Agribusiness Management and Trade 3(3+0)

Lesson-37 Absolute Advantage Theory of International Trade

37.2  THEORY OF MERCANTILISM

The theory of mercantilism attributes and measures the wealth of a nation by the size of its accumulated treasures. Accumulated wealth is traditionally measured in terms of gold, as earlier gold and silver were considered the currency of international trade. Mercantilists, therefore, suggested that the fundamental task of the national government is to acquire as much of gold and other precious metals as possible, through foreign trade. The only way in which this can be accomplished by a country is, when it is able to run perpetually favourable balance of trade for itself. i.e. by exporting more and more and importing less and less. The difference between exports and imports, which must be always in favour of the nation, would be settled by an inflow of gold and other precious metals. The more gold the nation had, richer and more powerful it would be. All this could be guaranteed by foreign trade that is in favour of the country. The mercantilists, as great “nation builders” advocated that the government should adopt policies which are designed to restrict imports and stimulate exports; because we lose gold by importing and earn gold by exporting.  The theory of mercantilism aims at creating trade surplus, which in turn contributes to the accumulation of a nation’s wealth. Between the 16^th and 19^th centuries, European colonial powers actively pursued international trade to increase their treasury of goods, which were in turn invested to build a powerful army and infrastructure.

Mercantilism was implemented by active government interventions, which focused on maintaining trade surplus and expansion of colonization. National governments imposed restrictions on imports through tariffs and quotas and promoted exports by subsidizing production. The colonies served as cheap sources for primary commodities, such as raw cotton, grains, spices, herbs and medicinal plants, tea, coffee, and fruits, both for consumption and also as raw material for industries. Thus, the policy of mercantilism greatly assisted and benefited the colonial powers in accumulating wealth.

The main limitation of this theory is, accumulation of wealth takes place at the cost of another trading partner. If one nation has to gain from international trade the partner country must lose. Therefore, international trade is treated as a win-lose game resulting virtually in no contribution of global wealth. Thus, international trade becomes zero-sum game.

A number of national governments still seem to cling to the mercantilist theory, and exports rather than imports are actively promoted. This also explains the reason behind the ‘import substitution strategy’ adopted by a large number of countries prior to economic liberalization. This strategy was guided by their keenness to contain imports and promote domestic production even at the cost of efficiency and higher production costs. It has resulted in the creation of a large number of export promotion organizations that look after the promotion of exports from the country. However, import promotion agencies are uncommon in most nations. Presently, the terminology used under this trade theory is neo-mercantilism, which aims at creating favourable trade balance and has been employed by a number of countries to create trade surplus.

37.3  THEORY OF ABSOLUTE ADVANTAGE

In 1776, Adam Smith published his famous book The Wealth of Nations, in which he attacked the mercantilist view and showed that it was all wrong and illogical, for one thing, not all nations can have an export surplus simultaneously. Mercantilist policy, therefore, cannot be considered as international economic policy. Their policy was highly nationalistic and biased heavily against the other countries. It was Adam Smith who first developed a model of international trade and showed convincingly that all countries could gain form trade. Mercantilists had measured the wealth of nation by the stock of precious metals that the nation possessed. Adam Smith rejected all this and argued instead, that the wealth of a nation is measured by the amount of goods and services that a nation produced, or by what is today called Gross National Product (GNP). He developed the comparative advantage model, where he showed that international trade could bring gains to all trading nations, thereby improving the wealth and standards of living of all the participating nations. In his model of trade, unlike the mercantilist’s model, a nation need not gain only at the expense of other nations; here all nations gain together and simultaneously.

An absolute advantage refers to the ability of a country to produce a good more efficiently and cost-effectively than any other country. Smith elucidated the concept of ‘absolute advantage’ leading to gains from specialization with the day-to-day illustrations as follows:

“It is the maxim of every prudent master of a family, never to make at home what is will cost him more to make than to buy. The taylor does not attempt to make his own shoes, but buys them from shoemaker. The shoemaker does not attempt to make his own clothes, but employs a taylor. The farmer attempts to make neither…”

What is true in the conduct of a family may also be applied for the nations. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it from them with some part of the produce of our own industry. Thus he advocated, instead of producing all products, each country should specialize in producing those goods that it can produce more efficiently. A country’s advantage may be either natural or acquired.

2.3.1  Natural Advantage

Natural factors, such as a country’s geographical and agro-climatic conditions, mineral or other natural resources, or specialized manpower contribute to a country’s natural advantage in certain products. For instance, the agro-climatic condition in India is an important factor for sizeable export of agro-produce, such as spices, cotton, tea and mangoes etc. The availability of relatively cheap labour contributes to India’s edge in export of labour-intensive products. The production of wheat and maize in US, petroleum in Saudi Arabia, citrus fruits in Israel, lumber in Canada, and aluminum ore in Jamaica are illustrations of natural advantages.

2.3.2 Acquired Advantage

The acquired advantage in either a product of its process technology plays an important role in creating such as shift. The ability to differentiate or produce a different product is termed as an advantage in product technology, while the ability to produce a homogenous product more efficiently is termed as an advantage in process technology. Development of software products in India, production of consumer electronics and automobiles in Japan, watches in Switzerland and shipbuilding in South Korea may be attributed to acquired advantage. Export centers in for precious and semi-precious stones in Jaipur, Surat, Navasari and Mumbai have come up not just because of their raw material resources but the skills they have developed in processing imported raw stones.

To appreciate the theory of absolute advantage, consider an example of two countries and two commodities model. Let Malaysia and India be the two such countries and Rubber and Textiles be the commodities. Assume that in the production of these commodities in two countries, there are constant returns to scale conditions i.e. there are constant marginal opportunity opportunity cost conditions in both countries in both commodities. Assume further production possibilities are such that both countries can produce both the goods if they wish. Finally assume that both countries have X amount of factors of production such that,

a.   With X factors of production, Malaysia can produce either 100 units of rubber or 50 units of textiles, or mix of rubber and textiles in the opportunity cost ratio of 2:1 (i.e. to produce 1 more unit of textiles, it has to give up the opportunity of producing 2 units of rubber).
b.  With X factors of production India can produce either 50 units of rubber or 100 units of textiles. Or some other combination of rubber and textiles subject to the opportunity cost ratio of 1:2 (This means that India has to give up producing 1 unit of rubber in order to produce 2 units of textiles or alternatively, India has to give up the opportunity of producing 2 units of textiles in order to product 1 more unit of rubber).

From the above supply conditions it is quite clear that Malaysia has an absolute advantage in the production of rubber and India has the absolute advantage in the production of textiles. This shows there is scope for specialization in production and also of establishing mutually beneficial trade between the two countries. Now let us see how it happens.

First in a situation of autarky or no trade, each country can produce and consume independent of other country, a combination of rubber and textile as shown in table 37.1. Malaysia produces and consumes 50 units of rubber plus 25 units of textiles (total 75 units). India produces 25 units of rubber plus 50 units of textiles (total 75 units). Therefore, in absence of any trade, the total units produced in the world are 150 units.

Table 37.1. Production and consumption levels with no trade

Countries	Commodities		Total output (units)
	Rubber (units)	Textiles (units)
Malaysia	50	25	75
India	25	50	75
World	75	75	150

Let us now examine what happens if they trade with each other. This is shown in the table 37.2. Malaysia would specialize in production of rubber and India in production of textiles with 100 units of rubber and textiles respectively by utilizing all the resources. Thus the total production in the world would be 200 units. Thus opening up trade resulted in higher production in both the countries. Both the countries became richer after trade in terms of production. This is production gain from international trade.

Table 37.2. Production levels after international trade

Countries	Commodities		Total output (units)
	Rubber (units)	Textiles (units)
Malaysia	100	0	100
India	0	100	100
World	100	100	200

 

What about the consumption gain? This depends on how the gains from the production are distributed between the two countries. In other words, it depends on the terms of trade, i.e., how many units of rubber exchange for one unit of textiles between India and Malaysia.

Suppose terms of trade are fixed at 1:1 i.e., Malaysia and India agree to exchange 1 unit of rubber for 1 unit of textiles. Then depending on the taste pattern in the two countries and upon how much they want to trade each other’s goods, the consumption gains can be determined. Supposing that the consumers in both countries want to consume some mix of both the goods; then Malaysia could export say 40 units of rubber in exchange for 40 units of textile imports from India. The resulting situation will be like that is presented in table 37.3. Malaysia after trade has produced 100 units of rubber. Consumers wish to consume 60 units of rubber to India. Malaysia exports 40 units of rubber to India in exchange for 40 units of textile imports from India. Similarly for India, it imports 40 units of rubber and exports 40 units of textiles. India’s post trade consumption of rubber and textile is 40 and 60. Clearly consumers in both the countries have gained from the trade.

The same analogy can be applied what happens if the terms of trade are different.

Table 37.3. Consumption shares after international trade

Countries	Commodities		Total output (units)
	Rubber (units)	Textiles (units)
Malaysia	60	40	100
India	40	60	100
World	100	100	200