Absolute Advantage: Examples, Assumptions, Criticism

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. The country has limited land but has high entrepreneurship, supported by a productive https://1investing.in/ 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.

  1. International trade is then the concept of this exchange between people or entities in two different countries.
  2. As some have argued, “geography is destiny.” Chile will provide copper and Guatemala will produce coffee, and they will trade.
  3. Starting at point C, which shows Saudi oil production of 60, reduce Saudi oil domestic oil consumption by 20, since 20 is exported to the United States and exchanged for 20 units of corn.
  4. Alternatively, if all the resources are used in the production of Y, it is possible to produce OB quantity of Y.
  5. Consider another example, such as when the United States and Saudi Arabia start at C and C’, respectively, as shown in Figure 1.

According to Adam Smith, who is regarded as the father of modern economics, countries should only produce goods in which they have an absolute advantage. An individual, business, or country is said to have an absolute advantage if it can produce a good at a lower cost than another individual, business, or country. For example, if Japan and Italy can both produce automobiles, but Italy can produce sports cars of a higher quality at a faster rate with greater profit, then Italy is said to have an absolute advantage in that particular industry. On the other hand, Japan may be better served to devote limited resources and labor to other types of vehicles (such as electric cars) or another industry altogether. This may help the country enjoy an absolute advantage rather than trying to compete with Italy’s efficiency.

Mercantilism advocated a national economic policy designed to maximize the nation’s trade and its gold and money reserves. In reality, countries often make strategic investments to create greater advantages in certain industries. Natural disasters, for example, can destroy farmland, factories, and other factors of production. In modern trade, however, globalization has now made it easy for companies to move their factories abroad. It has also increased the rate of immigration, which impacts a country’s available workforce.

A clear example of a nation with an absolute advantage is Saudi Arabia, a country with abundant oil supplies that provide it with an absolute advantage over other nations. If they then trade six tubs of butter for six slabs of bacon, each country would then have six of each. Both countries would now be better off than before, because each would have six tubs of butter and six slabs of bacon, as opposed to four of each good which they could produce on their own. In fact, the theory has been used to justify exploitative economic policies in the postcolonial era. Reasoning that all countries should focus on their advantages, major bodies like the World Bank and IMF have often pressured developing countries to focus on agricultural exports, rather than industrialization.

One way that many of these new nations promoted exports was to impose restrictions on imports. 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. China enjoys a low-cost manufactured goods advantage due to low labor costs, while Canada’s low land cost provides an agricultural production advantage. In his book, The Wealth of the Nations, Adam Smith used this idea to demonstrate how countries that specialize in producing and exporting certain goods gain from trade with other countries. Absolute advantage refers to how a company, country, or region produces a greater quantity of a product while maintaining the same amount of time it takes to produce the product.

History of Absolute Advantage and Comparative Advantage

Table 33.5 illustrates the range of trades that would benefit both sides. While they have helped economists, governments, and businesses better understand international trade and how to promote, regulate, and manage it, these theories are occasionally contradicted by real-world events. Countries don’t have absolute advantages in many areas of production or services and, in fact, the factors of production aren’t neatly distributed between countries.

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Comparative advantage occurs when a country cannot produce a product more efficiently than the other country; however, it can produce that product better and more efficiently than it does other goods. Comparative advantage focuses on the relative productivity differences, whereas absolute advantage looks at the absolute productivity. Developed in the sixteenth century, mercantilism was one of the earliest efforts to develop an economic theory. This theory stated that a country’s wealth was determined by the amount of its gold and silver holdings. In it’s simplest sense, mercantilists believed that a country should increase its holdings of gold and silver by promoting exports and discouraging imports.

Saudi Arabia has an absolute advantage in oil production due to its abundant oil reserves and low cost of production. As a result, it specialises in oil production and exports oil to other countries that do not have an absolute advantage in oil production. Secondly, he applies the opportunity cost principle to individuals in a society, using the particular example of a shoemaker not using the shoes he made himself because that would be a waste of his productive resources.

What Are the Different International Trade Theories?

He became well-known throughout history for his musings on comparative advantage. According to Ricardo, nations can benefit from trading even if one of them has an absolute advantage in producing everything. In other words, countries absolute advantage theory must choose to diversify the goods and services they produce, which requires them to consider opportunity costs. The theories of Smith and Ricardo didn’t help countries determine which products would give a country an advantage.

At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. Absolute Advantage looks into the efficiency of production for a single product. This leads to a greater production of goods overall, as shown in the chart below. Mexico would produce 8,000 shoes, and 10,000 refrigerators, shown in the chart below.

Absolute Advantage – definition and examples

It is also related to comparative advantage, which opens up more widespread opportunities for gains from trade, as well as division of labor. Absolute advantage refers to situations wherein one firm or nation can produce a given product of better quality, more quickly, and for higher profits than can another firm or nation. Comparative advantage, by contrast, looks at international trade more broadly—it accounts for the opportunity costs of choosing to manufacture multiple kinds of products using finite resources. Both absolute advantage and comparative advantage are enormously significant concepts for understanding how international trade works. Let’s look at a simplified hypothetical example to illustrate the subtle difference between these principles. Miranda is a Wall Street lawyer who charges $500 per hour for her legal services.

Thirdly, the ‘Vent for Surplus’ doctrine of Adam Smith is not completely satisfactory. This doctrine can have serious adverse repercussions on the growth process of the backward countries. These countries do not sell their surplus produce in foreign markets but are constrained to export despite domestic shortages for the reasons of neutralising their balance of payments deficit.

In Table 1, Saudi Arabia has an absolute advantage in the production of oil because it only takes an hour to produce a barrel of oil compared to two hours in the United States. The first expression means that the United States uses fewer labor resources (hours of work) to produce a pound of cheese than does France. In other words, the resource cost of production is lower in the United States. The second expression means that labor productivity in cheese in the United States is greater than in France.

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