According to Adam Smith (who is regarded as the father of modern economics), countries should only produce goods that they have an absolute advantage in.
A country is said to have an absolute advantage if the country can produce a good at a lower cost than another. Furthermore, this means that fewer resources are needed to provide the same amount of goods as compared to the other country. This efficiency in production creates “an absolute advantage,” which allows for beneficial trade.
As opposed to the Absolute Advantage Theory, the Comparative Advantage theory was developed by David Ricardo, argues that a country doesn’t have to have an absolute advantage for beneficial trade to occur.
Assumptions in Absolute Advantage
1. Lack of Mobility for Factors of Production
2. Trade Barriers
There are no barriers to trade for the exchange of good. Governments implement trade barriers to restrict or discourage the importation or exportation of a particular good.
3. Trade Balance
Smith assumes that exports must be equal to imports. This assumption means that we cannot have trade imbalances, trade deficits or surpluses. A trade imbalance occurs when exports are higher than imports or vice versa.
4. Constant Returns to Scale
Adam Smith assumes that we will get constant returns as production scales, meaning there are no economies of scale. For example, if it takes 2 hours to make one loaf of bread in country A, then it should take 4 hours to produce two loaves of bread. Consequently, it would take 8 hours to produce four loaves of bread.
However, if there were economies of scale, then it would become cheaper for countries to keep producing the same good as it produced more of the same good.
Example of Absolute Advantage
In our Absolute Advantage example, we assume that there are two countries, which are represented by a blue and red line, Blue Country and Red Country respectively.
To keep things simple, we also assume that only two goods are produced, Good A and Good B. From the table below, we can determine how many hours it takes to create one product.
Consider this table, which gives hours required to produce one unit of Good A and Good B by Blue and Red country:
The Blue country has an Absolute Advantage in the production of Good A (2 hours). This is because it takes fewer hours to produce a unit of Good A than Red country, which takes 10 hours.
Red Country takes fewer hours to produce Good B (4 hours), therefore Red Country has an Absolute Advantage in the production of Good B.
As a result, Blue Country will be better off if it specializes in the production of Good A.
Red Country will be better off if it specializes in Good B.
As you can see from our example, it makes sense from businesses and countries to trade with one another. All countries engaged in open trade benefit from lower costs of production.