Investopedia Video: Absolute Advantage

Summary

The concept of absolute advantage explains how individuals and countries can produce goods or services at a lower cost than competitors. Using the example of a consultant named Kendall and a new hire, Chris, the script illustrates how hiring someone to handle lower-value tasks allows specialists to focus on higher-paying work, leading to greater overall profits. This principle extends to international trade, where countries specialize in producing goods with the lowest opportunity cost, resulting in mutual benefits from trade. Through this approach, both parties can maximize their productivity and earnings.

Takeaways

• 😀 Absolute Advantage is the ability of a company or country to produce a good or service at a lower cost than competitors.
• 😀 An entity with Absolute Advantage can produce goods more efficiently, requiring fewer inputs, leading to undercutting competitors' prices.
• 😀 Kendall, a consultant with 10 years of experience, hires Chris, a recent graduate, as her accountant despite having more experience in the field.
• 😀 By hiring Chris, Kendall frees up her time to focus on higher-value consulting work, where she earns more per hour.
• 😀 Kendall’s decision to hire Chris is based on the principle of specializing in what she does best, maximizing her profits.
• 😀 Chris benefits from the job as he gains work experience, even though he is paid less than Kendall would earn in accounting.
• 😀 This principle of specialization and comparative advantage also applies to international trade.
• 😀 Countries should specialize in producing goods or services where they have the lowest opportunity cost, even if they have an Absolute Advantage in both.
• 😀 In international trade, the country with the lowest opportunity cost for producing a specific good should focus on that good, while the other country focuses on its own comparative advantage.
• 😀 Both countries can benefit from trade because each specializes in what it does best, leading to greater overall productivity and efficiency.

Q & A

What is absolute advantage?

Absolute advantage is the ability of an individual, company, or country to produce a good or service at a lower cost than any competitor. This advantage is due to more efficient processes or requiring fewer inputs.

How does Kendall's hiring of Chris illustrate the concept of absolute advantage?

Kendall, an experienced consultant and accountant, hires Chris, a less experienced accountant, to manage her books. By doing so, Kendall can focus on her higher-paying consulting work, where she has a comparative advantage. Chris benefits by getting a job, and Kendall benefits by specializing in what she does best.

Why does Kendall hire Chris despite having more experience in accounting?

Kendall hires Chris because her time is more valuable spent on consulting, which pays $200 per hour, compared to accounting work, which would pay her less. This way, she can earn more by focusing on consulting while Chris takes care of accounting.

How does the concept of opportunity cost relate to Kendall's decision?

Opportunity cost is the value of what you give up when you choose one option over another. For Kendall, the opportunity cost of doing accounting work is the $200 she could earn per hour by consulting. By hiring Chris, she minimizes this cost and specializes in her most lucrative skill.

What role does comparative advantage play in this example?

Comparative advantage refers to the ability to produce a good or service at a lower opportunity cost than others. Kendall has a comparative advantage in consulting, while Chris has a comparative advantage in accounting. By specializing in what they each do best, both parties maximize their productivity.

How does the principle of specialization benefit both Kendall and Chris?

By specializing, Kendall can focus on her high-paying consulting work, while Chris can gain valuable work experience in accounting. This leads to higher overall productivity and mutual benefit for both individuals.

How does international trade theory apply to this scenario?

International trade theory suggests that even if one country has an absolute advantage in producing multiple goods, both countries can still benefit by specializing in the production of goods where they have the lowest opportunity cost. This allows each country to focus on what they do best and trade for what they don't produce efficiently.

What is the difference between absolute advantage and comparative advantage?

Absolute advantage refers to the ability to produce a good at a lower cost than others, while comparative advantage refers to producing a good at a lower opportunity cost. A country may have an absolute advantage in producing both wine and financial services, but it will still benefit from specializing in the good with the lowest opportunity cost.

How does the concept of comparative advantage apply to international trade?

In international trade, countries should specialize in the goods and services they produce most efficiently (at the lowest opportunity cost). Even if one country has an absolute advantage in both goods, both countries can still benefit by trading and focusing on their comparative advantages.

What would happen if countries ignored comparative advantage and tried to produce everything on their own?

If countries ignored comparative advantage and tried to produce everything themselves, they would not be using their resources as efficiently, leading to lower productivity and higher costs. This would result in less overall wealth and lower standards of living for all countries involved.