According to the famous eighteenth century economist and “father” of economics, Adam Smith, the most important reason why nations trade is that it allows each country to specialize in making those products that it can most efficiently produce. Please click HERE for information about Adam Smith (pictured) and a content description of his most famous book, The Wealth of Nations (official title: An Inquiry into the Nature and Causes of the Wealth of Nations). In addition, www.econlib.org has free content of Adam Smith’s Wealth of Nations, as well as his other famous book, The Theory of Moral Sentiments.
The Law of Absolute Advantages
When a country produces a product more efficiently than another country, it has an absolute advantage in producing that good. It is economically beneficial for this country to specialize in the production of this product and trade with another country.
A country has an absolute advantage in producing a product if it can make a product more efficiently (at lower cost) than another country. Countries should specialize in producing products in which they have an absolute advantage. They should sell these products in exchange for products in which other countries have an absolute advantage.
A Numerical Example of Absolute Advantage Trade
The following numbers represent hours of production needed to manufacture 1 barrel of oil and 1 watch, respectively.
For Venezuela, producing 100 barrels of oil uses the same number of hours (100 times 10) as producing 50 watches (50 times 20). Therefore, if Venezuela specializes in and produces 100 additional barrels of oil in exchange for producing 50 fewer watches, it will employ the same resources.
For China, producing 100 watches uses the same number of hours (100 times 12) as producing 40 barrels of oil (40 times 30). Therefore, if China specializes in and produces 100 additional watches in exchange for producing 40 fewer barrels of oil, it will employ the same resources.
Problem: If both countries specialize in the manner described above, by how much will total world production increase?
Solution: Total world production of oil increases by 60, and total world production of watches increases by 50 (see table below).
|Venezuelan oil||+ 100||Venezuelan watches||– 50|
|Chinese oil||– 40||Chinese watches||+ 100|
|Additional oil production||+ 60||Additional watch production||+ 50|
Specialization and Trade Lead to an Increase in Standard of Living
The countries will have to decide on the terms of the trade. Feasibly, each country can split the additional production and end up with 30 additional barrels of oil and 25 additional watches. Without each country having to use any additional resources, and after trading the surplus production, each country is able to increase its standard of living.
For a video explanation of the law of absolute advantages and the law of comparative advantages (next section), please watch: