Free trade: absolute and

comparative advantage
(higher level topic)
The theory of absolute advantage dates back to the
work of the famous 18th-century economist Adam
Smith, who is considered to be the ‘Father of
Classical Economics’. Adam Smith was a strong
believer in the principle that specialization and free
trade (trade without any restrictions) can make all
countries better off. To explain this, he formulated
the theory of absolute advantage.
Theories of international trade
Using diagrams to explain the gains from
trade arising from absolute advantage
Absolute cost advantage
 Comparative cost advantage

If two PPCs do not intersect, how can we determine comparative advantages?

Very simply, the country that has the flatter PPC has a comparative advantage in the good measured on the horizontal axis. It follows
that the country with the steeper PPC has a comparative advantage in the good measured along the vertical axis.
Microchippia PPC is flatter than Cottonia PPC; therefore, Microchippia has a comparative advantage in microchips, which are
measured along the horizontal axis. Cottonia, with the steeper PPC, has the comparative advantage in cotton.
Microchippia has a lower opportunity cost in producing microchips, but Cottonia has a
lower opportunity cost in producing cotton. Though Cottonia has a higher absolute
cost in producing cotton, it has a lower relative cost, meaning that if Cottonia wants to
produce more cotton, it needs to sacrifice a smaller quantity of microchips than does
Microchippia. Therefore, Cottonia has a comparative advantage in cotton production,
while Microchippia has comparative advantage in
microchips.
 Therefore, whereas
under autarky (no
trade)
they would be
producing and
consuming on their PPC,
as a result of
specialization and trade
both countries
succeed in increasing
their consumption to a
greater
level than what is
possible under autarky.

With trade, both countries will consume at a point outside their PPCs.
Cottonia produces at point A of its PPC where it specializes entirely in cotton.
Microchippia produces at point C of its PPC where it specializes entirely in microchips.
They then decide to trade cotton and microchips at the price ratio of 1:1, so that 1 unit of
cotton trades for 1 unit of microchips and they agree to exchange 10 units of microchips for
10 units of cotton.
Thus with trade, Cottonia finds itself consuming 10 units of cotton (= 20 − 10 units of
exports) and 10 units of microchips (which it imports), or at point B which lies outside its
PPC. Microchippia finds itself consuming 40 units of Microchips (= 50 − 10 units of exports)
and 10 units of cotton (which it imports), or point D, which also lies outside its PPC.
Here country A has an absolute
advantage in the production of both
good X & good Y
The fact that the 2 PPCs are parallel
means that the two countries face
identical opportunity cost for the two
goods.
If OC are identical, there is no country
in which one good is relatively cheaper,
therefore there is no country that has a
comparative advantage in the
production of one or the other goods.
Under these circumstances (which do
not occur very often in the real world),
there are no possibilities for countries
to gain from specialization and trade,
and there is therefore no point in these
countries specializing and trading with
each other.
 Absolute advantage as a special case of
comparative advantage

According to the theory of comparative advantage,

countries gain from specialization and trade as long as
they have different relative costs of production, i.e.
different opportunity costs for their goods, regardless of
whether or not one country has an absolute advantage in
the production of all the goods.
This means that the theory of absolute advantage is
simply a special case that is included in the theory of
comparative advantage. Considering the case of Coffenia
and Robotia, the fact that Coffenia has an absolute
advantage in coffee and Robotia in robots does not affect
the conclusions of the theory of comparative advantage.
 The sources of comparative
advantage
countries can increase production and consumption of goods through
specialization and trade because of differences in factor endowments,
meaning differences in quantities and quality of factors of production,
and in levels of technology.
For example, a worker who is highly educated and skilled will likely be
able to produce a greater quantity of output per day than one who is
less educated and less skilled.
Similarly, a worker working with technologically advanced machines is
also likely to be able to produce more output than one working with
simpler machinery.
A country with a temperate climate will find it more costly to produce
crops such as coffee or cocoa, which are better suited to tropical
climates. Mountainous countries are less well suited to agriculture
than countries with fertile plains.
 The real-world relevance of the theory of
comparative advantage
The theory of comparative advantage depends on many unrealistic assumptions:
• Factors of production are immobile and Fixed
• Technology is fixed.
• There is perfect competition.
• There is full employment of all resources
• Imports and exports balance each other.
• There is free trade
• It is unrealistic to ignore transportation costs
• Specialization according to comparative advantage may not allow necessary structural
changes to occur in an economy.[Moreover, comparative advantage changes because of
changes in the
quantities and quality of factors of production and technology (as noted above). For example,
an agricultural economy may have a comparative advantage in agricultural products, but as it
becomes more industrialized, its comparative advantage may change in favor of manufactured
products.]
• Trade on the basis of comparative advantage may lead to excessive specialization.
[For example, if there is a fall in exports due to a global recession, or a fall in export prices due to
declining demand for the goods over long periods of time, the result will be falling revenues from
exports, falling incomes and economic decline.]