Absolute Advantage and Theory

Adam Smith's theory of absolute advantage and Ricardo's theory of comparative advantage offer two economic approaches to international trade. Each theory contributes to the field of international economics in different ways. This literature review will compare the two theories through the lens of scholarly articles published on the respective subjects.

By the 18th century (1776 to be exact), the development of international trade had reached a critical nexus: the colonies in America had revolted against the British Crown and a revolutionary character was evident throughout much of Western society. (The French would have their own Revolution before the century was out). Tackling the question of economic theory and its place in trade (in the light of this emerging climate) was Adam Smith with his massive treatise Wealth of Nations. Smith's concern focused on the specialization of labor -- the ability of producers to divide labor into parts to maximize output and achieve the greatest amount of profit as a result. When this theory was applied to international trade, a vision of all the countries of the world competing in a global marketplace emerged. As Smith pointed out, in a mercantilist system it would not be possible for all countries to maximize profitability if all were exporting more than they imported. Instead of placing harsh restrictions on imports and aggressively pursuing exports, Smith suggested that the theory of specialization be applied to trade and that a system of free trade be developed in which countries specialized in exporting only those items in which they had absolute advantage. Absolute advantage was defined thus: according to Smith's theory, some countries would be better than others at producing certain items -- such as cloth or wheat -- and therefore the better producer would be said to have absolute advantage over the other. It would therefore be in both countries interests (in terms of saving hours/labor) for the country with absolute advantage in producing a specific item to export it and for the other country to import it and vice-versa. In short, all countries would benefit through specialization and free trade: this was the heart of absolute advantage. The contribution it made to the field of international economics was that a system of free trade can in fact -- and must -- replace a mercantilist form of trade in the modern era.

However, if a country had no absolute advantage whatsoever, what would become of it? How would it ever profit in international trade? David Ricardo attempted to answer this question in 1817 when, building on the concept of absolute advantage, he devised the theory of comparative advantage. This theory held that even if a country does not have absolute advantage over another, it may have comparative advantage in that its labor productivity ratios are better. For Ricardo, labor was "the only source of value," which is why he devised the equation price = [rate of wages x labor production] / output. Thus, if a country's price of wheat was cheaper than in another country as a result of labor ratios, it would be able to be profitable in international trade (Chipman, 1966). Therefore, the contribution Ricardo's theory made to the field of international economics was that it showed that absolute advantage is not necessary for all countries to be profitable in free trade: comparative advantage is really all that is needed.

While both theories have been extremely important for modern economics, each has its limitations -- mainly because of the innumerable variables that can and do impact either side of the equations. As models or foundations of economic thought they are helpful instruments -- and as Schumacher (2012) notes, it is thanks to Smith that economists today can assert with confidence that "international trade exploits the quantitative and qualitative benefits of an extended division of labor" (p. 60). Yet, while "trade and development cannot be separated in Smith's theory," what happens when development breaks down (Shumacher, 2012, p. 60) -- i.e., what happens when social, political and economic infrastructures taken as norms two hundred years ago no longer apply? Ricardo's theory can help to fill the gap by indicating that a comparative balance may always be achieved -- but even here the framework can be exploited in such a way that the desired balance is not achieved but rather heavily tilted towards one side or the other. Such is, after all, the effect of off-shoring as evidenced by "free" trade agreements such as GATT and NAFTA. Understanding how Smith's theory and Ricardo's theory work in the real world today is important because, after all, what is past is prologue -- and preparing for tomorrow cannot be achieved until what happened yesterday is firmly comprehended.

As Shumacher (2012) notes, Smith takes an "optimistic view of growth and economic progress" (p. 60-61). In 1776, one can hardly blame him for doing so: revolution was happening in the West -- progress the buzzword -- Equality and Liberalism about to be literally enthroned and exalted in Paris. Yet, less than half a century later, Ricardo was already dealing with some of the more unpleasant realities of international trade, business and economics -- the reality that lofty ideals as put forward by revolutionaries do not always find purchase in the cold, hard world of business. In an attempt to reconcile the optimism and good faith of Smith with the encroaching realism of the 19th century, Ricardo took up Smith's theory and began to adapt it: countries without any absolute advantage should still be able to compete. In order to support this belief, all that Ricardo required was a new way to describe value. He turned not to capital but to labor -- as did many minds in the 19th century. This trick, promoting labor as the basic source of all value, helped provide economic minds with a working framework for approaching international trade and economics; however, no one could have predicted that with the rise of the Industrial Revolution, a re-balancing of world powers, and, finally, the dawn of the Digital Age, the basic unit of value -- labor -- would need to be reassessed all over again. Value would need to be re-described, relocated, re-identified. What had been valuable to the 19th century mind was now worlds away from what was valuable to the 21st century mind.

From this perspective -- the perspective of time -- the two theories can be compared and contrasted as well: Smith's theory depends upon specific characteristics of the world economy being in place -- namely, the prospect of development and growth alongside a fair and equitable balance of world powers motivated by principles that facilitate utilitarian ends. In brief, the ability to recognize and ensure a "common good" in both principle and practice is needed in Smith's theory -- otherwise, the framework cannot be applied with any degree of certainty of outcome: variables consistent with the lesser nature of humankind act as better predictors. In Ricardo's theory, these latter are somewhat more accounted for if only tangentially in the sense that firm equality and trade-off is not exactly the point -- instead, the concept of each nation finding advantage in some form of labor/trade relationship serves as the main support. Idealistic frameworks that molded the minds of thinkers of the previous generation are not as starkly relevant. Thus, in today's world, Ricardo's theory still serves as the better predictor of economic outcomes, as Das (2008) notes: "Ricardian theory performs better in empirical testing than most other theories" in the modern era of economics (p. 2).

Das (2008) does a basic comparison of absolute advantage and comparative advantage, indicating that the two work more like an evolutionary economic theory -- one that adapts and draws on experience in order to better construct an approach to understanding how labor, trade and specialization can all work together. As Costinot and Donaldson (2012) indicate, the model supplied by Ricardo can still be applied, empirically, in a situation where the values are evident or at least capable of being identified (and outcomes measured) ahead of time. In this respect, Costinot and Donaldson support the finding of Das (2008) in that Ricardo's model still can serve as an accurate empirical predictor. To test their hypothesis, Costinot and Donaldson (2012) apply Ricardian theory to the field of agribusiness by taking knowns -- "essential inputs such as water, soil and climatic conditions" -- and predicting outputs in a manner that can be universally applied "in all economic activities" (p. 1). Using a dataset of 17 crops from 55 different countries, the researchers computed the predicted output levels for all and posed the Ricardian question: "How do predicted output levels compare with those that are observed in the data?" (p. 2). Their finding showed that "output levels predicted by Ricardo's theory of comparative advantage agree reasonably well with actual data on worldwide agricultural production" (Costinot, Donaldson, 2012, p. 2).

Dorobat (2015) provides another perspective on the comparison between Smith's and Ricardo's theories. Dorobat (2015) identifies Smith as the progenitor of the British Classical School of Economic Thought, in which the division of labor is exalted as the means by which maximum output can be achieved "in a world of scarce resources and unlimited wants" (p. 110). Those "wants," however, have proven all too limited over time -- which explains the need of specialized forces to seek new and emerging markets or cheaper labor in order to continue to increase margins. According to Dorobat (2015), Ricardo simply continued the train of thought begun by Smith and adapted it to the new curve caused by the collapsing weight of Enlightenment ideology: Ricardo asserted that absolute advantage was neither necessary nor necessarily possible in every case -- what was needed was simply the ability to produce an item in "relatively less hours of labor" than one's competitor (p. 110). If this could be achieved, free trade would naturally benefit all participants.

What Ricardo did not envision in his theory, of course is the fact that exploitation of labor would become a pursuit as globalization grew. With that exploitation, new models of economic thought would emerge in attempts to reconcile the outcomes with the reality, while infusing a breath of idealism into the mix. The "positive-sum game" essential to and inherent in the theories projected by Smith and Ricardo would not stand up throughout the Industrial Age, wherein competition became fierce and monopolies became the objective. This is, of course, where both theories fail: in a world that rejects a positive-sum game, wherein "cooperation among nations" is pivotal, a new game emerges to displace the old -- and thus Mill's theory projected a "fixed-sum game," which ultimately gave way to the old mercantilist zero-sum game that had preceded Smith (Dorobat, 2015, p. 111). Thus, economic thought came full circle -- indicating that there is a current of thought that underlies economic thought -- namely, the ideals that society projects as worth pursuing. Today's world powers are in what appears to be a struggle over which ideal should underlay the global economic framework: in the East, the Classical notion of cooperation (ala Smith/Ricardo) appears to be taking hold (as China and Russia promote their multi-polar view of the world); but in the West, there remains the mercantilist spirit -- the notion that all nations are in fierce competition with one another and that in the end the game is zero-sum: there will be a winner and a loser.