Intro - Classical Theory of International Trade / COMPARATIVE COST THEORY

In 1817, David Ricardo, an English political economist, contributed theory of comparative advantage in his book 'Principles of Political Economy and Taxation'. This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade.

According to the classical theory of international trade, every country will produce their commodities for the production of which it is most suited in terms of its natural endowments climate quality of soil, means of transport, capital, etc. It will produce these commodities in excess of its own requirement and will exchange the surplus with the imports of goods from other countries for the production of which it is not well suited or which it cannot produce at all. Thus all countries produce and export these commodities in which they have cost advantages and import those commodities in which they have cost disadvantages.

Types of Cost Difference in Production

Economists speak about three types of cost difference in production, they are 1. 2. 3. Absolute cost difference, Equal cost difference, and Comparative cost difference.

1. Absolute Cost Differences :-

Adam Smith in his book 'Wealth of Nation' argued that international trade is advantageous for all the participating countries only if they enjoy absolute differences in the cost of production of the commodity which they specialise. As in the case of individuals where each specialises in the production of that commodity in which he has an absolutely superiority in terms of cost, so also each country specialises in production of goods based on absolute advantage. The principle of absolute difference in cost can be explained with the help of table given below. Let us assume that we have 2 countries, I and II specialising in the production of X and Y.

In country I, one day's labour produces 20x or 10y. The internal exchange rate is 2 : 1. In country II, one day's labour produce 10x or 20y which gives us the domestic exchange rate of 1 : 2. Country I has the absolute advantage in the production of X (as 20 > 10) and country II in Y ( as 10 < 20). If these countries enter into trade with the international exchange of 1 : 1, both countries stand to benefit. Country I will have 1y for 1x as against /2y for 1x within the country. Similarly country II will have 1x for 1y as against /2x for 1y within the country. Based on this example, according to Adam Smith, it can be pointed out that international trade to be beneficial, each country must enjoy absolute difference in cost of production.
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2. Equal Difference in Cost :Adam Smith, in order to strengthen his argument in favour of absolute difference in cost pointed out that trade is not possible if countries operate under equal difference in cost instead of absolute difference.

The above table gives us the internal exchange rate 2x : 1y in both countries. Since the exchange ratio between X and Y in both countries is the same; none of them will benefit by entering into international trade. Based on this example, according to Adam Smith, for international trade to be beneficial countries must enjoy absolute difference in cost. Trade would not take place when the difference in cost is equal.

3. Comparative Difference in Cost :David Ricardo agreed that absolute difference in cost gives a clear reason for trade to take place. He, however, went further to argue that even that the country has absolute advantage in the production of both commodities it is beneficial for that country to specialise in the production of that commodity in which it has a greater comparative advantage. The other country can be left to specialise in the production of that commodity in which it

has less comparative advantage. According to Ricardo the essence for international trade is not the absolute difference in cost but comparative difference in cost.

Ricardo's Theory of Comparative Advantage

David Ricardo stated a theory that other things being equal a country tends to specialise in and exports those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage. Similarly the country's imports will be of goods having relatively less comparative cost advantage or greater disadvantage.

1. Ricardo's Assumptions :Ricardo explains his theory with the help of following assumptions :1. 2. 3. There are two countries and two commodities. There is a perfect competition both in commodity and factor market. Cost of production is expressed in terms of labour i.e. value of a commodity is measured in terms of labour hours/days required to produce it. Commodities are also exchanged on the basis of labour content of each good. 4. 5. 6. 7. 8. 9. Labour is the only factor of production other than natural resources. Labour is homogeneous i.e. identical in efficiency, in a particular country. Labour is perfectly mobile within a country but perfectly immobile between countries. There is free trade i.e. the movement of goods between countries is not hindered by any restrictions. Production is subject to constant returns to scale. There is no technological change.

10. Trade between two countries takes place on barter system. 11. Full employment exists in both countries. 12. There is no transport cost.

2. Ricardo's Example :On the basis of above assumptions, Ricardo explained his comparative cost difference theory, by taking an example of England and Portugal as two countries & Wine and Cloth as two commodities. As pointed out in the assumptions, the cost is measured in terms of labour hour. The principle of comparative advantage expressed in labour hours by the following table.

Portugal requires less hours of labour for both wine and cloth. One unit of wine in Portugal is produced with the help of 80 labour hours as above 120 labour hours required in England. In the case of cloth too, Portugal requires less labour hours than England. From this it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo however tried to prove that Portugal stands to gain by specialising in the commodity in which it has a greater comparative advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.

Cost ratios of producing Wine and Cloth

Portugal has advantage of lower cost of production both in wine and cloth. However the difference in cost, that is the comparative advantage is greater in the production of wine (1.5 0.66 = 0.84) than in cloth (1.11 0.9 = 0.21). Even in the terms of absolute number of days of labour Portugal has a large comparative advantage in wine, that is, 40 labourers less than England as compared to cloth where the difference is only 10, (40 > 10). Accordingly Portugal specialises in the production of wine where its comparative advantage is larger. England specialises in the production of cloth where its comparative disadvantage is lesser than in wine.

Comparative Cost Benefits Both Participants

Let us explain Ricardian contention that comparative cost benefits both the participants, though one of them had clear cost advantage in both commodities. To prove it, let us work out the internal exchange ratio.

Let us assume these 2 countries enter into trade at an international exchange rate (Terms of Trade) 1 : 1. At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine. At home it is required to give 1.2 units of cloth for one unit of wine. England thus gains 0.2 of cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth. Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of cloth at home thus gaining extra cloth of 0.11. Here both England and Portugal gain from the trade i.e. England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit of wine.

In this example, Portugal specialises in wine where it has greater comparative advantage leaving cloth for England in which it has less comparative disadvantage. Thus comparative cost theory states that each country produces & exports those goods in which they enjoy cost advantage & imports those goods suffering cost disadvantage.

Applicability of Ricardian Theory in Real World

Comparative cost theory inspite of all limitations has remained as a basic principle of international trade. Today when the world is moving towards greater liberalisation and globalisation each country specialises in production of goods and services on the basis of comparative cost advantage and enters into international trade.

Image Credits Sodaro K.

Prof.

Gottfried Haberler,

Frank

William Taussig and

others

attempted

to

prove

the practical

importance and acceptability of comparative cost theory.

It is argued that :1. The two commodities two countries model can be extended to all the commodities and all the countries. Each country then will specialises in the production of those commodities in which it enjoys comparative advantage and export them to others and import the required goods from others where they are available at a lower price than at home.

2.

The theory which was explained in terms of labour can also be expressed in terms of money as it is possible to express the total cost in terms of money. Specialisation would take place on the basis of comparative advantage in terms of money cost.

3.

The assumption of constant returns to scale and no change in technology can also be relaxed. With changes in technology and production being subject to laws of returns, specialisation will still take place on the basis of cost advantage under increasing and decreasing cost.

4.

Assumptions of "no transport cost" makes the comparative advantage theory, it is argued very unrealistic. It is pointed out that after adding transport cost to the cost of production, each country will produce those goods in which it will have cost advantage. After adding transport cost, for example, India may not enjoy the cost advantage against USA or Mexico but it certainly will have the advantage for selling them in the neighbouring countries.

5.

It is suggested that cost would not undergo a change as the countries operate with assumptions like full employment, perfect competition, static nature of the economy, free trade and many other restrictive assumptions.

The supporter of Ricardian theory argued that all the restrictive assumptions of the comparative cost theory could be relaxed and make the theory practical in the real world situation where each country specialises in the production of those goods and services in which it has comparative cost advantage under the changing conditions. The doctrine of comparative advantage inspite of its limitations, has remained as the basic principle of international trade. Today when the world is moving towards greater liberalisation and globalisation, each country specialises in the production of goods and services on the basis of comparative cost advantage and enters intc international trade. Each country attempts to lower its cost of production of internationally traded goods .to get an advantage in the global market. Therefore, it could be argued that Ricardian explanation of the basis of international trade is valid and applicable to the real world.

Conclusion
On the basis of competitive cost advantage, countries can enter into international trade. Each country attempts to lower its cost of production of internationally traded goods to get in advantage in the global market. So Ricardian explanation of basic of international trade is valid and applicable to the real world situation.

What determines comparative advantage? Comparative advantage is a dynamic concept. It can and does change over time. Some businesses find they have enjoyed a comparative advantage in one product for several years only to face increasing competition as rival producers from other countries enter their markets. For a country, the following factors are important in determining the relative costs of production: The quantity and quality of factors of production available (e.g. the size and efficiency of the available labour force and the productivity of the existing stock of capital inputs). If an economy can improve the quality of its labour force and increase the stock of capital available it can expand the productive potential in industries in which it has an advantage. Investment in research & development (important in industries where patents give some firms significant market advantage) - for more information on this have a look at this page

Movements in the exchange rate. An appreciation of the exchange rate can cause exports from a country to increase in price. This makes them less competitive in international markets. Long-term rates of inflation compared to other countries. For example if average inflation in Country X is 4% whilst in Country B it is 8% over a number of years, the goods and services produced by Country X will become relatively more expensive over time. This worsens their competitiveness and causes a switch in comparative advantage. Import controls such as tariffs and quotas that can be used to create an artificial comparative advantage for a country's domestic producers- although most countries agree to abide by international trade agreements. Non-price competitiveness of producers (e.g. product design, reliability, quality of aftersales support)

Gains from Trade :The Theory of C o m p a r a t i v e A d v a n t a g e

The theory of comparative advantage was originally advanced by the 19th-centuryeconomist David Ricardo as an explanation for why nations trade with one another.The theory claims that economic well-being is enhanced if each countrys citizens pro-duce that which they have a comparative advantage in producing relative to the citi-zens of other countries, and then trade products. Underlying the theory are theassumptions of free trade between nations and that the factors of production (land,buildings, labor, technology, and capital) are relatively immobile. Consider the exam-ple described in Exhibit A.1 as a vehicle for explaining the theory.Exhibit A.1 assumes two countries, Aand B, which each produce only food and tex-tiles, but they do not trade with one another. Country Aand B each have 60,000,000units of input. Each country presently allocates 40,000,000 units to the production of food and 20,000,000 units to the production of textiles. Examination of the exhibitshows that Country Acan produce five pounds of food with one unit of production orthree yards of textiles. Country B has an absolute advantage over Country Ain the pro-duction of both food and textiles. Country B can produce 15 pounds of food or fouryards of textiles with one unit of production. When all units of production are em-ployed, Country Acan produce 200,000,000 pounds of food and 60,000,000 yards of textiles. Country B can produce 600,000,000 pounds of food and 80,000,000 yards of textiles. Total output is 800,000,000 pounds of food and 140,000,000 yards of textiles.Without trade, each nations citizens can consume only what they produce.While it is clear from the examination of Exhibit A.1 that Country B has an absoluteadvantage in the production of food and textiles, it is not so clear that Country A(B)has a relative advantage over Country B (A) in producing textiles (food). Note that inusing units of production, Country Acan trade off one unit

of production needed toproduce five pounds of food for three yards of textiles. Thus, a yard of textiles has an opportunity cost of 5/3 1.67 pounds of food, or a pound of food has an opportunitycost of 3/5 .60 yards of textiles. Analogously, Country B has an opportunity cost of 15/4 3.75 pounds of food per yard of textiles, or 4/15 .27 yards of textiles perpound of food. When viewed in terms of opportunity costs it is clear that Country Aisrelatively more efficient in producing textiles and Country B is relatively more effi-cient in producing food. That is, Country As (Bs) opportunity cost for producing tex-tiles (food) is less than Country Bs (As). A relative efficiency that shows up via alower opportunity cost is referred to as a comparative advantage.Exhibit A.2 shows that when there are no restrictions or impediments to free trade,such as import quotas, import tariffs, or costly transportation, the economic well-beingof the citizens of both countries is enhanced through trade. Exhibit A.2 shows thatCountry Ahas shifted 20,000,000 units from the production of food to the productionof textiles where it has a comparative advantage and that Country B has shifted10,000,000 units from the production of textiles to the production of food where it hasa comparative advantage. Total output is now 850,000,000 pounds of food and160,000,000 yards of textiles. Suppose that Country Aand Country B agree on a priceof 2.50 pounds of food for one yard of textiles, and that Country Asells Country B50,000,000 yards of textiles for 125,000,000 pounds of food. With free trade, ExhibitA.2 makes it clear that the citizens of each country have increased their consumptionof food by 25,000,000 pounds and textiles by 10,000,000 yards.

Following are the important limitations of Ricardian Comparative Cost Theory.

1. Restrictive Model
Ricardo's Theory is based on only two countries and only two commodities. But international trade is among many countries with many commodities.

2. Labour Theory of Value

Value of goods is expressed in terms of labour content. Labour Theory of value developed by classical economists has too many limitations and thus is not applicable to the reality. Value of goods and services in the real world is expressed in money i.e. the prices are the values expressed in units of money.

3. Full employment
The assumption of full employment helps the theory to explain trade on the basis of comparative advantage. The reality is far from full employment. Cost of production, even in terms of labour, may change as the countries, at different levels of employment move towards full employment.

4. Ignore transport cost

Another serious defect is that the transport costs are not consider in determining comparative cost differences.

5. Demand is ignored
The Ricardian theory concentrates on the supply of goods. Each country specialises in the production of the commodity based on its comparative advantage. The theory explains international trade in terms of supply and takes demand for granted.

6. Mobility of factor of production

As against the assumptions of perfect immobility between the countries, we witness difficulties in the mobility of labour and capital within a country itself. At the same time their mobility between nations was never totally absent.

7. No Free Trade
Ricardian theory assumes free trade i.e. no restriction on the movement of goods between the countries. Though it is unrealistic to assume not to have any restriction. what the real world witnesses is a lot tariff and non-tariff barriers on international trade. Poor countries find it difficult to enjoy the comparative advantage in the production of labour intensive commodities due to the protectionist policies followed by developed countries.

8. Complete specialisation
The comparative advantage theory comes to conclusion of complete specialisation. In the Ricardian example, England is specialising fully on cloth and Portugal on wine. Such complete specialisation is unrealistic even in two countries and two commodities model. It is possible if two countries happens to be almost identical in size and demand. Again, a complete specialisation in the production of less important commodity is not possible due to insufficient demand for it.

9. Static Theory
The modern economy is dynamic and the comparative cost theory is based on the assumptions of static theory. It assumes fixed quantity of resources. It does not consider the effect of growth.

10. Not applicable to developing countries

Ricardian theory is not applicable to developing countries as these countries are nowhere near to full employment. They are in the process of change in quality of their labour force, quality of capital, technology, tapping of new resources etc. In other words developing countries exhibit all the characteristics of dynamic economy.

11. Constant Returns to Scale

Another drawback of the Ricardian principle of comparative costs is that assumes constant Returns to scale and thus constant cost of production in both the countries. The doctrine holds that if England specialises in cloth; there is no reason why it should produce wine. Similarly if Portugal has a comparative advantage in producing wine, it will not produce cloth; but import all cloth from England. If we examine the pattern of international trade in practice, we find it is not so. A time will come when it will not be reasonable for Portugal to import cloth from England because of increasing cost of production. Moreover, in actual practice a country produces a particular commodity and also imports a part of it. This phenomenon has not been explained by the theory of comparative costs.