Strategic Management: Formulation and Implementation

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.