What’s it: Absolute advantage refers to the ability to produce goods or services more efficiently than others. As a result, those with this advantage can produce at a lower absolute cost.
Absolute advantage is important for explaining why some countries produce goods or services more efficiently than others. According to this theory, each should focus on these advantages when producing goods and services. And then, international trade facilitates them to get other goods which are less efficiently produced domestically.
What is the relationship between absolute advantage and international trade?
The absolute advantage was introduced by Adam Smith in the late 18th century. When we learn about international trade, this theory becomes the main introduction, in addition to comparative advantage.
International trade arises because not every country produces all goods and services at the most efficient level. Moreover, some countries can deliver goods more efficiently than others. As a result, they make at a lower absolute cost per unit than other countries.
According to this theory, each country should specialize in producing certain goods with an absolute advantage. They then sell the goods to other countries other than to meet domestic demand. Money from sales to buy other goods – which are inefficient if produced domestically – from other countries.
Finally, when each country does it all, it creates dependence on one another and encourages international trade. And global trade allows countries to obtain goods cheaper from abroad than to produce them at high costs domestically.
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What is the difference between comparative and absolute advantage, by example?
David Ricardo criticized the absolute advantage introduced by Adam Smith. He then introduced comparative advantage, which places opportunity costs as the primary consideration in production decisions, not absolute costs, as Adam Smith put it.
Why opportunity cost? Under Adam Smith’s theory, specialization is based on absolute costs. Each country focuses on the products it can produce at the lowest unit cost compared to other countries. So, if a country does not have an absolute advantage, then Adam Smith’s argument is not necessarily valid. This concept is incomplete in explaining international trade. In fact, several countries can produce the same product even though they do not have an absolute advantage, for instance, Japan, Germany, and the United States, in car production.
In addition, some countries are resource-rich. Therefore, they have an advantage when producing various goods because they have abundant labor, land, capital, and entrepreneurship.
In contrast, other countries are poor in these resources. Thus, according to absolute advantage, resource-poor countries can only import without being able to produce goods because they operate at high costs. So where do they generate income to import these goods?
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In contrast, resource-rich and resource-poor countries may still benefit from trade if they focus on their comparative advantage. This theory is based on opportunity cost, which is the next best alternative we sacrifice when we choose to produce a particular good.
Opportunity cost becomes a crucial explanation because we are dealing with scarce resources. When we use resources – such as land, labor, or capital, to produce certain goods, they are not available to produce other goods. For instance, Indonesia uses its land to produce rice because it has an absolute advantage in this aspect. However, if all the land is used to grow rice, none is available to grow other commodities, say corn. As a result, Indonesia gave up the opportunity to produce corn.
This comparative advantage underlies international trade. Resource-poor countries can focus on products with lower opportunity costs than other countries.
Now, take South Korea, for example. The country has limited land but has high entrepreneurship, supported by a productive workforce and capital. South Korea does not use its land to grow agricultural commodities or mine. But, the country focuses on manufactured goods where they have a comparative advantage. They import agricultural and mining commodities from abroad to meet domestic demand.
What are examples of absolute advantage and comparative advantage?
Let’s take a simplified case. For example, two countries, Indonesia and Malaysia, produce shoes and clothing. The table below shows each product’s hourly output per worker in the two countries.
From the table above, Indonesia has an absolute advantage in producing clothing and shoes. Indonesia produces 6 shoes and 3 clothes per hour, more than Malaysia, which only makes 1 shoe and 2 clothes per hour.
According to Adam Smith’s theory, Indonesia exports clothing and shoes to Malaysia. And Malaysia is only an importer. Or, trade does not exist because it is not profitable for Malaysia – it can only import without being able to generate income through exports because it is unable to compete with Indonesia.
However, from David Ricardo’s perspective, Malaysia and Indonesia trade because each has a comparative advantage. In Malaysia, the opportunity cost for 1 unit clothe is only 0.5 shoes (1/2). In Indonesia, on the other hand, the opportunity cost is 2 shoes (6/3). Therefore, because Malaysia has a lower opportunity cost, it has a comparative advantage in clothing.
Meanwhile, Indonesia has a comparative advantage in producing shoes. For example, Indonesia can make 1 shoe at an opportunity cost of 0.5 clothes (3/6). In contrast, Malaysia has an opportunity cost of 2 clothes (2/1).
Implications for international trade
In Adam Smith’s opinion, countries should specialize in products they have an absolute advantage by selling abroad. Then, the money they earn can buy other products with no absolute advantage.
On the other hand, in David Ricardo’s argument, a country should specialize in a good only when it has a comparative advantage and, for the rest, trade with other countries. In the example above, Malaysia focuses on clothing, and Indonesia specializes in shoes. According to this argument, the two will trade for a cheaper product. Indonesia buys clothes from Malaysia, and Malaysia buys shoes from Indonesia.
Why should Indonesia buy clothes from Malaysia?
The price of clothes and shoes answers that question. In the above case, the price of clothing in Malaysia is lower than in Indonesia because it bears lower opportunity costs than in Indonesia. Likewise, Indonesia produces more affordable shoes because it has a lower opportunity cost than Malaysia.
By trading, Indonesia gets clothes at lower prices from Malaysia than domestic production. Likewise, Malaysia buys Indonesia’s shoes because they are cheaper than domestic production.
What assumptions underlie the absolute advantage theory?
Adam Smith’s absolute advantage is based on several assumptions, including:
- The input or factor of production is only labor, and the cost of producing goods is calculated from the relative amount of labor required.
- Trade involves two countries and two goods.
- Goods flow freely between the two countries (free trade).
- Labor is immobile across countries but mobile within countries.
- No transportation costs can affect the selling price when the goods arrive at the destination country.
Where does absolute advantage come from?
Absolute advantage is achieved through low-cost production. If it is related to the factors of production – not only labor, as Adam Smith argued, it can come from several ways.
The first is cheaper labor or raw materials. Second, natural resources are available in abundance. For example, some countries are rich in petroleum reserves, while others have none.
The third is the capital investment level, including infrastructure. For example, greater public infrastructure investment can reduce transportation costs.
The fourth is greater efficiency and productivity in the production process through technological advances, division of labor, specialization, and other production techniques.
What are some criticisms of the absolute advantage theory?
There has been some criticism of Adam Smith’s absolute advantage. First, this theory assumes only two products and two countries. So, international trade involves only bilateral exchanges. This assumption is unrealistic because international trade in today’s modern economy involves many countries and products.
Second, the production input is not only labor. In fact, other factors, such as capital and natural resources, can also affect unit costs. So is technology. For example, capital such as more technologically advanced machines allows us to produce output at a lower cost.
Third, there are transportation costs in international trade. And those costs may contribute to eliminating the advantage effect. For example, the selling price will eventually be higher due to high transportation costs – caused by poor infrastructure – even though a country can produce at low unit costs.
In addition, trade barriers still exist today. For instance, some countries still apply for trade protection through tariffs and quotas. In addition, non-tariff barriers such as consumption and environmental safety requirements still exist.
What to read next
- Absolute Advantage: Examples, Assumptions, Criticism
- Comparative Advantage: Meaning, Assumptions, Examples, Criticisms
- International Trade: Why It Matters, Advantages, Disadvantages
- Where Do Comparative Advantages Come From?