
(units) (units) (units)

India 80 40 120
Malaysia 20 40 60

World 100 80 180
India produces and consumes 80 units of textiles plus 40 units of rubber, for a total real GNP of 120
units. Malaysia produces and consumes 20 units of textiles plus 40 units of rubber, for a total real
GNP of 60 units. The World GNP is 180 units (i.e. the GNP of India plus the GNP of Malaysia).
Table 7, therefore, represents pre-trade equilibrium situation.
If, however, the two countries decide to enter into trade breaking their isolation, there would be
International specialization in production, leading to increase in world GNP. In Table 7 below, where

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