Absolute cost advantages describe the state that one country has financial advantages over another country in the production of a certain commodity. As a result, the countries without the absolute cost advantages opt for external procurement and against in-house production. The absolute cost advantages are based on Adam Smith’s theory of the same name. Countries can use the concept of absolute cost advantages to make economically correct decisions.

In the following lesson you will learn everything about the absolute cost advantages and their importance. After the explanations, there are still some exercises that will help you to consolidate the knowledge you have just learned.

English: absolute cost advantages

Why are absolute cost advantages important?

Countries as well as companies that need to economically deal inexpensive and effective use of financial resources. Since the conditions in individual countries differ fundamentally, some countries can produce more cheaply than other countries. Due to the absolute cost advantages, the countries can then decide whether internal production or supply through foreign trade are preferable.

Theory of Absolute Cost Advantages

According to electronicsencyclopedia.com, the model of absolute cost advantages is part of the classical theory of foreign trade. The economist Adam Smith developed this theoretical approach as early as 1776.

Adam Smith’s work “Wealth of Nations” revolves around foreign trade and the division of labor between different countries, from which everyone involved should benefit equally.

Content of the theory

The theory of the absolute cost advantages states that the conditions for the production of a good differ in different countries. Depending on the respective advantages, a country should concentrate on a few goods, while other goods are obtained through trade. A country’s absolute cost advantage is when it can produce a product more cheaply than any other country.

Example

Both Germany and Poland produce paving stones. Germany produces one unit of the stones in 10 hours, while Poland only needs 5 hours. The opposite is the case with books, where Poland needs 10 hours for one unit and Germany only 5. Poland thus has an absolute cost advantage in the production of the paving stones and Germany in the books.

If both countries put in 30 hours of work, they can each produce two units in their own production. In total there are 4 units of books and 4 units of paving stones in Germany and Poland. However, if Poland focuses on the cobblestones and Germany on the books, both countries can produce six units each.

Absolute cost advantages – example

Conclusions

Countries can draw conclusions from the theory of absolute cost advantages in order to optimize their economic activity. All countries can have economic advantages as a result.

The country should therefore limit itself to the production of goods for which it has advantages in terms of production. All other countries should import this good and decide against producing it in-house.

Criticism

In reality there are different starting points for criticism aimed at preventing the simplified theoretical presentation from being fully transferable to practice.

There are trade barriers that limit the production advantages of the countries. It can happen that a trade barrier neutralizes the absolute cost advantages or even reverses them into the opposite. Trade barriers are all aspects that burden foreign trade between countries. In addition, there are countries that do not have any cost advantages in any area. According to the theory of absolute cost advantages, these countries cannot participate in foreign trade.

The theory of the comparative cost advantage here states that international trade can bring advantages even if this nation produces certain goods at lower opportunity costs.

Example

China and the USA have a trade relationship. Basically, China has absolute cost advantages in numerous industries due to the lower production costs. Due to high tariffs from the new US government, China can no longer sell the products cheaper. The cost advantages are neutralized.