Absolute Advantage

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Absolute Advantage

What It Means

Absolute advantage is a term used in discussions about international trade (the purchasing of goods made in one country by people in another country). When a country can produce any good more cheaply (using fewer resources) than a second country can, the first country is said to have an absolute advantage in regard to that good. If two countries are considering trading with one another, and each of them has an absolute advantage in a different good, then both can be sure of benefiting from free trade in these goods. In free trade goods and services are allowed to flow between countries without restrictions such as quotas (limits on the quantity of imports) and tariffs (taxes on imports).

For example, suppose that France can produce high-quality wine more cheaply than England, and England can produce high-quality beer more cheaply than France. It makes sense for the two countries to trade with one another, because consumers in both countries will get high-quality beer and wine at good prices. At the same time, French winemakers will produce more wealth by specializing in what they do well, and English beer manufacturers will produce more wealth by specializing in what they do well. Both countries will be better off than if they did not trade with one another.

When Did It Begin

Adam Smith (1723–90), the Scottish thinker widely considered the founder of the field of economics, introduced the concept of absolute advantage in his landmark book An Inquiry into the Nature and Causes of the Wealth of Nations (1776). Prior to the publication of Smith’s book, there was little support, among European countries, for free trade. A doctrine called mercantilism was the prevailing ideology among national leaders. According to this theory, a country should amass wealth by exporting more than it imports and by protecting its own industries from foreign competition (imposing tariffs and quotas on imports was the main way to do this). Smith successfully showed that mercantilist theories were illogical and harmful to the national interest.

When Did It Begin

Absolute advantage makes intuitive sense to most people. This may be because, if we translate it to the personal level, we can see that we all employ our own version of this principle in our daily lives.

In the contemporary world few of us produce our own food. Instead, we prefer to go to the grocery store and buy bread, meat, and vegetables. We understand that grocery stores can make these items available to us more efficiently than we would be able to produce them personally. If all of us had to grow and process our own wheat and then bake our own bread; feed, tend, and butcher our own cows and chickens; and plant, raise, and harvest our own vegetable crops, we would spend all of our time doing these things.

While such a lifestyle might have its appeal, it does not allow for the creation of wealth. In a modern economy farmers and grocers specialize in food production so that the rest of us can focus on what we do well. A computer programmer can create more economic value for herself and her community by spending as much time as possible writing software, while leaving other jobs, such as food production, in the hands of those who specialize in them.

Absolute advantage, in the arena of free trade, is simply the application of this idea to the level of nations. If a company in another country can provide jeans to American consumers for a lower price than U.S. companies can, it makes no sense, in the eyes of economists, to keep the foreign jeans out of the country and force consumers to go on paying higher prices for domestic jeans (domestic means produced within the country). While U.S. producers of jeans might have to fire employees if most Americans begin buying foreign jeans, ultimately the U.S. economy will be better off, because makers of jeans can focus on other products that cannot be made as efficiently in other countries. For instance, the United States excels in computer software. If more U.S. workers focus on making software than jeans, then the overall economy will produce more wealth than it did when trade in foreign jeans was restricted. At the same time, American consumers will get access to cheap jeans.

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Smith’s views regarding absolute advantage have not been seriously contested in the centuries since he first conceived them, but another early economist, David Ricardo (1772–1823) of England, supplemented Smith’s idea with the theory of comparative advantage, which justifies free trade in more complex situations. Together, the two theories provide the foundation for the belief, common to most present-day economists, that free trade among nations should be encouraged.

Comparative advantage addresses a situation in which a country has an absolute advantage in more than one area. For example, many Americans in the early twenty-first century worry about the fact that companies in a country such as China can produce virtually any item more cheaply than companies in the United States, because Chinese workers generally get paid far less than their American counterparts. The worry is that this will harm the U.S. economy by leading to American wage cuts and unemployment. But economists who subscribe to the idea of comparative advantage argue that this is not necessarily so.

Consider the hypothetical example of two products, blenders and radios. According to the theory of comparative advantage, even if Chinese companies can produce both items more cheaply than American companies, the Chinese might have a greater advantage in one good than the other, and they would benefit financially by specializing in this good and trading for the other. For instance, say that the Chinese can produce a blender for $10 and a radio for $10, while the Americans can produce a blender for $20 and a radio for $15. China has an absolute advantage in both products, but it has a comparative advantage in blenders. The comparative advantage is calculated according to opportunity cost, the value of the option given up. Whenever a company decides to use its resources to produce one product, it is giving up the chance to make a different product.

Continuing the above example, if a Chinese company spends $10 making 1 blender, it gives up the opportunity to use that $10 to make 1 radio. Meanwhile, if an American company makes 1 blender for $20, it gives up the opportunity to use that $20 to make 1.33 radios. The fact that the Chinese would be giving up less to make blenders than the Americans would (1 radio compared to 1.33 radios) means that China has a comparative advantage in blenders. Using the same reasoning, the Americans have a comparative advantage in radios, because they sacrifice less to make a radio than China does. (To make 1 radio for $10, the Chinese company would be giving up the opportunity to make 1 blender, but if the U.S. company makes 1 radio for $15, it gives up the opportunity to make 0.75 blenders.)

The key idea of comparative advantage is that it is in the best interests of both countries to maximize their combined production. That production is maximized by specializing and trading can be illustrated by comparing the total amount that could be produced if each country was self-sufficient with the total amount produced if each country focused on its comparative-advantage good and traded for the other good. If Chinese companies spend their available resources (say $1,000 for simplicity’s sake) on making both blenders and radios, allotting $500 to each product, they could produce 50 blenders and 50 radios. Meanwhile, if U.S. companies spend their resources (say $2,000; the amount that China spends does not affect the calculation, because each country is weighing its own options) on making both items (suppose it spends $1,000 on each, although it could be any proportion), they could make 50 blenders and 66.67 radios. In this example, the total amount of products made by both countries is 100 blenders and 116.67 radios. But if, spending the same amount of money as above, China focuses on blenders while the United States focuses on radios, and they trade blenders and radios accordingly, then the countries would create a greater total amount of products: 100 blenders (all made by China) and 133.3 radios (all made by the United States). The same amount of resources will have been used to create more goods to sell, and therefore more wealth, than if the countries restricted trade in these items.