Absolute Advantage
Arises when a person, company, or nation can produce it more efficiently, resulting in lower production costs than competitors
What Is Absolute Advantage?
An absolute advantage in a good or service arises when a person, company, or nation can produce it more efficiently, resulting in lower production costs than competitors. It is done in one of the following ways:
- Producing the same amount of a good or service with a lower cost per unit, using fewer inputs
- Creating more of a good or service using the same amount of inputs
Efficient production and lower costs occur when the individual or nation:
- Utilizes fewer resources for production
- Uses cheaper resources (land and capital) for production
- Employs workers at lower wage rates for production, ensuring cost-efficiency
- Achieves production with reduced time requirements
Key Takeaways
- Absolute advantage signifies the ability of an individual, company, or nation to produce a good or service more efficiently, resulting in lower production costs compared to competitors.
- Introduced by economist Adam Smith in "The Wealth of Nations" (1776), absolute advantage emphasizes specialization and efficient resource allocation to maximize wealth through international trade.
- The theory assumes the absence of trade barriers, immobile factors of production, and constant and scalable advantages, though real-world factors may deviate from these ideal conditions.
- Distinguished from comparative advantage, which considers opportunity costs, absolute advantage focuses on producing more with fewer resources, enhancing efficiency but potentially leading to industry dependency and job displacement.
Understanding absolute advantage
Scottish economist Adam Smith was the first to introduce this concept in his famous book The Wealth of Nations in 1776. Smith published these ideas and made significant contributions to international trade.
Smith discusses the importance of specialization and the efficient division of labor. His work revolves around the idea that entities specialize in producing the good in which they have an absolute advantage.
Specialization helps countries engage in free trade in a way where they sell the commodities that they are the best at producing.
They can buy other goods and services from various nations worldwide and focus on making the goods they have an advantage instead of producing everything. Thus, it allows for the efficient use of resources to maximize wealth.
Smith argued that keeping absolute advantage in mind would help countries gain through open free trade in the global market. So, they would allocate resources to make and export the goods they produced most efficiently and import other goods.
In this way, both players can gain from the trade. In other words, trade makes all entities better off if each country has an absolute advantage in at least one commodity over its competitors.
Note
Absolute advantage is determined by finding the largest output value for each product produced by each country in comparison.
Assumptions Of The Theory Of Absolute Advantage
Smith's theories of absolute advantage and Ricardo's comparative advantage are constructed on certain assumptions to explain trade benefits.
Some of the assumptions are:
- Trade Barriers: These theories assume an absence of trade barriers, neglecting factors like shipping costs and tariffs. However, in reality, such costs significantly influence trade likelihood. Moreover, countries strategically employ tariffs to gain competitive edges.
- Factors of Production: They also assume immobile factors of production, ignoring modern globalization's impact on company relocation and immigration. Companies often move manufacturing abroad, and immigration rates affect workforce availability.
- Consistency and Scalability: These theories assume constant and scalable absolute advantages for countries. However, strategic investments and unpredictable events like natural disasters can alter such advantages unpredictably.
Examples Of Absolute Advantage
Now, let us go through some of the examples below to understand the concept better.
Example 1
Consider two hypothetical countries, Country A and Country B, and assume they have equal resources at their disposal. Each country produces two goods – dates and oil – with the following production possibilities:
| Quantity of goods produced by each country | ||
|---|---|---|
| Country | Oil | Dates |
| Country A | 750 barrels | 75 tons |
| Country B | 500 barrels | 100 tons |
According to the above table:
- Country A can produce either 75 tons of dates or 750 barrels of oil
- Country B can produce either 100 tons of dates or 500 barrels of oil
- Country A has an absolute advantage in producing oil because it can produce more oil with the same amount of resources compared to Country B
- Country B has an absolute advantage in producing dates because it can produce more dates with the same amount of resources compared to Country A
Example 2
Hypothetically, consider an economy with two countries, Country A and B, and two goods. The hours of labor required to produce one unit of a good is
| Hours of labor work necessary to produce a single unit | ||
|---|---|---|
| Country | Computer | Clothing |
| A | 70 | 90 |
| B | 110 | 80 |
From the table above
- Country A can produce one computer after spending 70 hours of labor, while Country B takes 110 hours to produce the same. Therefore, Country A has the absolute advantage in producing computers as it utilizes fewer hours of labor.
- On the other hand, Country A can produce one unit of clothing after 90 hours, which is less efficient than Country B, which needs 80 hours of labor to perform the same task. So, Country B has the advantage in producing clothing.
Note
In autarky, economies do not engage in trade with one another and produce everything themselves. Each country produces one unit of clothing and one computer after putting in the specified hours of labor.
If Country A, which specializes in making computers, allocates all of its labor to that activity, it would require 70 hours, in addition to reallocating the 90 hours previously used for clothing production. So, Country A would produce
(70 + 90)/ 70 = 2.29 units
If Country B, which specializes in making clothing, allocates all of its labor to that activity, it would require 110 hours, 30 hours more than the 80 hours previously used for clothing production. So, Country B would produce
(110 + 80)/ 80 = 2.38 units
After specializing, each country now produces more of the products it specializes in than before. This creates the opportunity to trade with each other and mutually benefit from their respective comparative advantages.
Real-world Examples
Saudi Arabia, one of the countries in the Gulf Cooperation Council (GCC), has an absolute advantage in extracting oil, attributed to the country's strategic location and access to oil reserves. Oil production accounts for a significant portion of the country's revenue.
In the absence of trade, other countries, particularly those in the Western part of the world, might need to resort to more expensive methods, such as offshore drilling, to meet their oil needs.
Another real-world example is Colombia, where the temperature, rainfall, and soil facilitate coffee production. Other countries, like colder ones, may not be able to produce as much coffee, or even at all.
If either of these two countries attempted to produce the other product, the production costs would be relatively high compared to their production costs for their specialized goods. Thus, it would lead to a waste of talent, resources, and effort.
This scenario would reduce their overall productivity and incentivize them to engage in trade for those goods instead.
Absolute Advantage vs. Comparative Advantage
Absolute advantage looks at producing more of a good or service with fewer resources or through a more efficient method than rival players.
Meanwhile, comparative advantage refers to producing at a lower opportunity cost than competitors. So, the comparative advantage does not necessarily mean producing more or differing quality.
For instance, using the same scenario from Example 1:
| Quantity of goods produced by each country | ||
|---|---|---|
| Country | Oil | Dates |
| Country A | 750 barrels | 75 tons |
| Country B | 500 barrels | 100 tons |
The comparative advantage can be found by comparing the opportunity costs in terms of the other goods:
Oil:
- Country A: 75/750 = 1/10 tons of dates
- Country B: 100/500 = 1/5 tons of dates
1/10 < 1/5 → Country A has the lower opportunity cost → comparative advantage in oil
Dates:
- Country A: 750/75 = 10 barrels of oil
- Country B: 500/100 = 5 barrels of oil
5 < 10 → Country B has the lower opportunity cost → comparative advantage in dates
So, Country A has to forego fewer tons of dates to make more oil, and Country B has to sacrifice fewer barrels of oil to make more dates.
Pros and Cons of Absolute Advantage
Let's understand both the pros and cons of Absolute Advantage.
Pros
The pros are:
- Efficiency Boost: Absolute advantage promotes specialization, enhancing overall efficiency by allowing entities to focus on their areas of expertise and optimize production processes for greater productivity.
- Quality Improvement: Entities with absolute advantage can deliver higher quality products due to their efficiency and expertise, enhancing customer satisfaction and market competitiveness.
- Competitive Edge: Those with absolute advantage can outshine competitors by offering superior products at lower costs, gaining a stronger foothold in the market.
- Global Trade Benefits: Absolute advantage facilitates international trade as countries leverage their strengths to specialize in certain goods and services, fostering mutually beneficial exchanges.
- Stimulus for Economic Growth: Absolute advantage drives innovation, investment, and specialization, fueling economic growth through increased productivity and output.
Cons
On the other hand, the cons are:
- Industry Dependency: Relying heavily on absolute advantage may lead to overdependence on specific industries, making economies vulnerable to market fluctuations or disruptions.
- Potential Job Losses: Specialization driven by absolute advantage can result in job displacement in less efficient sectors, posing challenges such as unemployment and economic instability.
- Risk of Overreliance: Excessive reliance on absolute advantage without diversification exposes entities to risks such as changing market dynamics or policy shifts, jeopardizing long-term sustainability.
- Erosion of Domestic Industries: Intense competition from entities with absolute advantage may undermine domestic industries unable to compete effectively, impacting sovereignty and strategic capabilities.
- Income Disparities: Absolute advantage may exacerbate income inequality if the benefits disproportionately favor certain individuals or groups, widening the economic divide within societies.
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