Absolute advantage vs. comparative advantage: How are they different?

August 3, 20225 min read
Absolute advantage vs. comparative advantage: How are they different?
Share on facebookShare on TwitterShare on Linkedin

Key Takeaways

• Absolute advantage refers to the ability of a producer to manufacture a superior quality good at a faster and less expense rate than competitors.

• Comparative advantage takes opportunity cost into consideration when determining the best option for diversifying production of goods.

• Under certain circumstances, alternative investments can enjoy comparative advantages over traditional asset classes.

Absolute advantage and comparative advantage are economic concepts influencing how and why goods are produced. A company or a nation with the ability to produce a certain in-demand good of superior quality at a faster rate and a higher profit margin than all other competitors is said to have an absolute advantage as far as that good is concerned. 

A comparative advantage considers the costs of production of an in-demand good against those of a secondary in-demand good requiring the same resources. Regardless of how well a company or nation can produce that primary good, there’s an opportunity cost if a secondary good can return a better profit. The producer would have to sacrifice the additional profit the secondary good would return by focusing on the primary good, which gives the secondary good a comparative advantage. 

Absolute vs Comparative Advantages and International Trade

Adam Smith, the 18th century economist who wrote The Wealth of Nations, was the first to introduce these concepts. Considered by many to be the “father” of contemporary economics, Smith posited the notion that nations should produce the goods for which they hold an absolute advantage and trade for those where they lack a comparative advantage. 

Smith used the textile and winemaking industries to illustrate the idea. Given consistent factors of production, balanced imports and exports, an absence of trade barriers and excluding economies of scale, Smith said England was better at producing textiles and Spain was better at producing wine. Therefore, he reasoned, England should create textiles for export and import Spanish wines. Spain, he said, should do the exact opposite.

David Ricardo, a 19th century English economist, built upon Smith’s notions by applying comparative advantage in a broader fashion. Ricardo posited that a nation could benefit from trading even if it had an absolute advantage in the production of every good. Ricardo’s theory was that a country should diversify production regardless of its absolute advantage so that it might benefit from potential opportunity costs. 

In other words, where Smith’s trade theories focused on absolute advantage, Ricardo favored a focus on comparative advantage and the lower opportunity costs it might reveal. 

How Absolute Advantage is Determined

In general, absolute advantage refers to the efficiencies of production achievable with a certain good that is in high demand. Ideally, a producer will make the highest quality item that its resources will allow, at the lowest possible cost and with the utmost efficiency — when measured against the capabilities of its competitors. 

The producer has an absolute advantage if this is also the best product available. Among elements that contribute to a potential absolute advantage are less costly labor expenses, easy access to the resources needed for production and a larger supply of operating capital.

How Comparative Advantage is Determined

In situations in which a producer has the ability to create multiple in-demand products of high quality, it becomes necessary to determine which of those products will generate the best return on investment. Producing goods incapable of bettering the returns of others requiring the same resources will cost the organization an opportunity to maximize its revenues.  

Thus, when a producer can turn out multiple in-demand products of high quality, it becomes necessary to consider the comparative advantage of some of those goods over others. The following formula can be used to calculate the opportunity cost between two products.

Profitability of Product A – Profitability of Product B = Opportunity Cost

As an example, if Product A sells for $100, of which $50 is profit, and Product B also sells for $100, of which $65 is profit, the opportunity cost of producing Product A instead of B is $15. Therefore, the logical choice would be to manufacture Product B because it has a comparative advantage.

Comparative Advantage and Investing

Calculating the opportunity cost of an investment using hindsight is easy to accomplish. On the other hand, calculating the opportunity cost of a forward-looking investment must rely upon estimations. While historical data can offer some insights into how an investment can be expected to perform, past performance is no guarantee of future results. 

Another concern when applying comparative advantage to an investment strategy is the liquidity factor. For example, an opportunity projecting a 10% return over five years is at a comparative disadvantage to an investment opportunity of the same amount projecting a 10% return over two years. 

The difference in liquidity between the two introduces an opportunity cost. The latter asset allows the investor to take their profit in two years and move on to another potentially profitable investment. The former opportunity keeps the investor’s capital tied up for five years — to garner the same return.

Conversely, a low-risk investment returning a potential 5% over two years might enjoy a comparative advantage over a high-risk investment offering a potential 10% over five years. The risk factor, the lack of liquidity and the opportunity costs of keeping the investment capital tied up for five years could give the less risky investment a comparative advantage. 

Ultimately, however, all these factors must be weighed alongside the investor’s risk tolerance, overall goals, and time horizon.

Comparative Advantage and Alternative Investments

One of the benefits of incorporating alternative investments into a portfolio is the diversification they afford. Lacking direct correlation to the markets in general can often be a comparative advantage, particularly during periods of exceptional volatility. 

Traditional portfolio asset allocation envisions a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split incorporating 20% alternative assets may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets and collectibles are among the asset classes deemed “alternative investments.” These were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors who buy in at very high minimums — often between $500,000 and $1 million. However, Yieldstreet was founded with the goal of dramatically improving access to alternative assets by making them available to a wider range of investors.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.