COMPARITIVE COST THEORY

Comparative Cost Theory of International Trade 

- Presented By: Balkrishna Paudel

Meaning:

Comparative cost theory of international trade was  introduced by the classical economist David Ricardo  in 1915 and popularized by J.S. Mill, Cairnes and Bastable etc. Therefore, this theory is also known as a classical theory of international trade.

Loading…

Continue..

The comparative cost theory is based on the differences in production costs of similar commodities in different countries. In other words, a country in the long run tends to specialize in the production and export of that commodity which has less cost of production and import that commodity which has high  cost of production in the domestic  market.

Assumptions:

The comparative cost theory is based on the following assumptions:

1.Labor is taken as a single and homogeneous factor of production.

2.Perfect mobility of factor of production.

3.There  are two countries and two commodities.

4.There is full employment in the economy.

5.There is no transportation cost.

6.There is free trade between the countries.

7.Constant returns to scale take place in production. 

Loading…

Statement:

The theory is based on the differences in production cost. Cost of production may differ on the basis of ecological differences, efficiency of labour, technological development, supply of raw material, climate, amount of capital investment, government policy etc.

The theory guides each country to specialize in production of those goods in which they get greater comparative advantage and least comparative disadvantages.

Continue…

According to Ricardo- “other things being equal, a country tends to specialize in the export of those commodities in the production, of which it has maximum comparative cost advantages or minimum comparative disadvantages. Similarly, a country’s import will be goods  having relative less comparative cost advantage or greater disadvantage”.

Table:

Country	X-Good	Y-Good
A	40	80
B	90	100
Cost Ratio of A	40/90=0.44	80/100=0.8
Cost Ratio of B	90/40=2.25	100/80=1.25

Table:

According to the above table, in country A, 40 and 80 labor hours are required to produce one unit of X good and one unit of Y good respectively. Similarly, country B requires 90 and 100 labor hours for one unit of X good and one unit of Y good respectively. In this case the country A has an absolute advantage to produce both goods than in country B. But country A has greater comparative cost advantage over country B in production of X good because the cost ratio of X good (40/90=0.44) is less than that of Y good (80/100=0.8). Therefore, country A will gain more profit by producing only X good  and exporting it to country B.

Continue…

On the other hand, country B has greater comparative cost advantages in the production of Y good due to lower cost ratio 100/80=1.25 is less than 90/40=2.25. Therefore, country B will gain by producing only Y good and exporting it to country A at a price more than its domestic rate and importing X good from country A.  

Continue..

Thus, country A produces only X good and exports to country B and country B produces only Y good and exports to country A. In this way, international trade is beneficial for both countries.

Loading…

Criticisms:

1. Ignores demand side

2. Wrong assumption of two countries and two goods

3. Negligence of transportation cost.

4. The concept of full employment, free trade and perfect competition do not exist in the real world

5. Wrong concept of factor mobility.

THE END