Is the ability of an individual a firm or a country to produce a good or service at a lower opportunity cost than competitors?

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Absolute advantage and balance of trade are two important aspects of international trade that affect countries and organizations.
KEY Points
Absolute Advantage
Balance of Trade
Adam Smith’s Theory of Absolute Advantage
Assumptions of the Absolute Advantage Theory
Achieving an Absolute Advantage
Advantages of an Advantage
Absolute Advantage vs. Comparative Advantage
Criticisms against Absolute Advantage
Related Reading

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Absolute advantage and balance of trade are two important aspects of international trade that affect countries and organizations.

KEY Points

Absolute advantage: In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources.
Net exports: The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation’s imports and exports.
Advantageous trade: Advantageous trade is based on comparative advantage and covers a larger set of circumstances while still including the case of absolute advantage and hence is a more general theory.

Terms

Absolute advantage: The capability to produce more of a given product using less of a given resource than a competing entity.
Advantageous: Being of advantage; conferring advantage; gainful; profitable; useful; beneficial; as, an advantageous position.

In the drive for international trade, it is important to understand how trade affects countries positively and negatively—both how a country’s imports and exports affect its economy and how effectively the country’s ability to create and exportvital goods effects the businesses within that country. Absolute advantage and balance of trade are two important aspects of international trade that affect countries and organizations .

European Free Trade Agreement

The European Free Trade Agreement has helped countries international trade without worrying about absolute advantage and increases net exports.

Absolute Advantage

In economics, the principle of absolute advantage refers to the ability of a party (an individual, a firm, or a country) to produce more of a good or service than competitors while using the same amount of resources. Adam Smith first described the principle of absolute advantage in the context of international trade, using labor as the only input. Since absolute advantage is determined by a simple comparison of labor productivities, it is possible for a party to have no absolute advantage in anything; in that case, according to the theory of absolute advantage, no trade will occur with the other party. It can be contrasted with the concept of comparative advantage, which refers to the ability to produce a particular good at a lower opportunity cost.

Balance of Trade

The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value of exports and imports in an economy over a certain period. A positive balance is known as a trade surplus if it consists ofexporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap. The balance of trade is sometimes divided into a goods and a services balance.

The difference between the monetary value of exports and imports in an economy over a certain period of time.

The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. The concept that a certain good can be produced more efficiently than others due to a number of factors, including productive skills, climate, natural resource availability, and so forth.

Economy

Collective focus of the study of money, currency and trade, and the efficient use of resources.The system of production and distribution and consumption. The overall measure of a currency system; as the national economy.

To sell (goods) to a foreign country. Any good or commodity, transported from one country to another country in a legitimate fashion, typically for use in trade.

The act of selling to a foreign country the sale of capital, goods, and services across international borders or territories.

An object produced for market.

Something fed into a process with the intention of it shaping or affecting the outputs of that process. Each participant’s contributions that are viewed as entitling him/her to rewards or costs. Examples include time, effort, and loyalty.

The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative. The cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen). The value forfeited by taking a particular route.

Production; quantity produced, created, or completed. data sent out of the computer, as to output device such as a monitor or printer.

Productivity is a measure of the efficiency of production and is defined as total output per one unit of a total input. The rate at which goods or services are produced by a standard population of workers. A ratio of production output to what is required to produce it (inputs). The state of being productive, fertile, or efficient. The rate at which products and services are produced relative to a particular workforce.

Something that one uses to achieve an objective, e.g. raw materials or personnel.

That which is produced, then traded, bought or sold, then finally consumed and consists of an action or work.

A negative balance of trade.

A positive balance of trade.

The degree of importance given to something. A value is extremely absolute or relative ethical value, the assumption of which can be the basis for ethical action. A customer’s perception of relative price (the cost to own and use) and performance (quality)

A collection of guiding principles; what one deems to be correct and desirable in life, especially regarding personal conduct.

The capacity of an economic agent to produce a larger quantity of a product than its competitors

In economics, absolute advantage refers to the capacity of any economic agent, either an individual or a group, to produce a larger quantity of a product than its competitors. Introduced by Scottish economist, Adam Smith, in his 1776 work, “An Inquiry into the Nature and Causes of the Wealth of Nations,” which described absolute advantage as a certain country’s intrinsic capability to produce more of a commodity than its global competitors.

Smith also used the concept of absolute advantage to explain gains from free trade in the international market. He theorized that countries’ absolute advantages in different commodities would help them gain simultaneously through exports and imports, making the unrestricted international trade even more important in the global economic framework.

Adam Smith’s Theory of Absolute Advantage

The mercantilist economic theory, which was widely followed between the 16th and the 18th century, came under a lot of criticism with the emergence of economists like John Locke and David Hume. Mercantilism advocated a national economic policy designed to maximize the nation’s trade and its gold and money reserves. Mercantilism gained influence due to the emergence of colonial powers such as Britain and Portugal, before Adam Smith, and later Daniel Ricardo, both staunch critics of the concept, came up with their own theories to counter mercantilism.

Smith was the first economist to bring up the concept of absolute advantage, and his arguments regarding the same supported his theories for a laissez-faire state. In “The Wealth of Nations”, Smith first points out that, through opportunity costs, regulations favoring one industry take away resources from another industry where they might have been more advantageously employed.

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. Each individual thus specializes in the production of goods and services in which he or she has some sort of an advantage.

Thirdly, Smith applies the same principles of opportunity costs and specialization to international economic policy, and the principle of international trade. He explains that it is better to import goods from abroad where they can be manufactured more efﬁciently because it allows the importing country to put its resources into its own most productive and efficient industries. Smith thus emphasizes that a difference in technology between nations is the primary determinant of international trade flows around the globe.

Assumptions of the Absolute Advantage Theory

Smith assumed that the costs of the commodities were computed by the relative amounts of labor required in their respective production processes.
He assumed that labor was mobile within a country but immobile between countries.
He took into consideration a two-country and two-commodity framework for his analysis.
He implicitly assumed that any trade between the two countries considered would take place if each of the two countries had an absolutely lower cost in the production of one of the commodities.

Achieving an Absolute Advantage

An absolute advantage is achieved through low-cost production. In other words, it refers to an individual, company, or country that can produce at a lower marginal cost. Such an advantage is established when (compared to competitors):

Fewer materials are used to produce a product
Cheaper materials (thus a lower cost) are used to produce a product
Fewer hours are needed to produce a product
Cheaper workers are (in terms of hourly wage) used to produce a product

Advantages of an Advantage

Absolute Cost Advantage

Absolute cost advantage results from the specialization of labor proposed by Smith in his theory. Specialization of labor, or division of labor, results in a significantly higher productivity per unit of labor, and in turn, a lower cost of production. Smith also used the concept of “Economies of Scale” to explain the lowering of production costs, as a higher output due to labor diversification would significantly reduce production costs.

Natural Advantage

A country should produce those goods that are naturally favoring its climatic environment. The type of goods produced would also depend on the availability of natural resources. The presence of lots of natural resources would significantly provide an advantage to such a country while producing the goods.

Acquired Advantage

Acquired advantage includes advantages in technology and level of skill development.

Absolute Advantage vs. Comparative Advantage

Absolute and comparative advantage are commonly misunderstood concepts. An absolute advantage looks at the financial costs of production, while a comparative advantage looks at the opportunity cost of production. The two terms are contrasted below:

The ability to produce more of a good or service while using fewer resources compared to a competing entity.

Comparative Advantage

The ability to produce a good or service at a lower opportunity cost.

Criticisms against Absolute Advantage

The Absolute Advantage Theory assumed that only bilateral trade could take place between nations and only in two commodities that are to be exchanged. Such an assumption was significantly challenged when the trade, as well as the needs of nations, started increasing. Thus, the theory did not take into account the multilateral trade that could take place between countries.

The Absolute Advantage Theory also assumed that free trade exists between nations. It did not take into account the protectionist measures that are adopted by countries. The protectionist measures included quantitative restrictions, technical barriers to trade, and restrictions on trade on account of environmental protection or public policy.

Ricardo later came up with his own criticisms of Adam Smith’s theory. Ricardo’s 1817 work, “On the Principles of Political Economy and Taxation,” introduced a theory that later attained fame as the theory of comparative advantage, which places opportunity cost at the focus of agents’ production decisions.

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