Comparative cost theory of international trade
David Ricardo developed the classical theory of comparative advantage in 1817 to explain why countries engage in international trade even when one country’s workers are more efficient at producing every single good than workers in other countries. He demonstrated that if two countries capable of producing two commodities engage in the free market, then each country will increase its overall consumption by exporting the good for which it has a comparative advantage while importing the other good, provided that there exist differences in labor productivity between both countries
According to this theory, the international trade between two countries is possible only if each of them has absolute or comparative cost advantage in the production of at least one commodity. This theory is based upon following assumption
- There are only two countries and two commodities
- There is no governmental intervention in export and import
- Only labor is factor of production. Quantity of labor used gives cost of production
- There is perfect mobility of labor within the country but not between the countries
- There is no cost of transportation between the countries
- The law of constant returns to scale operates in production.
- The units of labor is homogeneous
- The units of each commodity in both countries are homogeneous
According to comparative cost advantage theory of international trade, each country exports the commodity in which it has cost advantage and imports the commodity in which it has cost disadvantage. This theory can be explained as following:
- Comparative cost advantage
If a country can produce both commodities with less cost than another country but in different ratio, the country is said to have comparative cost advantage
country | Labor required to produce clothe | Labor required to produce shoe |
Nepal | 10 | 4 |
India | 20 | 12 |
ratio | 10/20=0.5 | 4/12=0.33 |
In the above table, the cost of production of clothe in Nepal is only 50% of cost of production of clothe in India. In case of shoes, the cost of production is only 1/3rd of cost in India. It shows that Nepal can produce both commodities with fewer cost than India. But in order to take advantage, it produces only shoes and let India produce clothe for it. Nepal produces shoes and exports to India. India produces clothe and exports to Nepal. If they do so, both of them can take benefits.
- Absolute cost advantage:
If a country can produce a commodity with less cost but has to bear more cost in the production of another commodity than another country then the country is said to have absolute cost advantage. In this case, both of the countries produce and export the commodities in which they have absolute cost advantage
country | Labor required to produce clothe | Labor required to produce shoe |
Nepal | 10 | 8 |
India | 20 | 4 |
ratio | 10/20=0.5 | 8/4=2 |
In the above table, the cost of production of clothe in Nepal is less than in India. But cost of production of shoes is less in India than in Nepal. In this case, Nepal is said to have absolute cost advantage in production of clothe but absolute cost disadvantage in production of shoes. India is said to have absolute cost advantage in production of shoes but absolute cost disadvantage in production of clothe. Therefore, Nepal produces only clothe and exports to India. India produces only shoes and exports to Nepal. Doing it, both the countries can take benefit.
- No cost advantage:
If a country can produce both commodities with less cost than another country but in equal ratio, the country is said to have no cost advantage.
country | Labor required to produce clothe | Labor required to produce shoe |
Nepal | 10 | 4 |
India | 20 | 8 |
ratio | 10/20=0.5 | 4/8=0.5 |
In the above table, Nepal is shown able to produce both commodities with less cost than India in equal ratio. It means Nepal has no cost advantage. It is loss to the Nepal to import any commodity form India. That’s why it decides to produce both goods for itself. Therefore, India too produces both goods for itself. Hew is no trade between them.
Criticisms
- This theory is not applicable if there are more than two countries and more than two commodities
- In every country there is more or les government intervention in international trade
- There is cost of transportation form one country to another country
- The units of labor are not homogeneous and the workers are paid more or less in different countries
- There may be increasing or decreasing returns to scale
- Labor is not perfectly mobile within the country too. In the modern era, there is mobility of labor form one country to another
- The commodities produced in the different countries differ in quality, taste, size, quantity etc.