In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce a greater quantity of a good, product, or service than competitors, using the same amount of resources. Adam Smith first described the principle of absolute advantage in the context of international trade, using labour as the only input. Since absolute advantage is determined by a simple comparison of labour productiveness, it is possible for a party to have no absolute advantage in anything (Absolute, 2009); in that case, according to the theory of absolute advantage, no trade will occur with the other party (Absolute Advantage, 2009). It can be contrasted with the concept of comparative advantage which refers to the ability to produce specific goods at a lower opportunity cost.
The main concept of absolute advantage is generally attributed to Adam Smith for his 1776 publication ‘An Inquiry into the Nature and Causes of the Wealth of Nations’ in which he countered mercantilist ideas (Absolute, 2009; Marrewijk, 2007). Smith argued that it was impossible for all nations to become rich simultaneously by following mercantilism because the export of one nation is another nation’s import and instead stated that all nations would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage (Absolute, 2009) Smith also stated that the wealth of nations depends upon the goods and services available to their citizens, rather than their gold reserves (Harrington, 2009). While there are possible gains from trade with absolute advantage, the gains may not be mutually beneficial. Comparative advantage focuses on the range of possible mutually beneficial exchanges.
Example 1
Table 1 Hours of work necessary to produce one unit
|
Country |
Cloth |
Wine |
|---|---|---|
|
England |
80 |
100 |
|
Portugal |
120 |
90 |
According to Table 1, England commits 80 hours of labour to produce one unit of cloth, which is fewer than Portugal's hours of work necessary to produce one unit of cloth. England is able to produce one unit of cloth with fewer hours of labour; therefore, England has an absolute advantage in the production of cloth. On the other hand, Portugal commits 90 hours to produce one unit of wine, which is fewer than England's hours of work necessary to produce one unit of wine. Therefore, Portugal has an absolute advantage in the production of wine.
If the two countries specialize in producing the good for which they have the absolute advantage, and if they exchange part of the good with each other, both of the two countries can end up with more of each good than they would have in the absence of trade (Bruce, 2013; Teofilo, 2005). In the absence of trade, each country produces one unit of cloth and one unit of wine. Here, if England commits all of its labour for the production of cloth for which England has the absolute advantage:
Total of hours=80+100=180
England produces 2.25 units of cloth.
(80+100)÷80=2.25 units of cloth.
On the other hand, if Portugal commits all of its labour for the production of wine:
Total of hours =90+120=310
Portugal produces 2.33 units of wine:
(90+120)÷90=2.33 units of wine.
By exchanging the 2.25 units of cloth and the 2.33 units of wine, both of the two countries can end up with more of each good than they would have in the absence of trade.
Example 2
Table 2 Hours of work to commit after the specialization
|
Country |
Cloth |
Wine |
|---|---|---|
|
England |
80 + 100 |
0 |
|
Portugal |
0 |
90 + 120 |
You and your friends decided to help with fundraising for a local charity group by printing T-shirts and making birdhouses.
Scenario 1: One of your friends, Gina, can print 5 T-shirts or build 3 birdhouses an hour. Your other friend, Mike, can print 3 T-shirts an hour or build 2 birdhouses an hour. Because your friend Gina is more productive at printing T-shirts and building birdhouses compared to Mike, she has an absolute advantage in both printing T-shirts and building birdhouses.
Scenario 2: Suppose Gina wasn't as agile with the hammer and could only make 1 birdhouse an hour, but she took a sewing class and could print 10 T-shirts an hour. Mike on the other hand takes woodworking and so he can build 5 birdhouses an hour, but he doesn't know the first thing about making T-shirts, so he can only print 2 T-shirts an hour. While Gina would have the absolute advantage in printing shirts, Mike would have an absolute advantage in building birdhouses.
Comparative advantage is what a country is the best at producing, when compared to other countries, for the lowest opportunity cost. A country has a comparative advantage when it is better than any other country in producing something, and it doesn't give up as much by producing it (Maneschi, 1998).
It's more likely to be goods, like jets, luxury automobiles, or cheese, than a service. That's because goods are easier to export.
But some countries do have an advantage in services, such as banking and entertainment. (Source: Comparative Advantage, Bureau of Labor Statistics. Comparative Advantage, Financial Times.)
For example, oil-producing nations have a comparative advantage in chemicals. That's because the oil provides a cheap source of material for the chemicals when compared to countries without it. As a result, Saudi Arabia, Kuwait, and Mexico are competing with U.S. chemical production firms.
Their opportunity cost is low. They don't have to give up much to produce chemicals. That's because a lot of the raw ingredients are produced in the oil distillery process. (Source: "Robust Growth and the Strong Dollar Set Pattern for Import and Export Prices, Bureau of Labor Statistics).
What It Means to You? Comparative advantage is what you do best while giving up the least. If you’re a great plumber and a great babysitter, you should become a plumber.
You’ll make more money as a plumber and can buy more babysitting services. Even if you are the best babysitter in the world, you’ll be able to buy fewer plumbing services. That’s because you’ve given up the opportunity of making more money as a plumber (BLS, 2009).
David Ricardo created the theory of comparative advantage. He argued that a country boosts its economic growth the most by focusing on the industry in which it has the largest comparative advantage.
For example, England was superior in manufacturing cloth. Portugal was better at making wine. Ricardo correctly predicted that England would stop making wine, and Portugal would stop making cloth. England made more money by trading its high-value cloth for Portugal's high-value wine, and vice versa. Why make inferior wine yourself when you can get a larger quantity of superior wine by selling your cloth?
This theory of comparative advantage became the rationale for free trade agreements. Ricardo developed the comparative advantage theory to combat trade restrictions on wheat in England. That's because it was lower cost and higher quality when grown in countries with the right climate and soil conditions. England received more value by exporting products that required skilled labour and machinery. It could receive more wheat in trade than it could grow on its own (The Theory, 2015).
The theory of comparative advantage explains why trade protectionism doesn't work in the long run. Political leaders are always under a lot of pressure from their local constituents to preserve jobs by raising tariffs. That temporarily protects local industries from overseas competition. However, it hurts the nation in the long run by allowing the country to waste resources on poor-performing industries. It also forces consumers to pay higher prices to buy lower-quality goods.
David Ricardo started out as a successful stockbroker, making $100 million in today's dollars. After reading Adam Smith’s ‘The Wealth of Nations’, he became an economist. He was the first person to point out that significant increases in the money supply create inflation. This theory is known as monetarism.
He also developed the law of diminishing marginal returns, one of the most important concepts in microeconomics. It states that there comes a point in production where the output isn't worth the additional input in raw materials (Dixit, 2013).
Example
United States: America's comparative advantage is its large land mass, bordered by two oceans. It also has lots of fresh water, arable land, and available oil. It has a diverse population with a common language and national laws. For more, see The Power of the U.S. Economy.
Those all give U.S. businesses cheap natural resources, protection from land invasion, and a large test market to support innovation of new products and services. As a result, the United States became a global leader in banking, aerospace, defence equipment, and technology. For more, see the 4 Major Things the U.S. Is Good at Producing and How Silicon Valley ls America's Innovative Advantage.
Absolute and comparative advantage are two important concepts in international trade that largely influence how and why nations devote limited resources to the production of particular goods. Though the global economy is highly complex, the economics of food production offer a straightforward illustration of both of these key concepts (Baumol, 2003).
Though it is not economically feasible for a country to import all of the food needed to sustain its population, the types of food a country produces can largely be affected by the climate, topography and politics of the region. Spain, for example, is better at producing fruit than Iceland. The differentiation between the varying abilities of nations to produce goods efficiently is the basis for the concept of absolute advantage.
If Japan and the United States can both produce cars, but Japan can produce cars of a higher quality at a faster rate, then it is said to have an absolute advantage in the auto industry. A country's absolute advantage or disadvantage in a particular industry plays a crucial role in the types of goods it chooses to produce. In this example, the U.S. may be better served to devote resources and manpower to another industry in which it has the absolute advantage, rather than trying to compete with the more efficient Japan (O'Sullivan, 2003).
The focus on the production of those goods for which a nation's resources are best suited is called specialization. Given limited resources, a nation's choice to specialize in the production of a particular good is also largely influenced by its comparative advantage. Whereas absolute advantage refers to the superior production capabilities of one nation versus another, comparative advantage is based on the concept of opportunity cost. The opportunity cost of a given option is equal to the forfeited benefits that could have been gained by choosing the alternative. If the opportunity cost of choosing to produce a particular good is lower for one nation than for others, then that nation is said to have a comparative advantage.
Assume that both France and Italy have enough resources to produce either wine or cheese, but not both. France can produce 20 units of wine or 10 units of cheese. The opportunity cost of each unit of wine, therefore, is 10 / 20, or 0.5 units of cheese. The opportunity cost of each unit of cheese is 20 / 10, or 2 units of wine. Italy is able to produce 30 units of wine or 22 units of cheese. Italy has an absolute advantage for the production of both wine and cheese, but its opportunity cost for cheese is 30 / 22, or 1.36 units of wine, while the cost of wine is 22 / 30, or 0.73 units of cheese. Because France's opportunity cost for the production of wine is lower than Italy's, it has the comparative advantage despite Italy being the more efficient producer. Italy's opportunity cost for cheese is lower, giving it both absolute and comparative advantage (Steven, 2010).
Since neither nation can produce both items, the most efficient strategy is for France to specialize in wine production because it has the comparative advantage and for Italy to produce cheese. International trade can enable both nations to enjoy both products at reasonable prices because each has specialized in the efficient production of one item.
