Absolute Advantage Theory & Law of Comparative Advantage - International Business | International Business - B Com PDF Download

Absolute Advantage definition and examples

• Absolute advantage means that an economy can produce a greater total of goods for the same quantity of inputs.

• Absolute advantage means that fewer resources are needed to produce the same amount of goods and there will be lower costs than other economies.

Simple example of absolute advantage

• In this example, Brazil has an absolute advantage in producing bananas (8 to 1).

• The US has an absolute advantage in producing cars (5 to 2)

Absolute advantage and labour costs

This is a different way of showing absolute advantage. Rather than show the output, we show the hours of labour required. This reflects the effective cost of production.

• In the above case, England has an absolute advantage in producing cloth (only requires 60 hours compared to Portugal’s 120).

• Portugal has an absolute advantage in producing wine (only requires 70 hours compared to  110 hours in England)

Absolute advantage in everything

It is possible for an economy to have an absolute advantage in everything. Whilst, some countries may have no absolute advantage in any goods or services.

In the above case, the US has an absolute advantage in producing clothing (5 to 4) and also has an absolute advantage in producing aeroplanes. (12 to 1)

Absolute vs Comparative advantage

Absolute advantage is concerned with producing at a lower cost. Comparative advantage is concerned with producing at a lower opportunity cost (ie. relatively better at producing)

Having absolute advantage doesn’t necessarily mean an economy should produce that good. It is not advisable to try and produce everything. It is more helpful to consider comparative advantage.

Comparative advantage measures the opportunity cost of producing a good.

• If the US produces clothing, the opportunity cost is 12/5 = 2.4 aeroplanes foregone.

• If Brazil produces clothing, the opportunity cost is 1/5 = 0.25 aeroplanes foregone.

• Therefore, the US should specialise in producing aeroplanes. Brazil should specialise in producing clothing (even though it doesn’t have an absolute advantage)

After specialisation

After specialisation, we assume countries are able to concentrate on doubling production because they produce only one good rather than two. Total output and economic welfare increases.

For example, one country may have an absolute advantage in many goods but it is better to focus on on goods where you have a relative advantage.

Absolute advantage in the workplace

Suppose:

• Susan can produce 11 cups of tea per hour and file 13 reports.

• Bob is a lazier worker and can only produce 10 cups of tea per hour and file 3 reports.

In this case, Susan has an absolute advantage in making cups of tea and filing reports.

• However, Susan should not try to do everything. She should specialise in compiling the reports, whilst Bob specialises in making cups of tea.

Notes about absolute advantage

• Absolute advantage can be hard to measure for many complicated goods because there are many different factor inputs.

What is 'Comparative Advantage'

Comparative advantage is an economic law referring to the ability of any given economic actor to produce goods and services at a lower opportunity cost than other economic actors. The law of comparative advantage is popularly attributed to English political economist David Ricardo and his book “Principles of Political Economy and Taxation” in 1817, although it is likely that Ricardo's mentor James Mill originated the analysis.

BREAKING DOWN 'Comparative Advantage'

One of the most important concepts in economic theory, comparative advantage lays out the case that all actors, at all times, can mutually benefit from cooperation and voluntary trade. It is also a foundational principle in the theory of international trade.

Comparative vs. Absolute Advantages

Comparative advantage is contrasted with absolute advantage. Absolute advantage refers to the ability to produce more or better goods and services than somebody else. Comparative advantage refers to the ability to produce goods and services at a lower opportunity cost, not necessarily at a greater volume.

To see the difference, consider an attorney and her secretary. The attorney is better at producing legal services than her secretary and is also a faster typist and organizer. In this case, the attorney has an absolute advantage in both the production of legal services and secretarial work.

Nevertheless, they benefit from trade thanks to their comparative advantages and disadvantages. Suppose the attorney produces $175/hr in legal services and $25/hr in secretarial duties. The secretary can produce $0 in legal services and $20 in secretarial duties in an hour. Here, the role of opportunity cost is crucial.

To produce $25 in income from secretarial work, the attorney must lose $175 in income by not practicing law. Her opportunity cost of secretarial work is very high. She is better off by producing an hour's worth of legal services and hiring the secretary to type and organize. The secretary is much better off typing and organizing for the attorney; his opportunity cost of doing so is extremely low. It’s where his comparative advantage lies.

International Trade

David Ricardo famously demonstrated how England and Portugal both benefit by specializing and trading according to their comparative advantages, Portugal with wine and England with cloth.

A contemporary example: China’s comparative advantage with the United States is in the form of cheap labor. Chinese workers produce simple consumer goods at a much lower opportunity cost. The United States’ comparative advantage is in specialized, capital-intensive labor. American workers produce sophisticated goods or investment opportunities at lower opportunity costs. Specializing and trading along these lines benefits each.

Diversity of Skills

People learn their comparative advantages through wages. This drives people into those jobs they are comparatively best at. If a skilled mathematician earns more as an engineer than as a teacher, he and everyone he trades with is better off when he practices engineering.

Wider gaps in opportunity costs allow for higher levels of value production simply by organizing labor more efficiently. The greater the diversity in people and their skills, the greater the opportunity for beneficial trade through comparative advantage.