Theories of International Trade

Theories Of International
Business : Classical Theory Of

Comparative Cost Advantage
Aswathy Gopinadhan
4th Sem MBA,
DCMS, University of Calicut
Theory Of Comparative Advantage Of International
Trade
The classical theory of international trade is popularly known as the Theory of Comparative Costs or
Advantage. It was formulated in 1815 by David Ricardo is his book, Principles of Political Economy and
Taxation.
This Classical approach, in terms of comparative cost advantage, basically seeks to explain how and
why countries gain by trading.
The idea is drawn in view of deficiencies observed in Adam Smith’s principle of absolute cost
advantage in explaining territorial specialisation as a basis for international trade.
According to this theory every country should specialize in production. It should export those goods in
which it has greater comparative advantage and import those goods in the production which it has greater
comparative disadvantage.
Basis of International Trade
1. Absolute Difference in Costs
2. Comparative Difference in Costs
3. Equal Difference in Costs

Absolute Difference in Costs
According to Adam Smith, the main basis of international trade is the difference in absolute
costs. This difference in absolute costs arises when one country is in a position to produce a
commodity at a very low cost compared to the first country.
Equal Difference in Costs

When the production ration of two goods in two countries is equal, it is called equal difference in
costs. In this situation, IT will not be possible.
Comparative Difference in Costs
According to Ricardo, comparative difference in costs is the sole cause of international trade.
Comparative difference in costs means that a country is in a position to produce both the goods at
less cost than the other country, yet it has greater comparative advantage in the production of other
goods.
Assumptions
 There are only 2 countries and they produce 2 goods.
 Labour is the only factor of production and cost of production is measured in terms of labour units.
 All units of labour are homogeneous.
 Production is subject to law of constant returns.
 Factors of production are perfectly mobile within the country but are perfectly immobile between 2
countries.
Assumptions
 There is full employment in countries concerned.
 Perfect competition in labour and product markets.
 No technological changes take place in the countries.
 There are no transport costs involved.
 There are no government restrictions on trade between the two countries.

Causes for the Difference in Costs
a. Provision of special facilities by nature such as Climate and Soil, Mineral resources, Land
fertility, Availability of abundant water, etc.
b. Provision of different human facilities in the form of physique, mental endowments, scientific
and rational mind, spirit of enterprise, etc.
c. Legacy of the past, traditionally high levels of intelligence and education (Provides head start in
building infrastructure)
d. Uneven distribution of population that affects availability of labour for production.

Criticism
 There are more than 150 countries involved in active international trade, hence restricting the
theory to two countries is unrealistic
 Production involves material, capital & enterprise in addition to labour, hence restricting it
exclusively to the last factor is incorrect.
 All units of labour ate not homogenous. Some workers are more efficient than others.
 Certain degree of unemployment is always there in each country, theory based on full
employment, is therefore unrealistic.
Criticism
 Labour is not perfectly mobile in a country, especially like India with its different languages,
cultures and climates. Further workers in construction industry cannot move to IT industry with
ease.
 When output levels change there is corresponding change in requirement of labour inputs and
usually law of diminishing returns is experienced. Hence theory cannot be based on constant
returns.
 In this dynamic world technological advances are increasing productivity effectively. The theory
assumes no such changes & renders itself unrealistic.

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Theories Of International

Business : Classical Theory Of

1. Absolute Difference in Costs

2. Comparative Difference in Costs

3. Equal Difference in Costs

Equal Difference in Costs

 There are only 2 countries and they produce 2 goods.

 All units of labour are homogeneous.

 Production is subject to law of constant returns.

 There is full employment in countries concerned.

 Perfect competition in labour and product markets.

 No technological changes take place in the countries.

 There are no transport costs involved.

 There are no government restrictions on trade between the two countries.

d. Uneven distribution of population that affects availability of labour for production.

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