Absolute Advantage and Theory Literature Review

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Adam Smith's theory of absolute advantage and Ricardo's theory of comparative advantage offer two economic approaches to international trade. Each theory contributes to the field of international economics in different ways. This literature review will compare the two theories through the lens of scholarly articles published on the respective subjects.

By the 18th century (1776 to be exact), the development of international trade had reached a critical nexus: the colonies in America had revolted against the British Crown and a revolutionary character was evident throughout much of Western society. (The French would have their own Revolution before the century was out). Tackling the question of economic theory and its place in trade (in the light of this emerging climate) was Adam Smith with his massive treatise Wealth of Nations. Smith's concern focused on the specialization of labor -- the ability of producers to divide labor into parts to maximize output and achieve the greatest amount of profit as a result. When this theory was applied to international trade, a vision of all the countries of the world competing in a global marketplace emerged. As Smith pointed out, in a mercantilist system it would not be possible for all countries to maximize profitability if all were exporting more than they imported. Instead of placing harsh restrictions on imports and aggressively pursuing exports, Smith suggested that the theory of specialization be applied to trade and that a system of free trade be developed in which countries specialized in exporting only those items in which they had absolute advantage. Absolute advantage was defined thus: according to Smith's theory, some countries would be better than others at producing certain items -- such as cloth or wheat -- and therefore the better producer would be said to have absolute advantage over the other. It would therefore be in both countries interests (in terms of saving hours/labor) for the country with absolute advantage in producing a specific item to export it and for the other country to import it and vice-versa. In short, all countries would benefit through specialization and free trade: this was the heart of absolute advantage. The contribution it made to the field of international economics was that a system of free trade can in fact -- and must -- replace a mercantilist form of trade in the modern era.

However, if a country had no absolute advantage whatsoever, what would become of it? How would it ever profit in international trade? David Ricardo attempted to answer this question in 1817 when, building on the concept of absolute advantage, he devised the theory of comparative advantage. This theory held that even if a country does not have absolute advantage over another, it may have comparative advantage in that its labor productivity ratios are better. For Ricardo, labor was "the only source of value," which is why he devised the equation price = [rate of wages x labor production] / output. Thus, if a country's price of wheat was cheaper than in another country as a result of labor ratios, it would be able to be profitable in international trade (Chipman, 1966). Therefore, the contribution Ricardo's theory made to the field of international economics was that it showed that absolute advantage is not necessary for all countries to be profitable in free trade: comparative advantage is really all that is needed.

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While both theories have been extremely important for modern economics, each has its limitations -- mainly because of the innumerable variables that can and do impact either side of the equations. As models or foundations of economic thought they are helpful instruments -- and as Schumacher (2012) notes, it is thanks to Smith that economists today can assert with confidence that "international trade exploits the quantitative and qualitative benefits of an extended division of labor" (p. 60). Yet, while "trade and development cannot be separated in Smith's theory," what happens when development breaks down (Shumacher, 2012, p. 60) -- i.e., what happens when social, political and economic infrastructures taken as norms two hundred years ago no longer apply? Ricardo's theory can help to fill the gap by indicating that a comparative balance may always be achieved -- but even here the framework can be exploited in such a way that the desired balance is not achieved but rather heavily tilted towards one side or the other. Such is, after all, the effect of off-shoring as evidenced by "free" trade agreements such as GATT and NAFTA. Understanding how Smith's theory and Ricardo's theory work in the real world today is important because, after all, what is past is prologue -- and preparing for tomorrow cannot be achieved until what happened yesterday is firmly comprehended.

As Shumacher (2012) notes, Smith takes an "optimistic view of growth and economic progress" (p. 60-61). In 1776, one can hardly blame him for doing so: revolution was happening in the West -- progress the buzzword -- Equality and Liberalism about to be literally enthroned and exalted in Paris. Yet, less than half a century later, Ricardo was already dealing with some of the more unpleasant realities of international trade, business and economics -- the reality that lofty ideals as put forward by revolutionaries do not always find purchase in the cold, hard world of business. In an attempt to reconcile the optimism and good faith of Smith with the encroaching realism of the 19th century, Ricardo took up Smith's theory and began to adapt it: countries without any absolute advantage should still be able to compete. In order to support this belief, all that Ricardo required was a new way to describe value. He turned not to capital but to labor -- as did many minds in the 19th century. This trick, promoting labor as the basic source of all value, helped provide economic minds with a working framework for approaching international trade and economics; however, no one could have predicted that with the rise of the Industrial Revolution, a re-balancing of world powers, and, finally, the dawn of the Digital Age, the basic unit of value -- labor -- would need to be reassessed all over again. Value would need to be re-described, relocated, re-identified. What had been valuable to the 19th century mind was now worlds away from what was valuable to the 21st century mind.

From this perspective -- the perspective of time -- the two theories can be compared and contrasted as well:….....

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