Back To CourseEconomics 102: Macroeconomics
15 chapters | 111 video lessons
Jon has taught Economics and Finance and has an MBA in Finance
In the 1700s, famous economist Adam Smith taught us that countries should find out what they can produce more efficiently (which really means cheaper, better and faster), and then specialize in what they do best while trading with other countries who are also doing what they're best at.
For example, let's say you're entering the job market and you're evaluating your options for a career. At the same time, your neighbor, Bob, is also evaluating his options. Now, you have an absolute advantage over Bob in baking cakes. Whether it's chocolate cake, vanilla cake or pineapple-upside-down cake, if both of you baked the same cakes side-by-side, you'd be the one who could bake three times as many cakes in an hour as he could. You're really good at baking cakes, and certainly better than Bob is (who's struggling to get the first cake rolling). Between the two of you, you are the best at it. In economics, we say you have an absolute advantage over your neighbor when you can produce a good more efficiently in the same amount of time.
When we take the same concept and apply it to the world economy, we find that some countries have an absolute advantage at producing goods. Why is that? Because resources tend to be different in different countries. One country is rich in oil, while another country has an abundance of coconuts. When resources are different, it tends to create absolute advantages.
This idea became the basis of international trade for many years. If everyone exports what they're best at, then most countries will be better off because they'll be able to produce and sell more, and they'll have access to a lot more goods and services that other countries produce more efficiently than they do. But absolute advantage is different than comparative advantage, and it's important to know the difference.
Another famous economist, David Ricardo, saw the great ideas that Adam Smith had about absolute advantage, but also saw some limitations. For example, if everyone simply does what they're best at and trades with the rest of the world, it is possible that some countries aren't best at anything (or at least maybe they haven't discovered it yet).
David Ricardo would look at the same career example that we just talked about (between you and your neighbor), and notice something very important. He would notice that not only are you better than your neighbor at baking cakes, but you have the skill to be a rocket scientist as well. In order for you to choose a career as a cake boss, designing incredible enormous cakes for weddings and special events, you'd have to give up or sacrifice the opportunity to pursue an even more profitable career - starting a company that designs rockets that take people into space for short vacations, let's say.
Economist David Ricardo taught us about opportunity cost, which is what you have to give up in order to make a choice. In your case, to choose your absolute advantage as a cake boss, you would have to give up a rocket design career worth even more to you.
This led to the theory of comparative advantage, which says that nations should specialize in producing the good in which they have the lowest opportunity cost. In the end, people would not only look at absolute advantage, but they would also consider comparative advantage when deciding what goods to produce and for whom to produce them.
Here's an important point to remember: everyone has a comparative advantage in something, but may not have an absolute advantage. You could be better than Bob at everything, but Bob may have a lower opportunity cost of becoming a cake boss, based on the fact that he isn't a rocket scientist.
When we look at international trade, we see that a nation can have an absolute advantage in the production of every good, but they will not have a comparative advantage in everything. Absolute advantage is an important first step in this process, and that's why it's very helpful to learn how to identify it.
Let's look at two more examples:
Let's say there are only two countries: country A and country B, and they produce only two goods: corn cereal and designer jeans. Here's an illustration of how much each country can produce of these two goods using only one hour of labor to produce them:
|Country||Corn Cereal||Designer Jeans|
As you can see, country B can produce more of both goods than country A. They can produce either 15 boxes of corn cereal or four pairs of jeans per hour. Country A, on the other hand, can only produce ten boxes of corn cereal or they can produce three pairs of designer jeans instead. So, what can we say about these two countries and their production possibilities?
Country B has an absolute advantage in the production of both goods (in this case, corn cereal and designer jeans). That means they have an absolute advantage because they can produce more of these goods in the same amount of time.
Finally, let's look at another example from the perspective of labor productivity. Let's say that country A and country B can produce two goods: salmon or coconut crème pies.
|Country||Salmon||Coconut Crème Pies|
|Country A||2 labor hours||3 labor hours|
|Country B||3 labor hours||6 labor hours|
As you can see, we have two countries producing two goods again; however, instead of looking at how many goods they can produce in one hour, we're looking at how long it takes to produce one good. This is what we call labor productivity. So what can we say about these two countries?
Country A is capable of catching and canning one salmon in two hours. It takes them two labor hours to produce one good. To do the same thing, it will take country B three hours instead. We can see the same pattern going on with coconut crème pies. Country A can produce one coconut crème pie in three hours of labor, while it's going to take country B six hours (or twice as long) to produce the same good.
Now that we've looked at these two production possibilities and compared the numbers for both goods, we can say that country A has an absolute advantage in the production of these two goods.
To summarize what we've learned in this lesson, Adam Smith taught us about absolute advantage - that countries should find out what they can produce more efficiently (which means cheaper, better and faster), and then specialize in what they do best while trading with other countries who are also doing what they're best at.
Because resources tend to be different in different countries, some countries have an absolute advantage over producing goods. The idea of absolute advantage is different than the theory of comparative advantage, which says that nations should specialize in producing the good in which they have the lowest opportunity cost. Everyone has a comparative advantage in something, but may not have an absolute advantage. While a nation can have an absolute advantage in the production of every good, they won't have a comparative advantage in everything.
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Back To CourseEconomics 102: Macroeconomics
15 chapters | 111 video lessons