Absolute Advantage

By Jim Chappelow
Updated May 1, 2019

What is Absolute Advantage?

Absolute advantage is the ability of an individual, company, region, or country to produce a
greater quantity of a good or service with the same quantity of inputs per unit of time, or to
produce the same quantity of a good or service per unit of time using a lesser quantity of inputs,
than another entity that produces the same good or service. An entity with an absolute advantage
can produce a product or service at a lower absolute cost per unit using a smaller number of
inputs or a more efficient process than another entity producing the same good or service.

Key Takeaways

 Absolute advantage is when a producer can produce a good or service in greater quantity
for the same cost, or the same quantity at lower cost, than other producers.
 Absolute advantage can be the basis for large gains from trade between producers of
different goods with different absolute advantages.
 By specialization, division of labor, and trade, producers with different absolute
advantages can always gain over producing in isolation.
 Absolute advantage is related to comparative advantage, which can open up even more
widespread opportunities for the division of labor and gains from trade.

Understanding Absolute Advantage

The concept of absolute advantage was developed by Adam Smith in his book Wealth of Nations
to show how countries can gain from trade by specializing in producing and exporting the goods
that they can produce more efficiently than other countries. Countries with an absolute advantage
can decide to specialize in producing and selling a specific good or service and use the funds that
good or service generates to purchase goods and services from other countries.

By Smith’s argument, specializing in the products that they each have an absolute advantage in
and then trading products, can make all countries better off, as long as they each have at least one
product for which they hold an absolute advantage over other nations.

General Example of Absolute Advantage

Consider the two hypothetical countries, Atlantica and Krasnovia, with equivalent populations
and resource endowments, which each produce two products, Guns and Bacon. Each year
Atlantica can produce either 12 Guns or 6 slabs of Bacon, while Krasnovia can produce either 6
Guns or 12 slabs of Bacon. Each country needs a minimum of 4 Guns and 4 slabs of Bacon to
survive. In a state of autarky, producing solely on their own for their own needs,  Atlantica can
spend ⅓ of the year making Guns and ⅔ making Bacon for a total of 4 Guns and 4 slabs of
Bacon. Krasnovia can spend ⅓ of the year making Bacon and ⅔ making Guns to produce the
same, 4 Guns and 4 slabs of Bacon. This leaves each country at the brink of survival, with barely
enough Guns and Bacon to go around. However, not that Atlantica has an absolute advantage in
producing Guns, and Krasnovia has an absolute advantage in producing Bacon.

Absolute advantage also explains why it makes sense for individuals, businesses and countries to
trade. Since each has advantages in producing certain goods and services, both entities can
benefit from trade.

If each country were to specialize in their absolute advantage, Atlantica could make 12 Guns and
no Bacon, while Krasnovia makes no Guns and 12 slabs of Bacon. By specializing, the two
countries divide the tasks of their labor between them. If they then trade 6 Guns for 6 slabs of
Bacon, each country would then have 6 of each. Both countries would now be better off than
before, because each would have 6 Guns and 6 Bacon, as opposed to 4 of each good which they
could produce on their own.

This mutual gain from trade forms the basis of Adam Smith’s argument that specialization, the
division of labor, and subsequent trade leads to an overall increase of wealth from which all can
benefit. This, Smith believed, was the root cause of the eponymous Wealth of Nations. 

Absolute Advantage and Comparative Advantage

Absolute advantage can be contrasted to comparative advantage, which is when a producer has a
lower opportunity cost to produce a good or service than another producer. Absolute advantage
leads to unambiguous gains from specialization and trade only in cases where each producer has
an absolute advantage in producing some good. If a producer lacks any absolute advantage then
Adam Smith’s argument would not necessarily apply. However, the producer and its trading
partners might still be able to realized gains from trade if they can specialize based on their
respective comparative advantages instead.

Comparative Advantage
By Adam Hayes
Updated Jun 25, 2019

What Is Comparative Advantage?

Comparative advantage is an economic term that refers to an economy's ability to produce goods
and services at a lower opportunity cost than that of trade partners. A comparative advantage
gives a company the ability to sell goods and services at a lower price than its competitors and
realize stronger sales margins.
The law of comparative advantage is popularly attributed to English political economist David
Ricardo and his book “On the Principles of Political Economy and Taxation” in 1817, although it
is likely that Ricardo's mentor James Mill originated the analysis.

Explaining Comparative Advantage

Understanding Comparative Advantage

One of the most important concepts in economic theory, comparative advantage is a fundamental
tenet of the argument 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.

Key to the understanding of comparative advantage is a solid grasp of opportunity cost. Put
simply, an opportunity cost is the potential benefit that someone loses out on when selecting a
particular option over another. In the case of comparative advantage, the opportunity cost (that is
to say, the potential benefit which has been forfeited) for one company is lower than that of
another. The company with the lower opportunity cost, and thus the smallest potential benefit
which was lost, holds this type of advantage.

Another way to think of comparative advantage is as the best option given a trade-off. If you're
comparing two different options, each of which has a trade-off (some benefits as well as some
disadvantages), the one with the best overall package is the one with the comparative advantage.

Comparative advantage is a key insight that trade will still occur even if one country as an
absolute advantage in all products.

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 by organizing labor more
efficiently. The greater the diversity in people and their skills, the greater the opportunity for
beneficial trade through comparative advantage.

As an example (adapted from Farnam Street), consider a famous athlete like Michael Jordan. As
a renowned basketball and baseball star, Michael Jordan is an exceptional athlete whose physical
abilities surpass those of most other individuals. Michael Jordan would likely be able to, say,
paint his house quickly, owing to his abilities as well as his impressive height. Hypothetically,
say that Michael Jordan could paint his house in 8 hours. In those same 8 hours, though, he could
also take part in the filming of a television commercial which would earn him $50,000. By
contrast, Jordan's neighbor Joe could paint the house in 10 hours. In that same period of time, he
could work at a fast food restaurant and earn $100.

In this example, Joe has a comparative advantage, even though Michael Jordan could paint the
house faster and better. The best trade would be for Michael Jordan to film a television
commercial and pay Joe to paint his house. So long as Michael Jordan makes the expected
$50,000 and Joe earns more than $100, the trade is a winner. Owing to their diversity of skills,
Michael Jordan and Joe would likely find this to be the best arrangement for their mutual benefit.

Key Takeaways

 Comparative advantage suggests that countries will engage in trade with one another,
exporting the goods that they have a relative advantage in productivity.
 The theory was first introduced by David Ricardo in the year 1817.
 Absolute advantage refers to the uncontested superiority of a country to produce a
particular good better. Comparative advantage introduces opportunity cost as a factor for
analysis in choosing between different options for production.

Comparative Advantage Versus Absolute Advantage

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 or quality.

To see the difference, consider an attorney and her secretary. The attorney is better at producing
legal services than the 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 per hour in legal services and $25 per hour 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 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 low.
It’s where his comparative advantage lies.

Some economic historians suggest that it was actually David Ricardo's editor, James Mill, who
slipped in the theory of comparative advantage (which is only a short section) into Principles.
They argue that the theory seems inconsistent with the bulk of the book and its labor theory of
value.

Comparative Advantage Versus Competitive Advantage

A competitive advantage refers to a company, economy, country, or individual's ability to
provide a stronger value to consumers as compared with its competitors. It is similar to but
distinct from comparative advantage.
In order to assume a competitive advantage over others in the same field or area, it's necessary to
accomplish at least one of three things: the company should be the low-cost provider of its goods
or services, it should offer superior goods or services than its competitors, and/or it should focus
on a particular segment of the consumer pool.

Comparative Advantage in International Trade

David Ricardo famously showed how England and Portugal both benefit by specializing and
trading according to their comparative advantages. In this case, Portugal was able to make wine
at a low cost, while England was able to cheaply manufacture cloth. Ricardo predicted that each
country would eventually recognize these facts and stop attempting to make the product that was
more costly to generate.

Indeed, as time went on, England stopped producing wine, and Portugal stopped manufacturing
cloth. Both countries saw that it was to their advantage to stop their efforts at producing these
items at home and, instead, to trade with each other in order to acquire them.

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 benefit each.

The theory of comparative advantage helps to explain why protectionism is typically

unsuccessful. Adherents to this analytical approach believe that countries engaged in
international trade will have already worked toward finding partners with comparative
advantages.

If a country removes itself from an international trade agreement, if a government imposes

tariffs, and so on, it may produce a local benefit in the form of new jobs and industry. However,
this is not a long-term solution to a trade problem. Eventually, that country will be at a
disadvantage relative to its neighbors: countries that were already better able to produce these
items at a lower opportunity cost.

Criticisms of Comparative Advantage

Why doesn't the world have open trading between countries? When there is free trade, why do
some countries remain poor at the expense of others? Perhaps comparative advantage does not
work as suggested. There are many reasons this could be the case, but the most influential is
something that economists call rent-seeking. Rent-seeking occurs when one group organizes
and lobbies the government to protect its interests.

Say, for example, the producers of American shoes understand and agree with the free-trade
argument—but they also know that their narrow interests would be negatively impacted by
cheaper foreign shoes. Even if laborers would be most productive by switching from making
shoes to making computers, nobody in the shoe industry wants to lose his or her job or
see profits decrease in the short run.

This desire leads the shoemakers to lobby for, say, special tax breaks for their products and/or
extra duties (or even outright bans) on foreign footwear. Appeals to save American jobs and
preserve a time-honored American craft abound—even though, in the long run, American
laborers would be made relatively less productive and American consumers relatively poorer by
such protectionist tactics.

Theory of Comparative Advantage of

International Trade: by David Ricardo
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Theory of Comparative Advantage of International Trade: by David Ricardo!

The classical theory of international trade is popularly known as the Theory of Comparative
Costs or Advantage. It was formulated by David Ricardo in 1815.

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The classical approach, in terms of comparative cost advantage, as presented by Ricardo,

basically seeks to explain how and why countries gain by trading.

The idea of comparative costs advantage is drawn in view of deficiencies observed by Ricardo in
Adam Smith’s principles of absolute cost advantage in explaining territorial specialisation as a
basis for international trade.

Being dissatisfied with the application of classical labour theory of value in the case of foreign
trade,

Ricardo developed a theory of comparative cost advantage to explain the basis of international
trade as under:

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Ricardo’s Theorem:

Ricardo stated a theorem that, other things being equal, a country tends to specialise in and
export those commodities in the production of which it has maximum comparative cost
advantage or minimum comparative disadvantage. Similarly, the country’s imports will be of
goods having relatively less comparative cost advantage or greater disadvantage.
The Ricardian Model:

To explain his theory of comparative cost advantage, Ricardo constructed a two-country,

two-commodity, but one-factor model with the following assumptions:

1. Labour is the only productive factor.

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2. Costs of production are measured in terms of the labour units involved.

3. Labour is perfectly mobile within a country but immobile internationally.

4. Labour is homogeneous.

5. There is unrestricted or free trade.

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6. There are constant returns to scale.

7. There is full employment equilibrium.

8. There is perfect competition.

Under these assumptions, let us assume that there are two countries A and В and two goods X
and Y to be produced.

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Now, to illustrate and elucidate comparative cost difference, let us take some hypothetical data
and examine them as follows.

Absolute Cost Difference:

As Adam Smith pointed out, if there is an absolute cost difference, a country will specialise in
the production of a commodity having an absolute advantage (see Table 1).

Table 1 Cost of Production in Labour Units:

Country Country Comparative

A В Cost Ratio
Commodity X 10 20 10/20 = 0.5
Commodity Y 20 10 20/10 = 2
ADVERTISEMENTS:1 X = 1/2 1 X = 2 Y
Y
Domestic Exchange
Ratio:

It follows that country A has an absolute advantage over В in the production of X while В has an
absolute advantage in producing Y. As such, when trade takes place, A specialises in X and
exports its surplus to В and В specialises in У and exports its surplus to A.

Equal Cost Difference:

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Ricardo argues that if there is equal cost difference, it is not advantageous for trade and
specialisation for any country in consideration (see Table 2).

Table 2 Cost of Production in Labour Units:

Country A Country В Comparative

Cost Ratio
Commodity X 10 15 10 /15 = 0.66

Commodity Y 20 30 20/30 = 0.66

Domestic 1 X = 1/2 Y 1 X = 1/2 Y
Exchange
Ratio:

On account of equal cost difference, the comparative cost ratio is the same for both the countries,
so there is no reason for undertaking specialisation. Hence, the trade between two countries will
not take place.

Comparative Cost Difference:

Ricardo emphasised that under all conditions, it, is the comparative cost advantage which lies at
the root of specialisation and trade (see Table 3).

Table 3 Cost of Production in Labour Units:

Country A Country В Comparative

Cost Ratio
Commodity X 10 15 10/ 15 = 0.66
Commodity Y 20 25 20/25 = 0.80 25
Domestic IX = 0.5Y IX = 0.6Y
Exchange Ratio

It will be seen that country A has an absolute cost advantage in both the commodities X and Y.
However, A possesses a comparative cost advantage in producing X. For, comparatively, country
A’s labour cost involved in producing 1 unit of X is only 66 per cent of B’s labour cost involved
in producing X, as against that of 80 per cent in the case of Y.

On the other hand, country В has least comparative disadvantage in production of Y, though she
has absolute cost disadvantage in both X and Y.

It should be noted that, to know the comparative advantage, we have to compare the ratio of the
costs of production of one commodity in both countries (i.e., 10/15 in the case of X in our
example) with the ratio of the cost of producing the other commodity in both countries (i.e.,
20/25 in the case of У in our example). To state in algebraic terms:

If in country A, the labour cost of commodity X is Xa and that of У is Ya, and in B, it is Xb and
Yb respectively, then absolute differences in cost can be expressed as:

Xa/Xb < 1 < Ya/Yb

(Which means that country A has an absolute advantage over country В in commodity X and
country В has over A in commodity У). And, comparative differences in costs are expressed as:

Xa/Xb < Ya/Yb < 1

(Which implies that country A possesses an absolute advantage over В in both X and (Y, but it
has more comparative advantage in X than in Y). If, however, there is an equal cost difference,
i.e., Xa/Xb = Ya/Yb will be no international trade between the two countries.

In our illustration, since country A has comparative cost advantage in commodity X, as per
Ricardo s theorem, this country should tend to specialise in X and export its surplus to country В
in exchange for У (i.e., import of У from B). Correspondingly, since country В has least cost
disadvantage in producing У, she should specialise in У and export its surplus to A and import
X.