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Comparative Cost Theory of International Trade

ADVERTISEMENTS: Let us make in-depth study of the critical appraisal and factors for the variation of comparative cost theory of international trade. Critical Appraisal of Comparative Cost Theory: Theory of comparative cost which is the important doctrine of classical economics is still valid and widely acclaimed as the correct explanation of international trade. Most of […]

Comparative Cost Theory of International Trade

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Critical Appraisal of Comparative Cost Theory:

Theory of comparative cost which is the important doctrine of classical economics is still valid and widely acclaimed as the correct explanation of international trade.

Most of the criticisms that have been leveled against this doctrine relate to the Ricardian version of comparative cost theory based on labour-theory of value. Haberler and others broke away from this labour-cost version and reformulated the comparative cost theory in terms of opportunity costs which takes into consider­ation all factors.

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The basic contention of the theory that a country will specialise in the production of a commodity and export it for which it has a lower comparative cost and import a commodity which can be produced at a lower comparative cost by others, is based on a sound logic. The theory correctly explains the gain from trade accruing to the participating countries if they specialise ac­cording to their comparative costs.

These merits of the theory have led Professor Samuelson to remark, “If theories, like girls, could win beauty contents, comparative advantage would certainly rate high in that it is an elegantly logical structure.” He further writes, “the theory of comparative advantage has in it a most important glimpse of truth…. A nation that neglects comparative advan­tage may have to pay a heavy price in terms of living standards and potential rates of growth.”

Despite the sound logical structure and vivid explanation of gains from trade, the comparative cost theory, especially the Ricardian version based on labour theory of value has been criticized.

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1. In the first place, Ricardian version of comparative cost theory has been attacked on the ground that being based on labour theory of value, it considers only labour cost to measure the comparative costs of various goods.

It has been pointed out that labour is not the only factor needed for the production of commodities, other factors such as capital, raw materials, land also contribute to production. Therefore, it is the total money costs incurred on labour as well as other factors that should be considered for assessing comparative costs of various commodities.

Taussig tried to defend Ricardo by pointing out that even if labour theory of value was defective and even if other factors made important contributions to the production of goods, comparative costs could still be based on labour cost alone, if it is assumed that the trading countries are at the same stage of technological development.

This is because, he argued that given the same techno­logical development, the proportions in which other factors could be combined with labour would be the same. In view of this he asserted that other factors could be validly ignored and for purpose of comparative costs relative efficiency of labour alone of different countries could be considered.

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However, Taussig’s defense of Ricardian version of comparative cost theory is poor and invalid. The various trading partners are not at the same stage of technological development and therefore the factor proportions used for the production of commodities in different countries are vastly dif­ferent. Hence, it is quite unrealistic and improper to consider relative efficiency of labour alone.

However, as stated earlier, Haberler rescued the comparative cost theory from labour theory of value and reformulated it in terms of opportunity cost which covers all factors.

2. The comparative cost theory explained that different countries would specialise in the pro­duction of goods on the basis of comparative costs and that they would gain from trade if they export those goods in which they have comparative advantage and import those goods from abroad in respect of which other countries enjoyed comparative advantage.

But it could not provide a satisfac­tory explanation of why comparative costs of producing commodities in various countries differ. Ricardo thought comparative costs of producing commodities in various countries differed due to the differences in efficiency of labour. But this begs the question why labour efficiency is different in various countries.

Factors for Variation in Comparative Costs of Different Commodities:

1. The various countries differ in respect of factor endowments suited for the production of different commodities.

2. The different commodities require different factor proportions for their production.

Thus Heckscher and Ohlin supplemented the comparative costs theory by providing valid reasons for differences in comparative costs in various countries.

3. Against the Ricardian doctrine of comparative cost it has also been said that it is based on the constant cost of production in the two trading countries. This assumption of constant costs leads them to conclude that different countries would completely specialise in the production of a single product on the basis of their comparative costs.

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Comparative Costs Theory: Assumptions and Criticisms

ADVERTISEMENTS: Read this article to learn about the theory of comparative costs: it’s assumptions and criticisms! The Classical Theory of the International Trade, also known as the Theory of Comparative Costs, was first formulated by Ricardo, and later improved by John Stuart Mill, Cairnes, and Bastable. ADVERTISEMENTS: Its best exposition is to be found in […]

Comparative Costs Theory: Assumptions and Criticisms | Economics

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The Classical Theory of the International Trade, also known as the Theory of Comparative Costs, was first formulated by Ricardo, and later improved by John Stuart Mill, Cairnes, and Bastable.

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Its best exposition is to be found in the works of Taussig and Haberler.

Comparative Costs Theory:

The principle of comparative costs is based on the differences in production costs of similar commodities in different countries. Production costs differ in countries because of geographical division of labour and specialisation in production. Due to differences in climate, natural resources, geographical situation and efficiency of labour, a country can produce one commodity at a lower cost than the other.

In this way, each country specialises in the production of that commodity in which its comparative cost of production is the least. Therefore, when a country enters into trade with some other country, it will export those commodities in which its comparative production costs are less, and will import those commodities in which its comparative production costs are high.

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This is the basis of international trade, according to Ricardo. It follows that each country will specialise in the production of those commodities in which it has greater comparative advantage or least comparative disadvantage. Thus a country will export those commodities in which its comparative advantage is the greatest, and import those commodities in which its comparative disadvantage is the least.

Assumptions of the Theory:

The Ricardian doctrine of comparative advantage is based on the following assumptions:

(1) There are only two countries, say A and B.

(2) They produce the same two commodities, X and Y.

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(3) Tastes are similar in both countries.

(4) Labour is the only factor of production.

(5) All labour units are homogeneous.

(6) The supply of labour is unchanged.

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(7) Prices of the two commodities are determined by labour cost, i.e.. the number of labour-units employed to produce each.

(8) Commodities are produced under the law of constant costs or returns.

(9) Trade between the two countries takes place on the basis of the barter system.

(10) Technological knowledge is unchanged.

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(11) Factors of production are perfectly mobile within each country but are perfectly immobile between the two countries.

(12) There is free trade between the two countries, there being no trade barriers or restrictions in the movement of commodities.

(13) No transport costs are involved in carrying trade between the two countries.

(14) All factors of production are fully employed in both the countries.

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(15) The international market is perfect so that the exchange ratio for the two commodities is the same.

Cost Differences:

Given these assumptions, the theory of comparative costs is explained by taking three types of differences in costs: absolute, equal and comparative.

There may be absolute differences in costs when one country produces a commodity at an absolute lower cost of production than the other.

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The absolute cost differences are illustrated in Table 78.1

A 10 5 B 5 10

The table reveals that country A can produce 10 X or 5F with one unit of labour and country В can produce 5X or 10К with one unit of labour.

In this case, country A has an absolute advantage in the production of X (for 10 X is greater than 5 X), and country В has an absolute advantage in the production of Y (for 10 Y is greater than 5 Y).

This can be expressed as 10X of A/5X of B > 1 > 5 Y of A/10Y of B.

Trade between the two countries will benefit both, as shown in Table 78.2.

Commodity (1) (2) (2-1)

X Y X Y X Y A 10 5 20 — + 10 -5 В 5 10 — 20 -5 +10

Total Production 15 15 20 20 +5 +5

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Table 78.2 reveals that before trade both countries produce only 15 units arch of the two commodities by applying one labour-unit on each commodity. If A were to specialise in producing commodity X and use both units of labour on it, its total production will be 20 units of X. Similarly, if В were to specialise in the production of Y alone, its total production will be 20 units of Y. The combined gain to both countries from trade will be 5 units of X and Y.

Figure 78.1 illustrates absolute differences in costs with the help of production possibility curves. YA XA is the production possibility curve of country A which shows that it can produce either OXA of commodity X or OYA of commodity Y. Similarly, country В can produce OXB of commodity X or 0YB of commodity Y. The figure also reveals that A has an absolute advantage in the production of commodity X (OXA> OXB), and country В has an absolute advantage in the production of commodity Y(OYB > OYA).

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What Is Comparative Advantage?

Comparative advantage is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners.

ECONOMICS GUIDE TO MICROECONOMICS

What Is Comparative Advantage?

By ADAM HAYES Updated August 29, 2022

Reviewed by CAITLIN CLARKE

Fact checked by KATRINA MUNICHIELLO

Investopedia / Joules Garcia

What Is Comparative Advantage?

Comparative advantage is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners. Comparative advantage is used to explain why companies, countries, or individuals can benefit from trade.

When used to describe international trade, comparative advantage refers to the products that a country can produce more cheaply or easily than other countries. While this usually illustrates the benefits of trade, some contemporary economists now acknowledge that focusing only on comparative advantages can result in exploitation and depletion of the country's resources.

The law of comparative advantage is popularly attributed to English political economist David Ricardo and his book On the Principles of Political Economy and Taxation written in 1817, although it is likely that Ricardo's mentor, James Mill, originated the analysis.

KEY TAKEAWAYS

Comparative advantage is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners.

The theory of comparative advantage introduces opportunity cost as a factor for analysis in choosing between different options for production.

Comparative advantage suggests that countries will engage in trade with one another, exporting the goods that they have a relative advantage in.

There are downsides to focusing only on a country's comparative advantages, which can exploit the country's labor and natural resources.

Absolute advantage refers to the uncontested superiority of a country to produce a particular good better.

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Explaining Comparative Advantage

Understanding Comparative Advantage

Comparative advantage is one of the most important concepts in economic theory and a fundamental tenet of the argument that all actors, at all times, can mutually benefit from cooperation and voluntary trade. It is also a foundational principle in the theory of international trade.

The key to understanding comparative advantage is a solid grasp of opportunity cost. Put simply, an opportunity cost is a potential benefit that someone loses out on when selecting a particular option over another.

In the case of comparative advantage, the opportunity cost (that is to say, the potential benefit that has been forfeited) for one company is lower than that of another. The company with the lower opportunity cost, and thus the smallest potential benefit which was lost, holds this type of advantage.

Another way to think of comparative advantage is as the best option given a trade-off. If you're comparing two different options, each of which has a trade-off (some benefits as well as some disadvantages), the one with the best overall package is the one with the comparative advantage.

Diversity of Skills

People learn their comparative advantages through wages. This drives people into those jobs that they are comparatively best at. If a skilled mathematician earns more money as an engineer than as a teacher, they and everyone they trade with are better off when they practice engineering.

Wider gaps in opportunity costs allow for higher levels of value production by organizing labor more efficiently. The greater the diversity in people and their skills, the greater the opportunity for beneficial trade through comparative advantage.

Example of Comparative Advantage

As an example, consider a famous athlete like Michael Jordan. As a renowned basketball and baseball star, Michael Jordan is an exceptional athlete whose physical abilities surpass those of most other individuals. Michael Jordan would likely be able to, say, paint his house quickly, owing to his abilities as well as his impressive height.

Hypothetically, say that Michael Jordan could paint his house in eight hours. In those same eight hours, though, he could also take part in the filming of a television commercial which would earn him $50,000. By contrast, Jordan's neighbor Joe could paint the house in 10 hours. In that same period of time, he could work at a fast food restaurant and earn $100.

In this example, Joe has a comparative advantage, even though Michael Jordan could paint the house faster and better. The best trade would be for Michael Jordan to film a television commercial and pay Joe to paint his house. So long as Michael Jordan makes the expected $50,000 and Joe earns more than $100, the trade is a winner. Owing to their diversity of skills, Michael Jordan and Joe would likely find this to be the best arrangement for their mutual benefit.

Comparative Advantage vs. Absolute Advantage

Comparative advantage is contrasted with absolute advantage. Absolute advantage refers to the ability to produce more or better goods and services than somebody else. Comparative advantage refers to the ability to produce goods and services at a lower opportunity cost, not necessarily at a greater volume or quality.

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