International Business

Delivered in: Islamia University Bahawalpur

Presented By: Tasawar Javed

Theory of Absolute Advantage

Its a theory what it says??

You produce something; and produce it on low cost than any one else; should you produce same item or any other which is expensive to produce?? By specializing in the production of goods which they can produce more efficiently than any other nations, it can increase their wellbeing

Example now!!!

Theory of Absolute Advantage

Example:

Assume that two nations North and South Both produce two goods (commodities) cloth and Grain
Assume further that

Labor is the only factor of production and thus the only cost of production

Absolute Advantage Example

Labor cost (hours) of production for one Unit

Cloth 10 20

North South

Grain 20 10

Labor is the only cost of production, lower labor hours per unit means lower production costs, and higher productivity per labor hour. Who has advantage??

Absolute Advantage

North has absolute advantage in the production of cloth

Cost requires only 10 labor hour Compared with 20 labor hours in South Cost requires only 10 labor hour Compared with 20 labor hours in North

Similarly, south has absolute advantage in the production of Grain

Absolute advantage

Who is Gain by this Trade?

Assume Again they specialize and exchange cloth for grain at a relative price of 1:1 What you will do being the part of any Nation??? Participation from Class?? You will employ your resources to produce what???

Absolute Advantage

Each country can employ their resources to produce a greater amount of goods. North Can import one unit of Grain in exchange for one unit of Cloth

what does it mean??

They can get Grain only for 10 labor hours rather than 20 labor hours if they produce their self.

So who Gains?? North Gain 10 labor hours when import grain from South and similarly South gains 10 labor hours when they import Cloth from North

Absolute Advantage

Whats wrong with this theory??

It doesnt predict the exchange ration between cloth and grain once trade is opened nor does it resolve the division of the gains from trade between the two countries. We assumed 1:1; but it could be 2:1 or 1:2 We need to know the total resources of each country (total labor hour & demand of each country)

Absolute Advantage

Important implications
if one country has absolute advantage then there is potential for gains from Trade 2. The more a country is able to specialize in the production of the good it produces most efficiently, the greater its potential gains in national well-being 3. With in one country the competitive market does not evenly distribute the gains from Trade. Followed by example for 3rd implication.
1.

Absolute Advantage

Prior to Trade: The Grain producers in North require 20 hours; production of one unit of grain could be exchanged for two units of Cloth. After Trade: Grain producer, who remain could exchange one unit of grain for only one unit of cloth. The remaining grain producers are worse off trade.

Absolute advantage

Cloth producer in North, how-ever work 10 hours; produce one unit of cloth, & exchange it for one unit of grain. Where as previously they received only a half unit of grain. They are better off. If Grain producer in North switch to cloth production, then 20 hours of labor results production of 2 units of cloth production. They can exchange with 2 units of Grains. They are better off under this trade. Who is looser? Who is Gainer with this Trade???

Absolute Advantage

If North doesnt specialize completely in cloth, there will be gainer

Cloth producer and Grain producer now switched to cloth Those who continue as Grain producer

And losers?

Why?? Example of Pakistan. Especially in Sugar scenario.

What NEXT????

Other Theory

What Next???

If labor hour is same in both countries???? Where the Trade will stand??? Next lecture

Theory of Comparative Advantage

Thank You!!!!

Q&A