2.2 RICARDO’S COMPARATIVE COST THEORY 2.2.1 Introduction ¢ The Comparative Cost Theory was first systematically formulated by the EEL economist David Ricardo in his ‘Principles of Political Economy and Taxation’ (1817). It was later refined by J.S. Mill, Marshall, F.W. Taussig and Gottfried Von Haberler. TO hecording to David Ricardo, it is not the absolute but the comparative cost differences that determine trade relations between two countries. ° 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 concentrate on the production of those goods and services in which it has cost 24International Economics Theories of International Trade advantages and exchange them with the goods and services - produced ty other countries - for the production of which it was either less suited or had positive ‘cost disadvantages + The concept of ‘comparative advantage’ also explains why a country is capable of producing a wide variety of goods and services at a lower cost than any other country should concentrate on producing that good or services for which its cost advantage is the greatest and leave the production of other goods in which it has a positive but less cost advantage, to other countries. * According to David Ricardo, "the basis of international trade is that each country will specialise in the production of those commodities in which it has the greatest advantage or the least comparative disadvantage.” ‘© In other words, a country will export those commodities in which its comparative advantage is the greatest and import those commodities in which its comparative disadvantages is least. -2.2.2 Assumptions of the Ricardian Theory [= Ricardo and Mill had developed the theory of comparative costs on certain important assumptions, «The various explicit and implicit assumptions of the theory are as follows: is:] AT The Ricardian model is of two — country, two - commodity. : Ail). They produce the same two commodities. Alii) Production costs meant only labour costs. Labour was assumed to be the only productive factor. Hence, costs were to be treated as labour cost alone. It also means prices of two commodities are determined by labour cost. \G¥Y All labour was assumed to be homogenous. (¥)_ It assumes that there are no transportation charges. (i) Production is subject to constant costs, That is, changes in output are rot supposed to influence the unit cost of production (vii) The factors of production are perfectly mobile within the country but totally immobile between the countries (Will) Trade between the two countries takes place on the basis of the barter system ie, trade takes place in goods only and no capital movements take place between the countries concerned. 25Ce ee ee eee anal Trade is free trade. Full emloyment in two countries. No impact of trade cycle. Fig. 2.2: Ricardian Model 3 Explanation of the Ricardian Theory (Ce Keeping these assumptions in mind, we now proceed to explal in the movement of particular goods between two countries as determined by cost differences. + Three types of cost differences may be distinguished! (CA) Absolute Cost Difference (Adam Smith’s Theory): Adam Smith 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 in which they specialise. | (1B) Equal Differences: If there are equal differences in production costs, international trade cannot take place. There is hardly any possibility of profit in international trade when there are equal differences in production costs between the two countries and international trade comes to an end. ) 26International Economics “Theories of internation Co ae (Ce Ricardo shows that trade is possible between two countries even when one county has an absolute advantage in the production of both goods, but @ comparative advantage in the production of one commodity than in the othe. + We take the well-known example as given by Ricardo to explain the theory of comparative cost differences. It is trade between two countries ~ Britain and Portugal two commoaites ~ cloth and wine * David Ricardo in his model of a two-country, two commodity words, pointed cut that Portugal could produce both wine and cloth cheaper than Britain, but it possessed a greater cost advantage in wine than In cloth. Hence, it was inthe interest of Portugal to concentrate on the production of [Link] leave the production of cloth to Britain. : Terms of Man-Vears) Required for One Unit of a Commodity Table 2.3: Labour ( Yo Country wine loth 77 petain 120 100 Portugal 0 90 + Table 23 ilustrates that for producing one unit of wine in Britain, it requires 120 men for a year and for one unit of cloth it requires 100 men for the same period By contrast, Portugal requires to produce the same quantities of wine and cloth £0 and 90 men respectively. ‘It makes clear that Portuguese labour is more efficient than the Britain labour in producing both the goods ~ wine and cloth. In other words, Portugal possesses an absolute advantage in both ~ wine and cloth. However Portugal has more benefit in production of wine and exporting it to Britain as it possesses greater comporative odvantage in it * The cost of producing wine in Portugal is (80/120 men) which is relatively lesser than the production cost of cloth (90/100 mer), + Britain, on the other hand, should specialise in production of cloth as it has least idvantage. In Britain the production cost of cloth is (200/90 comparative men) which is less as compared to wine (120/80 men). Due to the comparative cost differences in trade is beneficial to both the countries,* Portugal has ai in the production 0 9 N absolute advantage in the pri produces OR of Britain. It produces OT of wine and OP of cloth, whereas Britain 10 PT shows wine and OB of cloth. The has a greater comparative advantage in the production Portugal devotes the resources required to produce OB of cl OS of wine which is still greater than OR of wine of Brit the least comparative disadvantage in the production of OB © Portugal will export OS of wine to Britain and in exchange from Britain. slope of ES which is parallel t 2.2.4 Gains from International Trade in. In con! that Portugal of wine because if loth, it can produce trast, Britain had cloth. Therefore, get OB of cloth Table 2.4: Exchange Ratios (Domestic) 7 ss Britain _ [Portugal : Wine 120: 100 cloth (6/5) Wine 80: 90 cloth (8/9) 1:12 1:0.89 Cloth 100: 120 wine (5/6) Cloth 90: 80 wine (9/8) 1:0.83 1:113 and for producing a unit of cloth is 100 men. 28 Table 2.4 reveals that the production cost of a unit of wine in Britain is 120 meneores of International Tags res of International Tray ante enn in — ———— re Ls the domestic exchange ratio of Bain ie TUNNEY oo unt of cloth, LEP? is the domestic exchange ratio of Portugal te. 2 unit > 1 unit of wine Between the) PIL shows the exchange rate of trade ie 1 unit of clot two countries, wine and gains to) A this exchange rae, gins to Bitin is UE Ge, 027 Ud of | Lorusalis pp! (O33 uni fet, ‘© Thus, both the countries, Britain and Portugal specialise '” the pr commodity on the basis of comparative costs. and will export thay ‘Each country reallocates its factor of production according * na wie : ‘commodity in which it has comparative advantage and impor ntries wil gai which it has @ comparative disadvantage. In this way, both the cou Sain through trade 2.2.5 cri ical Evaluation Until the First World War, Ricardo’ principle of comparative advantage has been the very basis of international trade. But after the First World War, critics have been able only to modify it and amply it In Prof. Samuelson’s words “if theories, like girls could win beauty contests, comparative advantage would certainly rate high in that it is an elegantly logical structure’ ‘The Ricardian theory is not free from defects and has been severely criticised|by Bertil Ohlin and Frank D. Grahams discussed as under: 2x2 Model Unrealistic: The Ricardian model is related to trade between two countries and two commodities. This is an unrealistic assumption as international trade is between ‘many countries and trading in many commodities) 2. No Free Trade: A serious weakness of the doctrine is that perfect and free world ade. Buin realty, there i no fee trade In tn, csey country applies restrictions on the free movement of n othe 900d t 7 ah 10 and from othe’ "tis based on the assumption of ReInernstional Economies ‘Theories of international Tra * Thus, tariffs and many other trade restrictions affect imports and exports of the world. Further, the commodities are nat homogenous, but are differentiated. By neglecting all these aspects, Ricardo's theory is far from being realistic. LAE Neglects Non-labour Costs: (Le An important criticism against the comparative advantage costs theory is that it is based on the labour theory of value. That is, in production costs, the only ‘component that it includes in its calculation is the labour costs and neglects non- {labour costs involved in the production of commodities ‘This is truly unrealistic because it is money costs and not labour costs that are the basis of national and international transactions of goods. (C4. Heterogeneous Labour: + The labour cost theory is based on the assumption of ‘homogenous labour’. This cannot be true because labour is heterogeneous. It is different in kind, grade, specialisation etc\ 5. Similarity in Tastes in the Two Countries: ‘+ The assumption of similar tastes is far from reality because tastes differ with difference in income in a country. ‘© Moreover, they also change with the growth in an economy and with the development of its trade relations with other countries. 6. No Transport Costs: Ricardian theory ignores transport costs in determining comparative advantage in trade, This is an unrealistic assumption because transport costs play a significant role in determining the pattern of world trade. Similar to the ‘economies of scale, it is an independent factor of production. ‘¢ For example, high transport costs may actually wipe out all the comparative costs advantage the country will enjoy and there may be no gains from international trade. 7. Full Employment in the Economy: ‘© The most unrealistic assumption underlying all classical theories and Ricardo’s. theory of comparative advantage is the existence of full employment in the ‘economy. This assumption robs the dynamic element from the theory and makes it static, 2International Economics + According to Ohlin, the same theory, namely, the general equilibrium theory which explains inter regional trade may be employed without any major modification to analyse the phenomenon of international trade. 2.3.2 The H. 0. Theory Statement + (4 The #0 theory states thatthe main determinant ofthe pattern of production, specialisation and trade among regions is the relative avalabilty of factor endowments and factor prices. Regions or countries have different factor lendowments and factor prices. Thats, some countries have much capital, others have much about + According to this theory, “Countries that are rich in capital wll export capital ~ intensive goods and countries that have much labour will export labour- intensive goods") CG Tooohin,aays the immediate reasons of international trade is that some goods ‘can be bought more cheaply from other regions and it can be produced at a high price in the sare region, Hence, the main cause of trade between regions is the ditference in prices of commodities and this diference is due to relative factor endowments and factor pices) }.3 Assumption of the Theory + Bertil Ohlin built up his theory of international trade on the bass ofthe following simplified assumptions: (@) Ris 22x 2x 2 model ie. two countries, two commodities and two factors of production (labour and capital (b) The factors of production are perfectly mobile within the regions, but immobile between the two counties a (©) There are no restrictions onthe movement of goods between the two regions. (d)_ There are no transportation costs. mat (©) Each region possesses a paper currency system whichis insulated from external financial influences. (f) The two countries in the theory cited ~ one is labour-intensive country and the other is capita-intensve county (9) Goods transactions alone are to be considered; exports will ten exacty balance with imports. 25\ 2.3.4 Explanation of the Theory Ohlin points out the similarity with the individual specialisation in production. | ability and Individual specialisation is partly due to difference in personal ab an aptitudes. Individual tend to specialise in different lines of economic activity according to their aptitudes. In the same manner, different geographical regions vary from each other with regard to their endowment of productive factors. Some are endowed with plenty of fertile lands; others have rich mines and forests. It would be the advantage of each geographical region if it specialises in the production of those goods for which its factor equipment was most suited. Each region specialises in the production ‘of those commodities for which it was best suited in terms of natural resources and factor equipment. It then exchanges these commodities for other goods for which other regions were better suited. | Ohlin, thus, points out that variation in productive factors is a cause of initer- regional trade and specialisation, just as differences in individual abilities and aptitudes. 2.16(@ a 5 Criticism (or Shortcomings) | Fig. 2.9 + the H-O theory) marks a considerable Though the factor-proportion theory (0 tive Cost theory of international trade, i improvement over the Classical Comparat is not completely free from criticisms ay fical. The theory is based on an unrealistic Production Functions are not identi assumption that the production function of the same good is identical in the at all justifiable. That is how can the two countries, This assumption is not productions of the same good be identical in the two countries? With differences in factor endowments and difference in states of technology, the production functions of the same good cannot be identical in the two countries. How can the production functions be identical in the two nations if the two countries are in different stages of economic development? ‘another criticism is that it is not the factor prices which determine costs, thus commodity prices as assumed by Ohlin, but itis commodity prices that determine the factor prices.) The Modem theory is grossly unrealistic in so far as it is based on certain very oversimplified and unrealistic assumptions- perfect competition, full employment of factors, absence of transport costs, identical production functions in the two countries, absence of product differentiation etc. A theory built on the basis of such assumptions cannot bear any relationship to reality.) 2.20