Theory of Absolute Advantage and Theory of Comparative Advantage

Theory of Absolute Advantage

• Founder: Adam Smith (1723–1790), in his book The Wealth of Nations (1776).
• Main Hypothesis:
  • A country has an absolute advantage if it can produce a good using fewer resources (i.e., at a lower cost or higher productivity) than another country.
  • International trade is beneficial when countries specialize in producing goods where they hold this absolute advantage, and then trade with each other.
  • Trade based on absolute advantage increases overall efficiency and welfare, because resources are allocated where they are most productive.

Example:
If Norway produces fish more efficiently than Portugal, and Portugal produces wine more efficiently than Norway, both countries gain by specializing and trading fish for wine.

Theory of Comparative Advantage

• Founder: David Ricardo (1772–1823), in his book On the Principles of Political Economy and Taxation (1817).
• Main Hypothesis:
  • Even if one country has an absolute advantage in producing all goods, trade can still be beneficial.
  • What matters is comparative advantage: a country should specialize in producing and exporting goods in which it has the lowest opportunity cost, and import goods where it has the highest opportunity cost.
  • Comparative advantage explains trade patterns more broadly than absolute advantage because it shows why less productive countries still gain from trade.

Example:
If England is more efficient than Portugal in producing both wine and cloth, but England’s relative efficiency is higher in cloth, then England should specialize in cloth, and Portugal in wine. Both countries benefit from trade.