The
theory of comparative cost was put forward by David Ricardo in 1817. The main purpose behind developing this theory was to advocate for mutual trade.
DEFINITION AND EXPLANATION
According to
Ricardo: he defined comparative cost
as a “nations should not waste
their scarce resources on producing the
commodities which they can obtain from abroad at lesser cost. A nation should
divert its resources only to the production of commodities in which they have greatest
relative efficiency and trade for those products which they cannot produce efficiently
EXAMPLE:
David Ricardo, with the help of his comparative cost
theory tried to illustrate that even if Portugal could produce wine and cloth
more cheaply(in terms of labor hours)
than England, it will be beneficial or
Portugal to specialize in the production
of wine, because she is comparatively
more efficient in its production than
cloth, so if Portugal concentrates in the production of wine and England specializes in the production of cloth, trade will be mutually profitable
to them because they have now a large
supply of wine and cloth.
The principle
of comparative cost can be made
clear by taking a simple example from our very day life. Let us suppose, there
is a very successful barrister who at
the very same time is a very good typist
will it
be advantageous for the barrister to type all his legal documents
himself? The answer is no. The time
which he spends in typing his papers can be more profitable utilized in
the preparation and pleading of his
cases in courts.
For instance, if he types all his legal documents he can save $2000 per month. If he
engages a typist and spends that
time in the preparation cases, he can
earn $4000 per month. It will thus be
profitable for the barrister to devote his time in the preparation of
cases and pleading them in court than
doing any other work. In
economic terminology, we can say, that though the barrister has an
advantage in both pleading his cases
and typing of documents, yet he can earn
more if he devotes himself exclusively
to the occupation in which he has the greater comparative advantage, i.e in legal work. We can take many other examples like this to
clear the concept of comparative cost. For instance, it is advantageous for a doctor to employ a dispenser than to do the work of
dispensary himself is a better dispenser.
The principle of comparative cost which we have
applied to individual cases is now
applied to regions and countries.
It pays each country to specialize in the production of those commodities in
which it has the greater comparative advantage or in which it suffers the least
comparative disadvantage. In the words of
Jacob Viner:
“The theory of comparative cost as applied to
international trade is therefore, that
each country trend to produce, not necessarily what it can produce
more cheaply than an other country, but
those articles which it can
produce at the greatest relative advantage ie
at the lowest comparative cost. Each country will produce that article
in the production of which its superiority is more marked or its inferiority least marked”
It may be remembered here that when the products of
one country exchange for that of another, it is not the cost of production
which we compare but the ratio between
the cost of the production of the commodities concerned.
BASIC
PRINCIPLES OF THEORY OF COMPARATIVE COST
The
basic principle of comparative costs in now illustrated by using a
simplified trade model where
i.
There are only two trading countries country A and
B
ii.
These two
countries produce only two goods cotton and sugar
iii.
The commodities
produced in each country are identical
iv.
There are no
barriers to trade and no transport
costs.
v.
Labor is the sole
productive resources in the country and it can move freely from one industry
to another industry within the country.
TYPES OF COST DIFFERENCES
Within the limits set by the model, we take three
possibilities and examine wheel trade is profitable
i.
Countries with
absolute difference in cost of producing goods
ii.
Countries with
equal difference in cost of producing goods
iii.
Countries
with comparative difference in cost of producing goods, international trade is
profitable only under 1 and 3 countries but not under 2 as a explained below
1. ABSOLUTE DIFFERENCE IN COST
Let us assume there are two countries, Pakistan and
India Pakistan specializes in the production of sugar and India in wheat.
Pakistan with X Labor cost produces 60 quintals of wheat or 30 quintals
of sugar in a season, as is shown in the
table below.
Case 1 : absolute cost differences:
|
Commodities
|
Wheat
|
Sugar
|
Cost ratio |
|
Pakistan
with x resources productions
|
30
quintals
|
60
quintals
|
1:2
|
|
India
with x resources produces
|
60
Quintals
|
30
quintals
|
1:1/2
|
This table
shows that in Pakistan 30 quintals of
wheat is equal in its exchange value
of 2
quintals of sugar, the
substitution ratio of the opportunity cost relation between wheat and sugar is
1:2 in India, the substitution
ratio between wheat and sugar in
1:1/2 (on quintal of wheat is
equal to ½ quintal of sugar). From this table it is clear that Pakistan has an absolute
advantage in the production of sugar and
India in the production of wheat, if
Pakistan specializes in the production
of sugar and India in wheat, there will
be increase in total output and both the countries will gain from mutual trade.
Pakistan will gain so long as it can receive more than
one quintal of wheat by giving two quintals of sugar. India will benefit from trade if she gets
more than ½ quintal of sugar in exchange for one quintal of wheat.
TRADE UNDER EQUAL DIFFERENCE COST RATIO
If the opportunity cost ratio between two countries is
equal, trade will not be advantageous to
any of them for example, if
Pakistan with X labour cost
produces 30 quintals of wheat or 60 quintals of sugar and
India will the same given resources produces 26
quintals of wheat or 52 quintals of sugar, international trade
will not take place between them.
CASE
II: EQUAL COST DIFFERENCES:
|
Commodities
|
Wheat
|
Sugar
|
Cost
ratio
|
|
Pakistan
with x Resources
|
30
quintals
|
60
quintals
|
1:2
|
|
India
with x Resources
|
28
quintals
|
52
quintals
|
1:2
|
Trade
is not gainful in both the countries because of the fact that in both Pakistan
and India, one quintal of wheat can be exchanged for 2
quintals of sugar, Pakistan can benefit only if it gets more than 2
quintals of sugar in exchange for one quintal of wheat- India wilt not
agree to this bargain because she herself can exchange that much quantity in her own country.
3.
COMPARATIVE DIFFERENCE IN COST RATIO
According to Ricardo, if one country is more efficient
than the other in the production of both the commodities, international trade will be mutually
profitable to them. The basic statement involves the principal of comparative
cost which is explained with the help of an example. Let us suppose, Pakistan
with x resources (labour) produces 10
quintals of wheat or 100 quintals of sugar and India with the same x resources (labor)
produces 5 quintals of wheat or 75
quintals of sugar.
CASE
III: COMPARATIVE COST DIFFERENCES:
Commodities |
Wheat
|
Sugar
|
Cost
ratio
|
|
With
x resources Pakistan produces
|
10
quintals
|
100
quintals
|
1:10
|
|
With
x resource India produces
|
5
quintals
|
75
quintals
|
1:15
|
It is clear from the table, above
that Pakistan has comparative
cost advantage in the production of both commodities, ie wheat and sugar .
But when we examine opportunity costs
of producing both the
commodities in two countries, the
picture is then different. In picture is
then different. In Pakistani the cost of
one quintal of wheat is equal to 10 quintals of sugar; whereas in India the cost of one quintal of
wheat is equal to 15 quintals of sugar. Pakistan, thus, has a comparative
advantage in the production of wheat and India in sugar, so if Pakistan specializes in the production of
whet and India in sugar, there will be greater output of both the commodities, trade will be beneficial to the trading countries.
As regards the rate of exchange, it is determined by
the relative elasticity’s of demand of two countries for the , goods of the
other, if Pakistanis demand for sugar in more intense than that of India for
wheat, the terms of trade will be more
favorable to India and vice varsa.
CRITICISM OF THE THEORY
The theory of comparative costs has been criticized on
the following grounds.
i.
Unrealistic
nature of the labor immobility assumption:
The theory assumes that labor
is mobile within the country but
immobile between countries. This is not
realistic assumption. The migration of
labor from one country to another has an important bearing on the traded goods.
ii.
Unrealistic
assumptions of constant cost: The assumption of zero transport cost and
constant cost is also not valid. It does not accord with facts.
iii.
Unrealistic
assumption of perfect competition: The
theory assumes perfect competition. But in the actual world, it is imperfect competition which prevails.
The theory thus has no practical utility.
iv.
Labor differs
in efficiency: The theory assumes
that all labor is of the same quality. The fact however, is that the efficiency of labor varies from
person to person.
v.
Based on labor
theory of value: The theory of comparative cost was based in terms of
labour theory of value, while in reality labor is only one element of total
cost.
LIMITATION OF COMPARATIVE COST THEORY
vi.
Restrictive
Model: Ricardo’s theory is based on only two
countries and only two commodities. But
international trace is among many countries with many commodities.
vii.
Full
Employment : The assumption of full
employment helps the theory to exaplin trade on the basis of comparative
advantage. The reality is far from full employment .
viii.
Ignore
Transport Cost: Another serious defect is that the transport costs
are not consider in determining comparative cost differences.
ix.
Static
Theory: The modern economy is dynamic and the comparative cost
theory is based on the assumption sand static theory it assumes fixed quantity
of resources if does not consider the effect of growth.
ASSUMPTION OF COMPARATIVE COST
The
comparative cost theory is based on the following assumptions:
1.
Labour is
regarded as the sole factor of production and the cost of production only consists of labour cost.
2.
Production is
subject to the law of constant returns
3.
Factors of
production are assumed to the perfectly mobile within a country but immobile
between countries
IMPORTANT OF COMPARATIVE THEORY’S
1.
The two
commodities two countries model can be extended
all the commodities and all the
countries. Each country then will specializes in the production of those
commodities in which the 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 coast in terms of money. Specialization 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,
specialization will still take place on the basis of cost advantage under
increasing and decreasing cost.
4.
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 of her restrictive
assumption.
The supporter of Ricordain theory argued that all the
restricted assumptions of the comparative cost theory could be relaxed and make
the theory practical in the real world situation where each country specializes
in the production of these goods and services in which it has comparative cost
advantage under the changing conditions.