Theory of Absolute Advantage

Theory of Absolute Advantage (Adam smith theory)

• Regarded as first formal theory in int’l trade
• Country’s wealth is based on its available goods/ services rather than gold
• Prescribes country to specialize in that product
  • That give it competitive advantage.
  • Advantage can be Natural/ Acquired.
• Natural adv. Considers climate and natural resources
• Acquired adv. Considers technology/ skill development through human effort

Country	Output of X	Output of Y
A	2 units	4 units
B	1 unit	6 units

• Absolute cost adv. To country A = product X, 2x>1x
• Absolute cost adv. To country B = Product Y, 6Y>4Y
• Specialization is recommended in respective goods.
  • Country A= X, Country B=y

Exchange rate:

Country A, 1x=2y

Country B, 1x=6y

• Country A export… 2x for 6y, net gain= 2y (6-4)
• Country B export … 6y for 2x, net gain= 1x (2-1)