Absolute cost Advantage theory-Adam Smith

Introduction :- The oldest and most popular theory of international trade is the classical theory of comparative costs or profit. Adam Smith was the first economist to emphasize that different countries can reach better living standards if they trade freely with each other. Mercantilists, before Adam Smith also expressed their views on international trade. According to him, trade should be done only by the government and it should be kept in mind that in exchange for exports, the treasury of other government countries should only increase the gold reserves of precious metals or other precious metals.

ASSUMPTIONS :-

1. Trade is between two countries
2. Only two commodities are traded
3. Free Trade exists between the countries
4. The only element of cost of production is
labour


Adam K. Smith let them know that the country is Opposed narrow-mindedness and placed more emphasis on open trade, meaning that different countries should exchange goods without interruption. Doing so would increase the distribution of labor internationally and benefit all trading nations. Adam Smith thinks that in such a situation every country is better than before The economic situation will be reached while no country will be in a worse economic situation than before. Smith's view of mercantilists is that any country can only make a profit if it pushes other countries doing business with it into a worse economic situation than before, i.e. one country benefits from international trade at the expense of other countries. It is the exact opposite of what one can earn. According to Adam Smith, every country should export what it has an absolute advantage in producing. According to him, the cost can only be measured in terms of labor cost and production of the commodity
According to Smith, it is important for the exporting industry to produce a greater amount of labor than any other industry by investing a given amount of labor and capital. . This principle is explained by the following list:

From the list above, it is clear that in the United States it takes 20 labor hours to produce one unit of textile and 10 labor hours to produce one unit of wheat. Similarly in England it takes 10 labor hours to produce one unit of cloth and 20 labor hours to produce one unit of wheat. It is clear that the United States has a net profit in wheat production and England has a net profit in textile production. In such a case, if the two countries trade with each other, then both Will benefit Naturally, the US will export wheat and England will export textiles. In other words, the US will import textiles from England and England will import wheat from the US. One thing to note here is how the two countries will exchange cloth and wheat. This international exchange rate will depend on the internal exchange rate of the two commodities produced by the two countries. In the above list the exchange rate of cloth and wheat in the United States is 12 and in the United Kingdom it is 2: 1, i.e. two units of wheat for one unit of cloth in the United States and one unit of wheat for two units of cloth in England. In other words, two units of wheat can be produced at the same cost as one unit of cloth produced in the United States. It is clear that the international exchange rate will be between 1: 2 and 1: 1/2. That is the international price of a unit of cloth or the international price of a unit of wheat If the price is between 1/2 and 2 units of cloth (whichever is between 12 and 2 units of wheat) then both the countries - USA and England will benefit from the trade in wheat and cloth. If the two countries exchange the two commodities with each other on a 1: 1 basis, that is, exchange one unit of wheat for one unit of cloth, then both will benefit.

The explanation is as follows: The United States will exchange a unit of wheat for a unit of English cloth, or England will give a unit of wheat produced by itself to the United States in exchange for a unit of wheat. By doing so, the United States would get one unit of cloth for only 10 labor hours and England would also get one unit of wheat for only 10 labor hours.
That is, if the United States produces two units of wheat instead of one, one for domestic consumption and the other for England, The production cost will be only 20 labor hours. Now he can give England a unit of wheat and get a unit of cloth from him. By doing so, the United States can get a single unit of wheat and clothing in just 20 working hours. Similarly, England can get a single unit of wheat and cloth for only 20 working hours. Now look at that situation Suppose the United States and England did not start trading with each other. In that case, the United States would have to spend 30 labor hours (10 plus 20) to produce a single unit of wheat and cloth. Similarly, England had to spend 30 labor hours (10 plus 20) to get one unit of cloth and wheat. However, by exchanging their production with each other, both the countries can get the same amount of cloth and wheat in just 20-20 working hours. It is clear that the two countries can save 10-10 labor hours by trading with each other and use that labor either for surplus production or to facilitate labor. The two will continue to benefit from mutual trade as long as their exchange is far between international (domestic) exchange rates between the two countries. The farther the international exchange is from the domestic exchange rate of a country, the more the country will benefit from trade. Conversely, the smaller the difference between a country's domestic exchange rate and an international exchange rate, the less that country will benefit from trade. If the international exchange rate and the domestic exchange rate are equal then there will be no profit from trade. Of course this is a very simple and simple form of trade but one thing that is very important, is that the two countries start trading with each other and get a greater amount of both commodities than before with a given amount of labor. Can Or they can get the same amount of labor for less than before. Adam Smith's concept of free trade or non-interference in trade is also based on his above explanation.

Of course by Smith the above argument for profit from trade is plausible but it is no better. The other side of Smith's theory above is that trade is primarily a means by which the country's surplus production can be absorbed by sending it to other countries. In other words, trade paves the way for surplus production in the country. The same additional production routes Is the principle of (vent for surplus doctrine). There are two main aspects to this. First, international specialization is part of the development second, The country must have real or potential surplus production capacity before starting a business. This unused production capacity can be utilized once the business is started.

CRITICISM OF THE THEORY :-

Adam Smith's theory emphasizes the benefits of trading. According to him, doing business with each other will definitely benefit all the countries to some extent. But in such a situation, it may be possible for one country to benefit more from trade and the other less. In that case, the gap between the two will widen.

Second, according to Smith, trade would only be possible and profitable if each country had a net profit in the production of one commodity or another. That doesn't have to be. It is also possible for a country to produce any commodity There is no net benefit in What would that country do in that situation? Adam Smith's theory is unable to answer this.
Adam Smith's theory of exporting surplus production is also complete Not satisfying. According to him, freedom of trade is essential for everlasting growth. But Smith's theory about the rules of trade is silent. In fact, Smith's theory, which is a bit of a crunch, was Done later better presented by Mynt and Findley.
Similarly, Smith's theory of absolute profit was later further refined by Torres and Ricardo, who called it the theory of comparative costs.Of course, Smith's business model is incomplete and does not answer the question of what is the basis of trade between different countries, but it must be admitted that Smith did this to economists Forced to think after him. 

Life-cycle hypothesis

The life-cycle hypothesis (LCH) is an economic theory that describes the spending and saving habits of people over the course of a lifetime. The concept was developed by Franco Modigliani and his student Richard Brumberg in the early 1950s. The theory is that individuals seek to smooth consumption  throughout their lifetime by borrowing when their income is low and saving when their income is high.
the life-cycle hypothesis (LCH) is a model that strives to explain the consumption patterns of individuals.

The life-cycle hypothesis suggests that individuals plan their consumption and savings behaviour over their life-cycle.Modigliani and Brumberg observed that individuals build up assets at the initial stages of their working lives. Later on during retirement, they make use of their stock of assets. The working people save up for their post-retirement lives and alter their consumption patterns according to their needs at different stages of their lives.

Related post 👉Permanent-income-hypothesis

ASSUMPTIONS :-

The life-cycle hypothesis (LCH) is based on some assumptions,that are given below

1 There is no change in the price level in the lifetime of the consumer.

2 The interest rate remains constant.

3 The consumer does not inherit any assets and his Net assets are the result of his own savings.

The theory states consumption will be a function of wealth, expected lifetime earnings and the number of years until retirement.

Consumption will depend on




C= consumption
W = Wealth
R = Years until retirement. Remaining years of work
Y = Income
T= Remaining years of life
It suggests for the whole economy consumption will be a function of both wealth and income.

If every individual in the economy plans consumption in this manner, then the aggregate consumption function will be quite similar to the individual one. Thus, the aggregate consumption function of the economy is


The main purpose of the consumers is to maximize their satisfaction over a lifetime
Which will further depend on the total income or resources. If Given a limit of person's life ,his Consumption would be in proportion to his resources.But consumer who have Plans to spend the resources (income) in a way that in the early years of his life His expenses increases, in the middle of his life expenses Is high over the years and at the time of retires Decreases sharply.
Therefore,they take on debt and save less when they are young, assuming future income will enable them to pay it off. They then save during middle age in order to maintain their level of consumption when they retire.Eventually the person's level of consumption remains almost constant or slightly increasing throughout life as shown by the CC1 curve in Figure 8..
Y0,Y,Y1 Curve represent lifetime income of an individual through the T years of his life.

 


20 years are the initial time of an individual life and CB is the level of consumption which is depend upon debt Y0,B,C.
At the middle age between 20 to 65 year of age ,a consumer will pay off his debt and save B,Y,S  for his furure.
After 65 year of an individual's age,he took retirement and he will use his savings(B,Y,S) for the consumption.
According to this theory, consumption is a function of expected income of one's life,which is further depend on the resources.
There is also some resources which Includes current income (Yt), current value of future expected labor income(Ylt) and current value of assets (At). Therefore, representation of consumption function :-

Ct+f(Vt).........(1)

And

Vt=f(Yt+Ylt+At).....(2)

After Substituting equation (2) in (1) and linearizing (2) and separating The weighted average of the income categories then the total consumption function :-



where Ct= Consumption expenditure in a period t.

YLt = Income earned from doing some labour in the current period t.

YeL = the average annual income expected to be earned from labour during the further years of working life.

Wt – wealth currently owned

a1 represents marginal propensity to consume out of current income

a2 is marginal propensity to consume out of expected lifetime income, and

a3 is the marginal propensity to consume out of wealth.

Now for APC , Consumption function :-




In Long run or over time, APC is stable because of current earnings,the share of labor income and the ratio of total assets to current income remains fixed,When the economy grows.
Based on the life-cycle theory, Endo and Modigliani Conducted several studies to produce long-term consumption functions.Form there studies,it found that maximum individuals were belongs to the minimum-income level because they were on the last period of their life.Thus,their APC was higher.On the other hand, higher than average people belonging to the higher income group were at higher income levels Because they were in the middle years of their lives. Thus their APC is relatively
Was low. Overall ,as income grows,As a result, the APC was declining which resulted in APC> MPC.An examination of US data showed that in the long run APC was stable at = 0.7.

The Ando-Modigliani short-run consumption function is shown by the Cs. curve in Fig. 2 At any given point of time, the CS curve can be considered as a constant and during short-run income fluctuation, when wealth remains fairly constant, it looks like the Keynesian consumption function. But it- intercept will change as a result of accumulation of wealth (assets) through savings.

Fig. 2

As wealth increases overtime, the non-proportional short-run consumption function Cs shifts upward to CS1 to trace out the long-run proportional consumption function. The long-run consumption function is CL, showing a constant APC as income grows along the trend. It is a straight line passing through the origin. The APC is constant over time because the share of labour income in total income and the ratio of wealth (assets) to total income are constant as the economy grows along the trend.

Conclusion:

Despite these, the life cycle hypothesis is superior to the other hypotheses on consumption function because it includes not only wealth as a variable in the consumption function but also explains why APC > MPC in the short-run and APC is constant in the long-run.