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 order to generate export augmentation and import restriction lay at the root of the
mercantilist theory of international trade. However, the later versions of the mercantilist
doctrine explained that trade surplus was not an overlasting phenomenon. A positive
trade balance led to an increase in the commodity prices relative to other countries. The
increase in commodity prices caused a drop in export and, thereby, erosion in the surplus
of the trade balance. Moreover, the exponents of this theory ignored the concept of
production efficiency through specialization. In fact, it is production efficiency that
brings in gains from trade (Heckscher, 1935).

CLASSICAL APPROACH

Classical economists refuted the mercantilist notion of precious metals and specie being
the source of wealth. They thought domestic production was the prime source of wealth;
and thereby assumed productive efficiency to be the motivating factor behind trade. Two
of the classical theories need to be mentioned here: one propounded by Adam Smith and
the other propounded by David Ricardo.

Theory of Absolute Cost Advantage

Adam Smith was one of the forerunners of the classical school of thought. He
propounded a theory of international trade in 1779, which is known as the theory of
absolute cost advantages. He was of the opinion that productive efficiency differed
among different countries because of diversity in the natural and acquired resourced
possessed by them. The difference in natural advantages manifests in varying climate,
quality of land, availability of minerals, water and other natural resources; while the
difference in acquired resources manifests in different levels of technology and skills
available. A particular country should specialize in producing only those goods that it is
able to produce with greater efficiency that is at lower cost; and exchange those goods
with other goods of their requirement from a country that produces those other goods
with greater efficiency, or at lower cost. This will lead to optimal utilization of resources
in both the countries. Both countries will gain from trade insofar as both of them will get
the two sets of goods at the least cost.

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 Adam Smith explains the concept of absolute advantages in a two-commodity,
two-country framework. Suppose Bangladesh produces one kilogram of rice with 10
units of labour or it produces one kilogram of wheat with 20 units of labour. On the other
hand, Pakistan produces the same amount of rice with 20 units of labour and produces the
same amount of wheat with 10 units of labour. Each of the countries has 100 units of
labour. Equal amount of labour is used for the production of two goods in the absence of
trade between the two countries.

In the absence of trade, Bangladesh will be able to produce 5 kilogram of rice and
2.5 kilogram of wheat. At the same time, Pakistan will produce 5 kilogram of wheat and
2.5 kilogram of rice. But when trade is possible between the two countries, Bangladesh
will produce only rice and exchange a part of the rice output with wheat with Pakistan.
Pakistan will produce only wheat and exchange a part of the wheat output with rice from
Bangladesh. The total output in both the countries will rise because of trade. Bangladesh,
which was producing 7.5 kilogram of food grains in the absence of trade, will now
produce 10 kilogram of food grains. 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 5 kg 2.5 kg Bangladesh 10 kg Nil
Pakistan 2.5 kg 5 kg Pakistan Nil 10 kg
Total output in two Total output in two
countries: 15 kg countries: 20 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

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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,
in India, 5 units of labour are required to produce one kilogram of wheat and 8 units of
labour are required for producing kilogram of rice. If one looks at this situation from the
viewpoint of absolute cost advantage, there will be no trade as India possesses absolute
cost advantages in the production of both commodities. But Ricardo is of the view that
from the viewpoint of comparative cost advantages, these will be trade because India
possesses comparative cost advantage in the production of wheat. This is because the
ratio of cost between Bangladesh and India is 2:1 in case of wheat, while it is 1.25:1 in
case of rice. Because of this comparative cost advantages, India will produce only 20
kilogram of wheat with 100 units of labour and export a part of the rice to India. The total
output of foodgrains in the two countries, which was equal to 26.25 kilogram prior to
trade, rises to 30 kilogram after trade. Thus, it is the comparative cost advantage that
leads to trade and to specialization in production and, thereby, to increase in the total
output of the two countries.

Despite being simple, the classical theory of international trade suffers from a few
limitations. Firstly, it takes into consideration only one factor of production, that is
labour. But in the world, there are other factors of production too that play a decisive role
in production. Similarly, the theory does not take into account the transportation cost
involved in trade.

Theory of Comparative Cost Advantage

Amount of Production in Absence of Trade Amount of Output after Trade

Rice Wheat Rice Wheat
Bangladesh 5.00 kg 5.00 kg Bangladesh 10.00kg Nil
Pakistan 6.25 kg 10 kg Pakistan Nil 20.00kg
Total output in Total output in
two countries: 26.25 kg two countries: 30 kg

Secondly, the theory assumes the existence of full employment, but in practice,
full employment is a utopian. Normally, entire resources in a country are not fully
employed. In such cases, the country restricts import in order to employ its idle resources,
even if these resources are being employed efficiently.

Thirdly, the theory stresses too much on specialization that is expected to improve
efficiency. But it is not always the case in real life. The countries may pursue some other
objectives too, which may not necessarily be productive efficiency. This is because when
the country when the country specializes in the production of a particular good, changes
in technology make the economy highly vulnerable.

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 Fourthly, classical economists feel that resources are mobile domestically and
immobile internationally. But neither of the two assumptions is correct. Within the
country, it is difficult for the labour to move from one occupation to another, especially
when the job is highly technical. On the contrary, labour and capital move easily across
nations.

Nevertheless, the empirical tests carried on by MacDougall (1951), Stern (1962),

and Balassa (1963) supported the Ricardian hypothesis. It would not be wrong to say that
the classical theory holds good even today insofar as it suggests how a nation could
achieve the consumption level beyond what it could do in the absence of trade. This is
why countries stress upon expansion in the world trade (Haberler, 1950).

FACTOR PROPORTIONS THEORY

Almost after a century and a quarter of the classical version of the theory of international
trade, two Swedish economists, Eli Heckscher and Bertil Ohlin, propounded a theory that
is known as the factor endowment theory or the factor proportions theory. In fact, it was
Eli Heckscher (1919) who mooted the notion of a country’s comparative advantage
(disadvantage) based on relative abundance (scarcity) of factors of production. Later on,
his student, Bertil Ohlin (1933) developed this notion of relative factor abundance into a
theory of the pattern of international trade.

The theory explains that in a two-country, two-factor, and two-commodity

framework different countries are endowed with varying proportions of different factors
of production. Some countries have large populations and large labour resources. Thus, a
country with a large labour force will be able to produce the goods at a lower cost using a
labour intensive mode of production. Similarly, countries with a large supply of capital
will specialize in goods that involve a capital intensive mode of production. The former
will export its labour intensive goods to the latter and import capital intensive goods from
the latter. After the trade, both the countries will have two types of goods at the least cost
(Ohlin, 1933).

All this means that the theory holds good if a capital abundant country has a
distinct preference for the labour intensive goods and a labour abundant country has a
distinct preference for capital intensive goods. If it not so, the theory may not hold good.
Again, the theory does not hold good if the labour abundant economy is technologically
advanced in capital intensive goods or if the capital abundant economy is technologically
advanced in the production of labour intensive goods.

Samuelson (1948, 1949) introduced refinements to factor proportions theory by

considering the effect of trade upon national welfare and the prices of the factors of
production. He stated that the effect of the free trade among nations would be to increase
the overall welfare by equating not only the prices of goods exchanged but also the prices
of factors of production involved in the production of those goods in different countries.
For example, the price of capital in the capital abundant economy of the USA will be

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much lower than that in case of the labour surplus economy of India. But after trade is
established between the two countries, more capital intensive commodities will be
produced in the USA. As a result, the price of capital will increase in the USA and the
existing differential in this respect between the two countries will be lower. Similarly,
more labour intensive commodities will be produced in India. Wage level will increase in
India, with the result that the wage differential between level will increase in India, with
the result that the wage differential between the two countries will be narrower.

Leontief (1954) put this theory to empirical testing and found in case of US trade
during 1950s the country was exporting less capital intensive goods even when it had an
abundance of capital compared to labour. Had the factor proportions theory been true, the
USA would have exported more capital intensive goods. This is really a paradox,
generally known as the Leontief Paradox. However, Leontief himself re-examined this
issue and found that the paradox disappeared if the natural resource industries were
excluded. Moreover, he found that the USA exported more labour intensive goods
because the productivity of labour in this country was higher than in many labour
abundant countries. According to him, even in case of labour abundant economics
different countries differ in the sense that some countries posses a large skilled labour
pool, whereas in other countries the labour resource may be largely unskilled. A country
with a large skilled labour force will be to manufacture the same labour intensive product
in a more capital intensive fashion and will be able to export that product to labour
abundant countries where skilled labour is not employed in the manufacture of the same
product. Thus, it is not only that factor endowments are not homogeneous; they differ
along parameters other than that of relative abundance. Leontief’s later views find
support in a couple of studies. The studies of Hufbauer (1966) and Gruber, Mehta, and
Vernon (1967) reveal that improved technology was involved in the US export of labour
intensive goods that characterized US exports as technology intensive rather than labour
intensive.

Soon after Leontief’s study Tatemoto and Ichimura (1959) found that in the case
of US-Japan trade, Japan exported labour intensive goods to the USA and imported
capital intensive goods from the latter. Similarly, Bharadwaj (1962) found that in case of
Indo-US trade, India mainly imported capital intensive goods from the USA and exported
labour intensive goods to the latter in 1951. These two empirical tests support the
Heckscher-Ohlin theory of international trade.

NEO-FACTOR PROPORTIONS THEORIES

Externdign Leontief’s view, some of the economists emphasize on the point that it is not
only the abundance (scarcity) of a particular factor, but also the quality of that factor of
production that influences the pattern of international trade. The quality is so important in
their view that they analyse the trade theory in a three-factor framework instead of two-
factor framework taken into account by Heckscher and Ohlin. The third factor manifests
in the form of:

1. Human capital

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 2. Skill-intensity
3. Economies of scale
4. Research and development (R&D), including technological innovation

As Kravis (1956) suggests, human capital, which is the result of better education and
training, should be treated as a factor in put like physical labour and capital. A county
with improved human capital maintains an edge over other countries with regard to the
export of commodities product with the help of improved human capital.

The skill intensity hypothesis is similar to the human capital hypothesis as both of
them explain the capital embodies in human beings. It is only the empirical specifications
of these two hypotheses that differ. Keesing (1965, 1971) computed the direct skill
requirements for production of 1957 manufactured exports and imports for 9 countries
and 15 manufacturing sectors. The study revealed that labour is a non-homogeneous
factor and it is the differing quality of labour in terms of sills that determines the pattern
of international trade.

The scale economies hypothesis explains that the rising output, unit cost decreases.
The producer achievers internal economies of scale. A country with large production
posses an edge over other countries with regards to export. However, even a small
country can reap such advantages if it produces exportables in large quantities.

Last but not least, R&D activity is positively associated with the competitive ability
of manufacturing industries. It is proxy for trade advantage, meaning that a country with
large expenditure on R&D possesses a comparative trade advantage. Krugman and
Obstfeld (1994) deal both with the process innovation and the product innovation. The
process innovation hypothesis examines how different countries ranked on the basis of
technological level and how goods are ranked by technological intensity. The higher
ranked countries always maintain an absolute advantage over low ranked countries.
Again, their model with product innovation demonstrates that the process of innovation
goes on continuously. A technologically advanced country exports newly innovated
goods where its innovation continues to remain its monopoly. It imports “old” goods
where the technology has already been imitated by producers in other countries.

COUNTRY SIMILARITY THEORY

Different from the classical argument or the factor proportions theory, Linder (1961) did
not emphasizes on the supply side or the cost of production. He rather stressed on the
demand side, meaning that trade is dependent upon the preference of the consumers. The
pattern of consumption depends upon the level of income. And so, consumers in
developed countries demand sophisticated goods in contrast with consumers in less
developed countries who demand less sophisticated goods. Whenever firm manufactures
a particular commodity, it design the product keeping in view the tastes of domestic
consumers. It is because meeting the demands of domestic consumers is the primary
concern. The manufacturer expands production in order to achieve economies of scale
and only then it is able to export the product. Exports are sent to similar countries or

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countries with the same level of income. In other words, international trade in
manufactured goods is influenced by similarity of demand. For example, if the level of
income between the USA and the UK is similar, US manufactured goods will be exported
to the UK or the latter’s goods will be exported to the USA. US goods may not be in
demand in Bangladesh because the living standard and the consumption pattern there is
quite different from that in the USA. In the words of Linder, “their more similar the
demand structures of two countries, the more intensive potentially, is the trade between
these two countries” (p.94). If two countries have the same pattern of demand, their items
of export and import will be the same, although they will vary on the basis of product
differentiation, which in turn depends upon the degree of specialization.

Linder tested his theory empirically by the use of a matrix trade intensities for a
sample of 32 countries. He found that most high trade intensities lay closer to the
diagonal, meaning that countries with similar per capita income record most of the
greater trade intensities. Using Linder’s data, Sailors, et al (1973) have tested the theory
with the help of rank correlation between absolute differences in per capita income and
trade intensities for 31 countries. Their findings generally support Linder’s hypothesis.

NATIONAL COMPETITIVE ADVANTAGE

It is a fact that Porter (1990) never focused primarily on the factors determining the
pattern of trade, yet his theory of national competitive advantage does explain why a
particular country is more competitive in a particular industry. If, for example, Italy
maintains competitive advantage in the production of ceramic tiles and Switzerland
possesses the competitive advantage in watched, it can be interpreted that the former will
export ceramic tiles and the latter will export watches and both of them will import goods
in which their own industry is not competitive.

Why is this there a difference? Porter explains that there are four factors
responsible for such diversity. He calls those factors the “diamond of national
advantage”. The diamond includes:

1. Factor conditions
2. Demand conditions
3. Related and supporting industries
4. Firm strategy, structure and rivalry

These factors have been more or less taken into account by earlier economists. What
is crucial in Porter’s thesis is that it is the interaction among these factors that shapes the
competitive advantage.

Factor conditions show how far the factor of production in a country can be utilized
successfully in a particular industry. This concept goes beyond the factor proportions
theory and explains that availability of the factors of production per se is not important,
rather their contribution to the creation and upgradation of product is crucial for
competitive advantage. If one says that Japan possesses competitive advantage in the

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 production of automobiles, it is not simply because Japan has easy access to iron ore, but
because the country has skilled labour force for making this industry competitive.

Secondly, the demand for product must be present in the domestic market from the
very beginning of production. Porter is of the view that it is not merely the size of the
market that is important, but it is the intensity and sophistication of the demand that is
significant for competitive advantage. If consumers are sophisticated, they will make
demands for sophisticated products and that, in turn, will help the production of
sophisticated products. Gradually, the country will achieve competitive advantage in such
production.

Thirdly, the firm operating along with its competitors as well as its complementary
firms gathers benefit through a close working relationship in form of competition or
backward and forward linkages. If competition is acute, every firm will like to produce
better quality goods at a lower cost in order to survive in the market. Again, if there is
agglomeration of complementary units in a particular region, there may be strong
backward and forward linkages. All this will help attain national competitive advantage.

Factor Demand
Conditions Conditions

National
Govern Competitive Chance
ment Advantage

Related and Firm strategy

Supporting Structure and
Industries Rivalry

Figure 1: Porter’s Diamond of National Advantage

Fourthly, the firm’s own strategy helps in augmenting export. There is no fixed rule
regarding the adoption of a particular strategy. It depends upon a number of factors
present in the home country or the importing country and it differs from time to time.
Nevertheless, the strategic decisions of the firm have lasting effects on their future
competitiveness. Again, equally important is the industry structure and rivalry among

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different companies. The greater the rivalry, the greater the competitive strength of the
industry.

Besides the four factors, Porter gives weightage to a couple of factors, such as
governmental policy and the role of chance of events. Governmental policy influences all
the four factors through various regulatory/deregulatory measures. It can control the
availability of various resources of change the pattern of demand through taxes and so on.
It can encourage/discourage supportive industries through various
incentives/disincentives. Similarly, chance of events, such as war or some unforeseen
events like inventions/innovations; discontinuities in the supply of inputs; and so forth
can eliminate the advantages possessed by competitors.

However, there are various criticisms put forth against Porter’s theory. First, there
are cases when the absence of any of the factors embodies in Porter’s diamond does not
affect the competitive advantage. For example, when a firm is exporting its entire output,
the intensity of demand at home does not matter. Secondly, if the domestic suppliers of
inputs are not available, the backward linkage will be meaningless. Thirdly, Porter’s
theory is based on empirical findings covering 10 countries and four industries. A
majority of the countries in the sample have different economic backgrounds and do not
necessarily support the finding. Fourthly, availability of natural resources, according to
Porter, is not the only condition for attaining competitive advantage and there must be
other factors too for it. But the study of Rugman and McIlveen (1985) shows that some
Canadian industries emerged on the global map only on the basis of natural resource
availability. Fifthly, Porter feels that sizeable domestic demand must be present for
attaining competitive advantage. But there are industries that have flourished because of
demand from foreign consumers. For example, a lion’s share of Nestle’s earnings comes
from foreign sales. Nevertheless, these limitations do not undermine the significance of
Porter’s theory.

GAINS FROM TRADE

Static Gains

A country opts for trade with any other country only when it expects gains from trade.
Gains from trade manifest in many ways. Static gains manifest in the increase in the
trading country’s real income, based on efficient international resources allocation. The
very discussion of the comparative cost advantage theory in the earlier sections has
shown how the total output and, thereby, the total consumption in trading countries
increases owing to specialization in the production of a particular commodity. The extent
of increase in the total output and total consumption on this count is nothing but static
gains from trade. Had there been no trade, there would have been no specialization and
each trading country could have produced both commodities (in a two country, two-
commodity framework), with the result that the total output would not have increased and
the total consumption would have remained at a lower level. If output and consumption
increases as a sequel to trade, the increase is called the gains from trade.

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Dynamic Gains from Trade

The increase in output or consumption is not once over. Rather, it is a continual

phenomenon manifesting in higher rate of growth in income over a period of time. This
type of continuity indicates dynamic gains from trade. In fact, dynamic gains have been
discussed for a long time. John Stuart Mill’s emphasis on the indirect effects of trade in
the form of widening of the market and the resultant improvement in the process of
production indicated dynamic gains. Similarly, the productivity theory of international
trade, explained by Hla Myint (1985, 1977), links economic growth with the country’s
foreign trade. It is because trade encourages innovations, overcomes technical
individualities, and raises labour productivity. These are nothing but dynamic gains.

Leibenstein (1966) is of the view that free trade may lead to promote X-
efficiency, which means better use of inputs so as to reduce real costs per unit of output.
Here, the cost reduction is definitely the dynamic gain from trade.

TERMS OF TRADE

The concept of terms of trade is important in view of ascertaining the gains from trade. It
is based on “what you get for what you give”. If you get more than what you give, the
terms of trade move in your favour and the trade brings in gain to you. For example,
raising of oil prices in 1973 by the OPEC nations improved their terms of trade and
worsened the terms of trade of oil importing countries. To explain this phenomenon, if
the import price rises relatively to the export price, it means that one physical unit of the
export will buy fewer physical units of import than before. This is nothing but
deterioration in the terms of trade. For a comparative analysis of the trend in the export
and the import prices, one constructs the price index for exports and imports in the same
fashion that the consumer price index is constructed.

There are different measures of terms of trade such as net barter terms of trade,
gross barter terms of trade, income terms of trade, factoral terms of trade, utility terms of
trade and the real cost terms of trade (Meier, 1965). However, the first three measures are
more commonly used for empirical analysis. Net barter terms of trade represent the ratio
between the export price index and the import price index. In form of an equation.

Net barter terms of trade = Px / Pm (1)

Where

Px is the export price index, and

Pm is the import price index.

For example, if in India in 2001, the export price index is 183 and the import price
index is 224 (1980 = 100), the net barter terms of trade in 2001 will be unfavourable at
0.817, showing a decline by 18 per cent over the base year.

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 In case of gross barter terms of trade, the index of import quantity and the index
of export quantity are computed and then the ratio between the two is found out. Since
the quantity of different commodities cannot be easily added up, it is the value of export
and import that is taken into account for this purpose. Gross barter terms of trade are
favourable if a given quantity (value) of export is able to import a larger quantity (value)
of import. In other words, gross barter terms of trade are reciprocal of the net barter terms
of trade. In the form of an equation,

Gross barter terms of trade = Qx / Qm (2)

Where

Qx is export quantity index, and

Qm is import quantity index.

If in India in 2001, the quantity of export index and quantity of import index are
respectively, 110 and 105, with the base year as 1980, the gross barter terms of trade in
2001 will be unfavourable at 1.048, showing a decline of 4.8 per cent over the base year.

The computation of the income terms of trade is also important. With a fall in the
export prices over a period, the net barter terms of trade will tend to deteriorate, but if the
demand is highly price elastic, the export earnings will rise at a greater rate, which is
beneficial from the viewpoint of the country’s foreign exchange earnings. If this is the
situation, the income terms of trade will tend to improve despite deterioration in the net
barter terms of trade. The computation of income terms of trade is very simple. The net
barter terms of trade index is multiplied by the index of the size of export.

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