Theory of Absolute Cost Advantage

4843 Words Jun 5th, 2008 20 Pages
Theory of Absolute Cost Advantage

MERCANTILISTS’ VERSION

Mercantilism stretched over nearly three centuries, ending in the last quarter of the eighteenth century. It was the period when the nation-states were consolidating in Europe. For the purpose of consolidation, they required gold that could best be accumulated through trade surplus. In order to achieved trade surplus, their governments monopolized trade activities, provided subsidies and other incentives for export, and restricted imports. Since most European countries were colonial powers, they imported low cost raw material from their colonies and exported high cost manufactured goods to the colonies. They also prevented colonies from producing manufacturing. All this was done in
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Similarly in Pakistan 10 kilogram of food grains will be produced instead of 7.5 kilogram.

The theory of absolute cost advantage explains how trade helps increase the total output in the two countries. But it fails to explain whether trade will exist if any of the two countries produces both of goods at lower cost. In fact, this was the deficiency of this theory, which led David Ricardo to formulate the theory of comparative cost advantage (Haberler, 1950).

Theory of Absolute Cost Advantage

Amount of Production in Absence of Trade Amount of Production after Trade Rice Wheat Rice Wheat
Bangladesh
Pakistan
Total output in two countries: 5 kg
2.5 kg

15 kg 2.5 kg
5 kg Bangladesh
Pakistan
Total output in two countries: 10 kg
Nil

20 kg Nil
10 kg

Theory of Comparative Cost Advantage

Ricardo focuses not on absolute efficiency but on relative efficiency of the countries for producing goods. This is why his theory is known as the theory of comparative cost advantage. In a two-country, two-commodity model, he explains that a country will produce only that product which it is above to produce more efficiently.

Suppose Bangladesh and India, each of the two has 100 units of labour. One half of the labour force is used for the production of rise and the other half is used for the production of wheat in the absence of trade. In Bangladesh, 10 units of labour are required to produce either one kilogram of rice one kilogram of wheat. On the contrary,
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