Theory Of Absolute Advantage

Adam Smith, in The Wealth of Nations, postulated that under free trade, each nation should specialize in producing those goods that it could produce most efficiently. Some of these would be exported to pay for the imports of goods that could be produced more efficiently elsewhere.

Smith ridiculed the fear of trade bo comparing nations to households. Since every household finds it worthwhile to produce only some of its needs and to buy others with products it can seel, the same should apply to nations:

It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The taylor does not attempt to make his own shoes, but buys them from shoemaker... What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with some part of the product of our own industry, employed in a way in which we have some advantage.

The theory of absolute advantage is based on the assumption that the nation is absolutely better (i.e., more efficient) at production of certain goods than are its trading partners. Smith showed by his example of absolute advantage that both nations would gain from trade.

Theory Of Comparative Advantage

David Ricardo, in 1817, enunciated his refinement of Smith's concept by postulating the principle of comparative advantage (as opposed to Smith's concept of absolute advantage). The theory of comparative advantage states that even if a country is able to produce all its good at lower costs than another country can, trade still benefits both countries, based on comparative costs. His writings demonstrated what has become known as:

"... the principle of comparative advantage: a nation, like a person, gains from the trade by exporting the goods or services in which it has its greatest comparative advantage in productivity and importing those in which it has the least comparative advantage."

The key word is comparative, meaning relative and not necessarily absolute. There are gains from trade whenever the relative price ratios of two goods differ under international exchange for what would be under conditions of no trade. In addition, the theory of comparative advantage demonstrates that countries jointly benefit from trade (under the assumption of both goods).

With the theory of absolute advantage, Ricardo's theory of comparative advantage does not answer why production cost differ within each country and also no consideration is given to the possibility of producing the same goods with different combinations of factors.

The leading theory of what determines nations' trade patterns was presented by Eli Heckscher in 1919 and a clear overall explanation was developed and publicized in the 1930s by Heckscher's student, Bertil Ohlin.