The terms absolute advantage and comparative advantage are used when trade between two countries is being considered. If one of them has the ability to produce all the goods which are being considered for trade at a lesser cost, it is referred to as absolute advantage. A lesser cost implies the use of a lesser quantity of all resources.
Even if one country has an absolute advantage in all products that can be traded. it does not rule out trade between them in a rational world. This is due to what is called comparative advantage.
To better understand the concept of comparative advantage let us consider an example of two products A and B and two countries C1 and C2 between which A and B can be traded.
If C1 is capable of producing A as well as B at a lesser cost than C2 it would seem pointless for C1 to buy anything from C2. Now let us assume that with the resources C1 has it can produce 10 items of A and 20 items of B. On the other hand C2 can produce with the resources it has 8 items of A and 10 items of B. We see that for each of A that C1 produces it has to sacrifice producing 2 of B, while for each of A that C2 produces it sacrifices producing only 1.25 of B. This gives C2 a comparative advantage over C1 in producing A. To maximize the total production C2 should only produce A and C1 should only produce B. The extra quantities that each of them produce can be traded between them.
This shows how trade between C1 and C2 is possible in spite of the fact that C1 can produce both of A and B at a lower cost than C2.
Comparative advantage explains the trade between nations even where one of the nations can produce all products that can be traded at a lower absolute cost than the other nations.
The division and specialization of production in the global economy is shaped by two key principles of capitalism: absolute advantage and comparative advantage. While absolute advantage indicates which nation is best at producing a given good, comparative advantage is an indication of which nation stands to lose the least by choosing to produce one good versus another.
A nation is said to have an absolute advantage if it requires fewer resources—generally raw materials, manpower or time—to produce a given item. For example, assume France and the United States both produce airplanes. In one month, France can produce 14 planes while the U.S can churn out 45 of comparable quality. This means it takes France 2.14 days to manufacture each plane versus the U.S. rate of 0.67 days. The U.S. has absolute advantage because its ability to produce high-quality products at a quicker rate than its competition indicates a more efficient production model.
Comparative advantage is all about reducing the opportunity cost of a given production strategy. The opportunity cost of producing a particular item is equal to the potential benefit that could have been gained by choosing an alternative. Assume that, utilizing the same amount of time and resources, China can produce either 30 computers or 45 cellphones. The opportunity cost of manufacturing one computer is 45/30, or 1.5 cellphones. Conversely, the opportunity cost of producing one cellphone is 30/45, or 0.67 of a computer.
Comparative advantage comes into play when neighboring Thailand decides it can also produce computers or cellphones, but not both. If Thailand's opportunity cost for producing cellphones is lower than 0.67 of a computer, then it has the comparative advantage for the production of cellphones. In this case, it is mutually beneficial for Thailand to produce phones and China to produce computers. Even if China is more efficient at producing both items, giving it the absolute advantage, establishing specialized production and arranging an international trade agreement allows both countries to benefit.
(For related reading, see: Is it possible for a country to have a comparative advantage in everything?)