1.Absolute advantage Theory 2.Comparative Cost Advantage Theory 3.Heckscher-Ohlin Theorem 4.Purchasing Power Parity Theory 5.

Product Life Cycle

Theory of Absolute Advantage

Any country produce good chipper than other country it has absolute advantage in the product of that goods. (given by Adam smith) Same country countries should produce and export surpluses in what they have absolute advantage. buy whatever else they need from rest of world. A country has an absolute advantage economically over other, in a particular good, when it can produce that good more efficiently.

Principle of Absolute Advantage

A country has an absolute advantage over it trading partners. It is able to produce more of a good or service with the same amount of resources or the same amount of a good or service with fewer resources.

1.Illustration
The Production Possibility Curve can be used to illustrate the principles of absolute advantage.

2.Illustration
The following Example is given No of unit of Wheat per unit of labor of USA and UK and No of unit of cloth per unit of labor in USA and UK.
USA No. of unit of wheat per unit of labor No. of unit of cloth per unit of labor 10 UK 4

Assumptions
It has not advocated quality, premium and brand aspect of a product. It has restricted itself only to considering the maximum to labour force. It has failed to take into account the fact that many cost reduction techniques are adopted in mass production. There are many duties applicable when goods enter into other countries, which has not been account for. The nature of the commodity may incur huge transportation cost, which may be even greater than the cost of the labour.

Limitation of Absolute Advantage

It is not fully applicable in the current century. although it was an accepted during the period of when industrialization was catching up in Europe during the period of Adam smith.

 It was David Ricardo, one of the prominent classical economist, who

Propounded the theory of Comparative Cost Advantage. In 1817 in his Book called The Principles of Political Economy & Taxation.  According to him, it was the comparative difference in the cost that has lead to the trade between two countries.  Each country specialize in the production of the commodity in which it has complete advantage cost. The country should import and export only those commodities in which it has higher comparative advantage.

Assumptions of the theory :-

 There should be two countries producing same two commod  Cost of labour  Technology  Transportation cost.  Full employment of factors.  Homogeneity in consumption, buying behavior and affordab

Illustration-1
 Two men live alone in an isolated Island. To survive they must undertake a Few basic economical activities like water carrying, fishing, cooking and shelter Construction.  The man is young, strong and educated and is much faster, better, More productive at everything. He has an absolute advantage in all activities The second man is old, weak and uneducated.  He has an absolute disadvantage In all activities. In some activities the differences between the two is great, in Other it is small.

How should they divide the work ?

The young man must spend more time on the task in which he is much Better and the old man must concentrate on the task in which he is only little Worse. Such an arrangement will increase total production.

Limitations: It considers as the only factor of production.  It considers labour as homogenous.  It assumes constant labour cost.  Uniformity in wages.  Theory only considers supply side.

1. The citizens of the two trading countries have the same needs. 2. The major factors of production, namely labor and capital are not available in the same proportion in bothcountries. 3. Labor and capital do not move between the two countries. 4. There are no costs associated with transporting the goods between countries. 5. The two goods produced either require relatively more capital or relatively more labor.

Initially, when the countries were not trading: 1) The price of capital-intensive good in capital-abundant Country will be bid down relative to the price of the good in the other country, 2) The price of labor-intensive good in labor-abundantcountry will be bid down relative to the price of the good in the other country.

y Once trade is allowed, profit-seeking firms will move their y products to the markets that have (temporary) higher price. y As a result:


y y

1) The capital-abundant country will export the capital- intesive good 2) The labor-abundant country will export the labor-intensive good.

LEONTIEF PARADOX
Wassily Leontief, a Russian-born U.S. economist observed that the United States was relatively well-endowed with capital. According to the theory, the United States should export capital-intensive goods and import labor-intensive ones. He found that the opposite was in fact the case: U.S. exports are generally more labour intensive than the type of products that the United States imports. Because his findings were the opposite of those predicted by the theory, they are known as the Leontief Paradox

what is purchasing power theory?

It is formulated by Gustan Cassel in 1920. It is method of using the long equilibrium exchange rate of two currencies to equalize the currencies Purchasing power. It is based on law of one price. Illustration:- U.S dollar exchanged and spent in the peoples republic Of China will buy much more than a dollar spend in U.S.

Absolute ppp
For U.S dollar to buy as much in the UK as in the U.S. as is assumed under the Law of one price of a basket of goods in pounds in the UK (denoted as: p) times The Spot exchange rate ( denoted as: $p) should equal the price of the same basket in the U.S price in dollar (denoted as:$). p($/)=$p This implies that the exchange rate that equalize the value of a dollar of purchasing power (the ppp exchange rate) is : ($/)=$p/p\

Relative ppp
Relative ppp related the inflation rate (the exchange of price level) in each country to the change in the market exchange rate St = St-1 Pt/Pt-1 P*/p*-1

It is propounded by Vernon, emphasizes that every product has to pass through different stages called product life cycle. There are four stages which are :1. Introductory Stage 2. Growth Stage 3. Maturity Stage 4. Decline Stage