Theory of comparative cost advantage-converted.pptx

Theory of comparative cost advantage-converted.pptx

1. IN T R O DUC T ION The Classical Theory of the International Trade, also known as the Theory of Comparative Costs, was first formulated by David Ricardo , and later improved by John Stuart Mill, Cairnes, and Bastable. The principle of comparative costs is based on the differences in production costs of similar commodities in different countries.

2. STATEMENT According to Ricardo it follows that each country will specialize 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, or those commodities in which its comparative disadvantage is the least.

3. AS S U MPTI O NS There are only two countries, say A and B. They produce the same two commodities, X and Y. Tastes are similar in both countries. Labor is the only factor of production. All labor units are homogeneous. The supply of labor is unchanged. Prices of the two commodities are determined by labor cost, i.e. the number of labor-units employed to produce each. Commodities are produced under the law of constant costs or returns.

4. AS S U MPTI O NS Trade between the two countries takes place on the basis of the barter system. Technological knowledge is unchanged. Factors of production are perfectly mobile within each country but are perfectly immobile between the two countries. There is free trade between the two countries, there being no trade barriers or restrictions in the movement of commodities. No transport costs are involved in carrying trade between the two countries. All factors of production are fully employed in both the countries. The international market is perfect so that the exchange ratio for the two commodities is the same.

5. COMPARATIVE DIFFERENCES IN COSTS Comparative differences in cost occur when one country has an absolute advantage in the production of both commodities, but a comparative advantage in the production of one commodity than in the other.The comparative cost differences are illustrated in Table. Labor cost per unit of commodity Country Commodity X Commodity Y A 30 45 B 60 50

6. E XPLAN A T I O N Country A has comparative advantage in producing X because c omp ara t i ve produ c t i on c ost o f c om m od i t y X is 3 0/ 4 5 = 2 /3 = 0.6 7 of the production cost of commodity Y, but c ompa r a t i ve prod uc t i on c ost of c om m odi t y Y i s 45 / 30 = 3 / 2 = 1.5 of the production cost of commodity X. The cost of producing commodity Y is higher than that of commodity X.

7. E XPLAN A T I O N Country B has comparative advantage in producing Y because comparative production cost of commodity X is 60/50 = 6/5 = 1.2 of the production cost of commodity Y, but comparative production cost of commodity Y is 50/60 = 5/6 = 0.83 of the production cost of commodity X. The cost of producing commodity X is higher than that of commodity Y.

8. EXPLANATION Thus, the country A would specialize in production of commodity X and import commodity Y; and country B would specialize in the production of commodity Y and import commodity X. Both the countries will benefit from trade.

9. CRITICISMS Unrealistic Assumption of Labor Cost No Similar Tastes Static Assumption of Fixed Proportions Unrealistic Assumption of Constant Costs Ignores Transport Costs Factors not fully Mobile Internally Unrealistic Assumption of Free Trade Neglects the Role of Technology Impossibility of Complete Specialization