Q2 - Discuss in brief the Absolute and comparative cost advantage theories.
Ans:
Adam Smith (a social philosopher and a pioneer of political economics) argued that nations differ in their ability to manufacture goods efficiently and he saw that a country gains by trading. If the two countries exchanged two goods at ratio of 1:1, country I gets one unit of goods B by sacrificing only 10 units of labor, whereas it has to give up 20 units of labor if it produced the goods itself. In the same manner country II gives up only 10 units of labour to get one units of goods A, whereas it has to give 20 units of labour if it was made by itself. Hence it was understood that both countries had large amount of both goods by trading.
Ricardo (English political economist) questioned Smith’s theory stating if one country is more productive than the other in all lines of production and if country I can produce all goods with less labour costs, will there be a need for the countries to trade. The reply was affirmative.
He used England and Portugal as examples in his demonstration the two goods they produced being wine and cloth.
This case is explained using following table:
Labour cost of production (in hours)
1 unit of wine
1 unit of cloth
Portugal
70
80
England
110
90
According to him Portugal has an advantage in both areas of manufacture. To demonstrate that trade between both countries will lead to gains, the concept of opportunity cost (OC) is introduced.
Ans:
Absolute Advantage:
Adam Smith (a social philosopher and a pioneer of political economics) argued that nations differ in their ability to manufacture goods efficiently and he saw that a country gains by trading. If the two countries exchanged two goods at ratio of 1:1, country I gets one unit of goods B by sacrificing only 10 units of labor, whereas it has to give up 20 units of labor if it produced the goods itself. In the same manner country II gives up only 10 units of labour to get one units of goods A, whereas it has to give 20 units of labour if it was made by itself. Hence it was understood that both countries had large amount of both goods by trading.
Comparative Advantage:
Ricardo (English political economist) questioned Smith’s theory stating if one country is more productive than the other in all lines of production and if country I can produce all goods with less labour costs, will there be a need for the countries to trade. The reply was affirmative.
He used England and Portugal as examples in his demonstration the two goods they produced being wine and cloth.
This case is explained using following table:
Labour cost of production (in hours)
1 unit of wine
1 unit of cloth
Portugal
70
80
England
110
90
According to him Portugal has an advantage in both areas of manufacture. To demonstrate that trade between both countries will lead to gains, the concept of opportunity cost (OC) is introduced.
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