Here we observe two countries A and B. Let’s suppose that they are the only countries in the world and they only produce cloth and wheat but they do not presently trade with each other. If Country A produces cloth at a cost of one-fourth of that of Country B, and its cost of producing wheat is one-third of that of Country B. Now, if the two countries wish to trade with each other, what should country A do according to the Law of Absolute advantage and the Law of Comparative Advantage respectively? How about Country B then?
We may first compare the costs in producing cloth and wheat in Country A and Country B respectively:
Cost in Country A Cost in Country B
cloth 1/4 1
wheat 1/3 1
Law of Absolute Advantage: The law was put forward in1776 by Adam Smith. A country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it. It means the use of less resources per unit of output than other producers. Here, Country A has absolute advantage in producing both cloth and wheat than country B. According to the Law of Absolute Advantage, Country A will produce and export both products to Country B. County B will import both products
The Law of Comparative advantage: The law was put forward in 1817 by David Ricardo based on Adam Smith’s theory. A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost. Opportunity cost means the amount of other goods and services which could have been obtained instead of producing this good or providing this service. For example, the opportunity cost of going to a cinema is not going to go skating. The law of comparative advantage says that countries tend to export goods in which they have a comparative advantage and to import goods in which they have a comparative disadvantage. According to the law, Country A has comparative advantage in producing cloth (1/4) and comparative disadvantage in producing wheat (1/3). According to the Law of Comparative advantage, Country A will produce and export cloth and import wheat. Country B will produce and export wheat and import cloth.
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