Absolute Advantage (Economics) - Explained
What is Absolute Advantage?
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Table of ContentsWhat is Absolute Advantage?How to Determine Absolute AdvantageExamples of Absolute Advantage Academic Research on Absolute Advantage in Economics
What is Absolute Advantage?
The advantage of being able to produce a good or product with fewer input resources is called Absolute Advantage. The producer of the goods could be any legal entity from a single person, a business, to the economy of a country as a whole. It is a comparative term used in economics when comparing the output capacity of a country, business, or an individual in relation to another similar entity. The entity that produces more with less inputs has the Absolute Advantage.
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How to Determine Absolute Advantage
The metric of Absolute Advantage is the ability of an absolute unit to produce goods with fewer resources compared to another similar entity. Using fewer resources, incurring lower production and operational costs, and getting more returns deems it better at production than others. Access to better technology, cheaper labour, or more efficient operational procedures and production values is a given. Its a good way of drawing comparisons between goods producing ability of individuals, companies, and nations according to expenditure of resources. Since Adam Smith postulated this theory, its used as one of the basic metrics to compare international trade in the economic sphere. Smith posited that countries focus on specializing in producing goods they have an Absolute Advantage over. The theory also suggests that countries export these goods produced at low costs and efforts, and import goods they do not have Absolute Advantage in producing, from countries that do. This also keeps the fuel of international trade burning. But this theory in its basic form is too simplistic to explain international trade. For example, if a country X produces oil for $10 per barrel and coal for $12 per ton, while country Y produces oil for $12 per barrel and coal for $15 per ton, there could be no trade between the two. This is patently false as is evident from the actual trade scenario. Country X would have nothing to gain in trade with country Y according to the theory of Absolute Advantage. Thus it was concluded that international trade is conducted via Comparative Advantage as opposed to a strict adherence to Absolute Advantage. Renowned economist Adam Smith raised the question of why do countries trade goods, in his book The Wealth of Nations. In answering the question, he theorised that certain nations have an advantage in producing certain goods, but not all. Selling their better goods to buy other goods that are better made elsewhere is the first basis of international trade. He chose time - or the number of working hours required to produce a good - as the basic premise of measuring Absolute Advantage. Mercantilists believe that countries should strive to have as big a favourable trade balance as possible by maximizing the difference between their imports and exports. A country that produces the maximum number of goods to export, while its imports are few, has a favourable trade balance, as the difference in price is paid in Gold standard. Conversely, countries incapable of producing worthwhile goods need to import them from other countries, incurring a negative trade balance. Smith criticised this view and believed that the welfare of a country depended on meeting the needs of its populace and hence spending in acquiring goods while fuelling international trade was the way to go. He argues that production and consumption are the key factors to acquiring wealth and declares that needs of people, and the cost of social welfare must be prioritised. Thus he arrives at the theory of Absolute Advantage and how it is beneficial to all countries involved in international trade.
Examples of Absolute Advantage
Lets take the fictional example of Brazil vs China in the production of coffee and garments. Brazil requires 30 hours to produce a bag of coffee while China requires 60 hours to do the same. China requires 10 hours to produce a bolt of clothing while Brazil requires 40 hours to do the same. Considering the number of working hours required by each country to produce these goods as a homogenous source, Brazil has the Absolute Advantage in producing coffee while China has the Absolute Advantage in producing garments. Smiths theory falters when a certain country has the Absolute Advantage in producing the maximum number of goods. In this case the country would be almost self sufficient and has no need to participate in international trade. To counter this fallacy, economist David Ricardo suggested the theory of Comparative Advantage which also takes into account the opportunity cost of producing goods in addition to the number of working hours. Thus, countries rely on relative advantage of goods production to participate in international trade.
- Fixed Cost vs Variable Cost
- Actual vs Implicit Costs
- Marginal Cost
- Incremental Cost
- Average Total Cost
- Opportunity Cost
- Opportunity Set
- Sunk Costs
- Cost Curves
- True Cost Economics
- Absolute Advantage