Theory of Absolute Advantage and Comparative Advantage

Absolute Advantage

If one region can produce a commodity with less expense than another, and they exchange, then both should benefit. In a nutshell, this is the law of comparative advantage. It is used as the justification for WTO trade regulations.

Some land grows corn better than other land. This economical insight into farming in early 18th Century was the cornerstone of the law of absolute advantage. Some farmland will yield more corn per acre than another, therefore the good land confers an absolute advantage over other regions. The conclusion drawn from this argument is that the farmer of the poor land should change products that it can produce to its absolute advantage, such as grazing sheep.

The law of absolute advantage is based on the assumption that competition is the best paradigm within which to build an economy, it assumes that competition will improve production. The problem with the use of this paradigm is that it creates winners and losers. In every competition someone is excluded. That the farmer of the poor land should go raise sheep is not self-evident. This conclusion requires a firm faith in the motivation for profit as the raison d’etre of people and nations. It also follows that the net negative effects of the sheep farmer do not outweigh the benefits gained by that farmer or others in the region, or nation. Such may not be true. Competition is often used as an ideology to justify capitalism and the free market. Markets however, are primarily co-operative endeavours. Except for Darwinian battles of life and death, every competitive endeavour is established by first co-operating, setting rules, and agreeing to compete. Co-operative markets allow for competition, not the other way around. To this end, competition should never be seen as a natural law, but merely as a by-product of co-operation, an agreed upon behaviour.

Comparative Advantage

Comparative advantage developed from ideas generated around the “labour theory of value” in economic debate by David Ricardo. Ricardo was operating under the assumption that the value of any given product was to be derived from the total of its labour content. In a more complex society, we recognize the additional costs of land and capital involved in the evaluation of a good.

The law of comparative advantage posits that within a country, a region will produce goods it can make cheaper than other regions (Jackson, International Economic Relations, Kindleberger, 3rd ed. (West Group) Minn, 1995. P.8.). That the value of a commodity within a country is determined by its labour, land, and capital content. During the production life of a good, the supply will expand until the price is levelled down to the total value of the labour, land, and capital that it contains. Therefore a country should export the product in which it has the greater advantage, or comparative advantage, and import the commodity in which its advantage is less, or in which it has a comparative disadvantage. Even when one country can produce both commodities more efficiently than another country, both can gain from specialization and exchange, provided that the efficiency advantage is greater in some commodity or commodities than in others. International trade does not require offsetting absolute advantages but is possible where a comparative advantage exists. However, a comparative advantage is always accompanied by a comparative disadvantage.

In order for this to be true, the theory of comparative advantage must be restricted to a set of highly artificial and limited applications. The theory must assume efficient transportation, efficient labour and ready capital. All factors that fluctuate depending on social conditions. It also assumes that the value of a product is the sum of its production costs. The theory requires that full social costs be calculated in a benefits analysis of comparative advantage.  This is a very difficult endeavour requiring techniques to measure large intangibles. Even if the costs were known as to labour, land, and the capital involved, the benefits of a public bus route, phone lines, or transportation systems, plus a thousand other contributions are very difficult to measure.

Another problem with the general application of this theory is the limitation on sources of value for a good. Production costs are not the total cost involved over the life of a good. Products that end up polluting our land and water must be cleaned up, adding to the social cost of having the product. The total value of a good should include production costs and the final distribution costs in order to adequately reflect the full social value accruing to the good. Distribution costs can either be included in the price of delivery, or they can be an added expense after the sale. It is usually not known what the distribution costs of a product will be until it is consumed or used, or finds a last resting place. But so long as the theory of comparative advantage limits the evaluation of a product to production costs it will not accurately predict which trade in goods result in benefits. Limiting the value of a product to its production costs creates a false sense of benefit, if the advantage is offset by distribution costs.

Goods can fit into four different categories. Goods can be useful, useless, durable, or disposable. Obviously goods traded that are more useful and more durable are of better advantage than goods that are useless and disposable. Profit can be made on goods of any category, however comparing costs of useless goods to real goods may be misleading as to the actual values and benefits involved. The theory of comparative advantage does not adequately discriminate between products that are more useful than others. Trade in totally useless widgets, regardless of cheap production costs do not benefit the receiving parties.

The law of comparative advantage should distinguish between the production of durable, useful goods over goods that are merely profitable. To be accurate it its claims, the theory of comparative advantage only holds true if the value of the goods traded is of a similar nature. The character of the good should be taken into consideration in any value assessment. Cheap products of useless junk backed up by a great marketing campaigns do not create a comparative advantage of real value, although they do lead to speculative profit making. It would be better to import durable goods than trade them in exchange for non-value adding, or useless products. Importation of goods that are generally disposable and useless, in the long run will only disadvantage a community.

Source: Scribd.com

About Abey Francis

Abey Francis is the founder of MBAKnol - A Blog about Management Theories and Practices - and he's always happy to share his passion for innovative management practices. You can found him on Google+ and Facebook. If you’d like to reach him, send him an email to: [email protected]

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