Free trade

Theories of trade

1. Theory of absolute advantage
2. Theory of comparative advantage

I. Theory of absolute advantage

This theory was advocated by Adam Smith. It states "A country is said to have absolute advantage in the production of a commodity if it can produce that commodity more efficiently than the other country".

The theory is based on following assumptions

1. There are two countries and two commodities The theory operates on a simplified model where only two nations are involved in producing and trading two goods.
2. Labor is homogeneous in both countries It is assumed that all workers have the same skill level and efficiency within each country.
3. There is no difference in technology in both countries Both countries are assumed to have access to the same level of technology, so production differences are due only to labor efficiency.
4. Mobility of factors of production is perfect Within a country, labor and other resources can move freely from one industry to another without any cost or delay.
5. There is free trade No barriers such as tariffs, quotas, or restrictions exist, allowing goods to move freely between countries.
6. There is no transport cost The model assumes that goods can be traded at no cost, which simplifies analysis by ignoring shipping or logistical expenses.
7. There is perfect competition Many buyers and sellers exist, and no single party can influence the price, ensuring fair competition in both domestic and international markets.
8. The value of a commodity is determined by the amount of labor used in its production The theory follows the labor theory of value, meaning that the cost and value of goods are based on how much labor is required to produce them.

For example:

Item	Uganda output per labor	Tanzania output per labor
Coffee	15 kg	2 kg
Tea	4 kg	10 kg

From the above Uganda has absolute advantage in the production of coffee while Tanzania has absolute advantage in Tea. One unit of labor can produce 15 kg of coffee and only 4 kg of tea.

One unit of labor in Tanzania can produce 10 kg of tea and only 2 kg of coffee. Both countries can gain in trade if each would specialize in the production in which it has absolute advantage.

If one labor in Uganda can produce 15 kg of coffee by specializing. Uganda can produce 30 kg of coffee and if Tanzania would specialize in production it can produce 20 kg.

It can be illustrated as follows:

After specializing:

Item	Uganda output / labor	Tanzania output per labor
Coffee	30 kg	0 kg
Tea	0 kg	20 kg

Output before trade and specialization:

Item	Uganda output per labor	Tanzania output per labor	Total output
Coffee	15 kg	2 kg	17 kg
Tea	4 kg	10 kg	14 kg

Output after trade and specialization:

Item	Uganda output per labor	Tanzania output per labor	Total output
Coffee	30 kg	0	30 kg
Tea	0	20 kg	20 kg

Specialization would lead to

1. An increase in output in both countries When countries focus on producing what they are best at, overall production rises, as resources are used more efficiently.
2. Full utilization of resources of both countries Specialization ensures that labor, capital, and natural resources are not left idle but are fully engaged in the most productive sectors.
3. All countries will gain from exchange of commodities Through trade, each country can obtain goods it does not produce efficiently in exchange for its specialized products, resulting in mutual benefit.

Question: Given the following information:

	Production / Fuel	Labor per units Food
Country A	10	5	State which of the two countries has absolute
Country B	8	2	advantage in production of either commodity

II. Theory of comparative advantage

It is a condition in which a country produces some goods or services at a lower cost in terms of opportunity cost of other good and have services which could have been produced.

It is based on comparison of production cost and it is expressed in the form of comparative ratio which gives the opportunity cost.

It states that "If one country is less efficient in the production of both commodities and another country is more efficient in both commodities the two countries can benefit from trade by specializing in the production and export of commodity in which it has a low opportunity cost."

For example:

	Output per labor country A	Output per labor country B
Coal	3	9
Wheat	30	40

According to the above data country B has comparative advantage in the production of both products coal and wheat this is because one unit of labor in country B produces one units of coal compared to 3 units of coal produced by one unit of labor in country A.

According to comparative advantage the two countries can trade and gain from trade as follows:

–	Country A	Country B
Coal	30/3 = 10	40/4 = 4.4
Wheat	3/30 = 1/10 = 0.2	9/40 = 0.0225

Country A has comparative advantage in the production of wheat while country B has comparative advantage in the production of coal.

Example 2

Given the following production per unit labor:

	Fuel	Food
Country A	10	5
Country B	20	2

	Fuel	Food
Country A	5/10 = ½ = 0.5 of food	10/5 = 2 of fuel
Country B	2/10 = 1/5 = 0.2 of food	10/2 = 5 of fuel

Country B has a comparative advantage in production of fuel while Country A has a comparative advantage in production of food.

Question: Your given

Country	Cotton (Tonnes)	Sisal (Tons)
Tanzania	4	2
Sudan	12	4

The figure represents Input quantities per unit of output of the corresponding commodities.

1. Which country has absolute advantage in production of (i) sisal (ii) Cotton, give reasons.
2. Which country has comparative advantage in production of (i) sisal (ii) cotton, give reasons.
3. With reasons suggest how the two countries can specialize in production of two commodities so as to encourage trade between them.

Assumptions of the theory of comparative advantage

This theory, developed by David Ricardo, states that a country should specialize in producing goods it can produce at a lower opportunity cost compared to another country.

1. There is no transport cost Assumes goods can be traded freely without incurring any cost for moving them between countries.
2. Labor is homogeneous Assumes all labor within a country is equally skilled and interchangeable.
3. There is free trade No tariffs, quotas, or trade restrictions exist between countries.
4. There is perfect competition Assumes a market structure where no single buyer or seller can influence prices, ensuring efficiency.
5. There are only two countries or nations The model is simplified to consider only two countries trading with each other.
6. Factors of production are perfectly mobile within a country Resources like labor and capital can move freely between industries within a country without delay or cost.

Criticisms against the theory of comparative advantage

1. The assumption of two countries and two commodities is unrealistic In reality, international trade involves many countries and thousands of goods.
2. Labor is not homogeneous Skills, productivity, and efficiency vary among workers, even within the same country.
3. Transport costs must be involved Moving goods between countries costs money, which affects trade decisions and outcomes.
4. There are other important factors of production besides labor Capital, land, and technology also play vital roles in production, which the theory oversimplifies.

Application of the theory of comparative advantage

1. It encourages specialization Countries focus on producing goods they are most efficient at, improving overall productivity.
2. It leads to balance of payment between trading countries Efficient trade reduces deficits and improves the exchange balance.
3. It encourages free trade The theory supports the idea that removing trade barriers benefits all countries.
4. It provides a basis for international trade Explains why countries trade, even if one is better at producing everything.
5. It enables proper utilization of resources Resources are allocated to industries where they are most productive, reducing waste.