Chapter 4 Outline

Absolute Advantage

In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game. Smith argued that countries differ in their ability to produce goods efficiently. In his time, the English, by virtue of their superior manufacturing processes, were the world's most efficient textile manufacturers. Due to the combination of favorable climate, good soils, and accumulated expertise, the French had the world's most efficient wine industry. The English had an absolute advantage in the production of textiles, while the French had an absolute advantage in the production of wine. Thus, a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it.

According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries. In Smith's time, this suggested that the English should specialize in the production of textiles while the French should specialize in wine. England could get all the wine it needed by selling its textiles to France and buying wine in exchange. Similarly, France could get all the textiles it needed by selling wine to England and buying textiles in exchange. Smith's basic argument is that you should never produce goods at home that you can buy at a lower cost from other countries. Moreover, Smith demonstrates that by specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade.

Consider the effects of trade between Ghana and South Korea. The production of any good (output) requires resources (inputs) such as land, labor, and capital. Assume that Ghana and South Korea both have 200 units of resources and that these resources can be used to produce either rice or cocoa. Imagine that in Ghana it takes 10 resources to produce one ton of cocoa and 20 resources to produce one ton of rice. Thus, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa in between these two extremes. The different combinations that Ghana could produce are represented by the line GG' in Figure 4.1. This is referred to as Ghana's production possibility frontier (PPF). Similarly, imagine that in South Korea it takes 40 resources to produce one ton of cocoa and 10 resources to produce one ton of rice. Thus, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between these two extremes. The different combinations available to South Korea are represented by the line KK' in Figure 4.1, which is South Korea's PPF. Clearly, Ghana has an absolute advantage in the production of cocoa (more resources are needed to produce a ton of cocoa in South Korea than in Ghana), and South Korea has an absolute advantage in the production of rice.

Now consider a situation in which neither country trades with any other. Each country devotes half of its resources to the production of rice and half to the production of cocoa. Each country must also consume what it produces. Ghana would be able to produce 10 tons of cocoa and 5 tons of rice (point A in Figure 4.1), while South Korea would be able to produce 10 tons of rice and 2.5 tons of cocoa. Without trade, the combined production of both countries would be 12.5 tons of cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15 tons of rice (5 tons in Ghana and 10 tons in South Korea). If each country were to specialize in producing the good for which it had an absolute advantage and then trade with the other for the good it lacks, Ghana could produce 20 tons of cocoa, and South Korea could produce 20 tons of rice. Thus, by specializing, the production of both goods could be increased. Production of cocoa would increase from 12.5 tons to 20 tons, while production of rice would increase from 15 tons to 20 tons. The increase in production that would result from specialization is therefore 7.5 tons of cocoa and 5 tons of rice. Table 4.1 summarizes these figures.

By engaging in trade and swapping one ton of cocoa for one ton of rice, producers in both countries could consume more of both cocoa and rice. Imagine that Ghana and South Korea swap cocoa and rice on a one-to-one basis; that is, the price of one ton of cocoa is equal to the price of one ton of rice. If Ghana decided to export 6 tons of cocoa to South Korea and import 6 tons of rice in return, its final consumption after trade would be 14 tons of cocoa and 6 tons of rice. This is four tons more cocoa than it could have consumed before specialization and trade and one ton more rice. Similarly, South Korea's final consumption after trade would be 6 tons of cocoa and 14 tons of rice. This is 3.5 tons more cocoa than it could have consumed before specialization and trade and 4 tons more rice. Thus, as a result of specialization and trade, output of both cocoa and rice would be increased, and consumers in both nations would be able to consume more. Thus, we can see that trade is a positive-sum game; it produces net gains for all involved.

Figure 4.1

The Theory of Absolute Advantage

Table 4.1

Absolute Advantage and the Gains from Trade

			Resources Required to Produce 1 Ton of Cocoa and Rice
			Cocoa		Rice
	Ghana		10		20
	South Korea		40		10
			Production and Consumption without Trade
			Cocoa		Rice
	Ghana		10.0		5.0
	South Korea		2.5		10.0
	Total production		12.5		15.0
			Production with Specialization
			Cocoa		Rice
	Ghana		20.0		0.0
	South Korea		0.0		20.0
	Total production		20.0		20.0
			Consumption after Ghana Trades 6 Tons of Cocoa for 6 Tons of South Korean Rice
			Cocoa		Rice
	Ghana		14.0		6.0
	South Korea		6.0		14.0
			Increase in Consumption as a Result of Specialization and Trade
			Cocoa		Rice
	Ghana		4.0		1.0
	South Korea		3.5		4.0