BUSINESS

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Absolute vs. Comparative Advantage: An Overview

Absolute and comparative advantage are economic concepts that help companies and nations decide how to best use their resources in producing goods for trade internationally.

Absolute advantage is the ability to manufacture a product at a higher quality and a faster rate for a greater profit than competing businesses or countries. Comparative advantage considers the capability of a company or a nation to produce a product more efficiently or more cheaply than others.

Key Takeaways

• Absolute advantage is the ability to create the best possible product at the lowest possible cost among all competing producers.
• Comparative advantage considers the relative benefits of various choices of products to be produced, factoring in the lost opportunities in the discarded options.
• Both of these economic concepts are useful to businesses and nations making decisions about what products they should produce and which products they should leave to others.

Absolute Advantage

The ability of a company or nation to produce goods more efficiently than its competitors is the basis for absolute advantage. Absolute advantage can be achieved by exploiting lower labor costs, access to a supply of resources, and a large pool of available capital.

For example, Japan and Italy both produce automobiles. If Italy can manufacture higher quality sports cars and make a greater profit than the competition, Italy would have an absolute advantage in the market for sports cars. Rather than competing in that segment, Japan might devote its resources to electric cars, SUVs, or another industry niche. Rather than competing head-on with Italy’s sports car market, Japan would opt to exploit an absolute advantage in another part of the market.

Absolute advantage is accomplished by creating the good or service at a lower absolute cost per unit using fewer inputs or a more efficient process.

Comparative Advantage

Comparative advantage considers the relative benefits of various options open to a company or nation that must prioritize its output. When a country or business has multiple resources to produce various goods and services, it looks for products with a comparative advantage.

Comparative advantage takes opportunity cost into account. That is, the opportunity cost of a given option is equal to the benefits that have been forfeited in deciding against another of the options available.

For example, China might have the resources to produce either 10 million smartphones or 10 million laptop computers. If computers generate a higher profit, the opportunity cost is the difference in value lost from producing a smartphone rather than a computer.

If China earns $100 for a computer and $50 for a smartphone, then the opportunity cost is $500 million. In this example, China will probably select computers because the potential profit is higher.

Important

Opportunity cost is the benefit that would have been derived from an option other than the one chosen.

Economic Theory

Scottish economist Adam Smith helped originate the concepts of absolute and comparative advantage in his book, The Wealth of Nations. Smith argued that countries should specialize in the goods they can produce most efficiently and trade for any products they can’t produce as well.

Smith touted the marriage of specialization and international trade as they relate to absolute advantage. He suggested that England could produce more textiles per labor hour and Spain could produce more wine per labor hour, so England should export textiles and import wine, and Spain should do the opposite.

Smith’s theory assumes that the factors of production between countries don’t change, that there are no barriers to trade, and that exports and imports are equal.

British economist David Ricardo built on Smith’s concept of comparative advantage in the early 19th century. According to Ricardo, nations can benefit from trading even if one has an absolute advantage in producing everything.

Did the Economist Adam Smith Promote the Benefits of Trade?

Scottish economist Adam Smith is credited with developing the theories of absolute and creative advantage in his book, The Wealth of Nations. According to Smith, countries should focus on goods they can produce efficiently and use trade to acquire anything they can’t efficiently make themselves.

The mutual benefits of trade form the basis of Smith’s argument that specialization, based on a nation’s intrinsic strengths and resources, can lead to prosperity for all.

What Is an Example of Absolute Advantage?

Saudi Arabia has an absolute advantage in the oil industry, given the sheer size of its oil reserves. However, about 95% of the nation consists of desert, so it is unlikely to compete effectively as an agricultural producer. Saudi Arabia imports about 80% of its food while paying for it with the money it receives from oil exports.

What Is the Benefit of Having Absolute Advantage in One Product?

Making a product that others need and can’t produce allows a company or country to maintain a trade relationship for goods and services it needs but can’t produce. This creates a mutually beneficial trading relationship.

The Bottom Line

Scottish economist Adam Smith explained how countries can thrive by making only the goods they can produce most efficiently for export while importing the products they can’t make efficiently. This is the concept of absolute advantage, which can be used by companies and nations to decide what products they should produce.

The concept of comparative advantage is a somewhat different take on the issue. It suggests that, with various options available, a nation or company should choose the one with the highest potential benefit, while factoring in the lost opportunity of the options that were discarded.