What it is:
How it works/Example:
Let's assume Company XYZ and Company ABC make wood chips. Company XYZ is located in Oregon, where lumber is abundant; Company ABC is located in Death Valley, California, where lumber is not abundant.
Company ABC must spend more than Company XYZ to make wood chips because it has to bring wood in from other states, which makes its supply costs 20% higher than Company XYZ's supply costs. Also, Company ABC uses four workers to manufacture a unit of chips; Company XYZ uses two. As a result, the cost per unit of wood chips at Company ABC is $2.50; it is only $1.25 at Company XYZ. Because it is more efficient, Company XYZ has an absolute advantage to Company ABC.
Why it matters:
Absolute advantage is not a theory of relativity. If a company is relatively better at making a product, it should make that product and not something else. As such, absolute advantage is an important concept in global trade and is why many countries concentrate on producing a good or service more efficiently than other countries.