Page 28 - DMGT545_INTERNATIONAL_BUSINESS

Unit 2: Theories of International Trade

notes
commodity → Production before trade Production after trade Gains from trade
country (1) (2) (2 – 1)
↓
X Y X Y X Y
A 10 5 20 -- +10 -5
B 5 10 -- 20 - 5 + 10
Total production 15 15 20 20 + 5 +5
The above reveals that before trade both countries produce only 15 units each of the two
commodities by applying one labour unit on each commodity. If A were to specialize in producing
commodity X and use both units of labour on its total production will be 20 units of X. Similarly,
if B were to specialize in the production of Y above, its total production will be 20 units of Y. The
combined gain to both countries from trade will be 5 units each of X and Y.

Pitfalls

1. The theory is vague and lack clarity.
2. According to this theory, every country should be able to produce certain products at
low cost compared to other countries and should produce certain other products at
comparatively high costs than other countries. International trade takes place only under
such conditions. But in reality, most of the developing countries do not have absolute
advantage of producing at the lowest cost any commodity, yet they participate in the
international business. Thus Smith’s analysis is weak and unrealistic.

case: absolute cost Difference

According to Adam Smith, the Father of Economics, the basis of international trade was absolute
cost advantage. There may be a case where a commodity can be produced by two countries,
but the cost of producing the commodity in one country is absolutely lower than the cost of
producing it in the other country. In such a case, the commodity will be produced in that country
where the cost of production is the lowest. This is explained as follows. Suppose:

In India, 10 days of labour can produce 100 units of cotton, or
In India, 10 days of labour can produce 50 units of jute.
In Pakistan, 10 days of labour can produce 50 units of cotton, or
In Pakistan, 10 days of labour can produce 100 units of jute.

In this case, in India the same number of labour days, can produce either 100 units of cotton or
50 units of jute. The cost-ratio between cotton and jute is, 100:50 or 1 unit of cotton = 1/2 unit of
jute. Similarly, in Pakistan, the cost-ratio is, 50:100 or 1/2 unit of cotton = 1 unit of jute or 1 unit
of cotton = 2 units of jute.
Absolute cost differences arise, when each of the two countries can produce the commodity, at
an absolutely lower production cost, than the other. In above example, India has an absolute
advantage over Pakistan, in the production of cotton and Pakistan has a similar absolute
advantage over India, in the production of jute. India’s superiority in the production of cotton is
seen by the fact that:
100 units of cotton in India 50 units of jute in India
50 units of cotton in Pakistan > 100 units of jute in Pakistan

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