comparative cost advantage theory of international trade

Table 1 Cost of Production in Labour Units: It follows that country A has an absolute advantage over В in the production of X while В has an absolute advantage in producing Y. If each country now specializes in one producing good then assuming constant returns to scale, the output will double. Adam Smith’s theory of absolute cost advantage in international trade was evolved as a strong reaction of the restrictive and protectionist mercantilist views on international trade. As in the absolute cost advantage theory, this theory also says that international trade is solely due to differences in the productivity of labour in different countries. (iv) Production function is homogeneous of the first degree. The country may not be the best at producing something. The absolute differences in costs can be measured as: It shows that country A has absolute advantage in producing X and country B has an absolute advantage in commodity Y. Historical Overview. Hence, the trade between two countries will not take place. The theory of comparative advantage states that if countries specialise in producing goods where they have a lower opportunity cost – then there will be an increase in economic welfare. If Japan can produce rice at a relatively lesser cost than computers, it will decide to specialise in the production and export of computers and India, which has less comparative cost disadvantage in the production of rice than computers will decide to specialise in the production of rice and export it to Japan in exchange of computers. The labour cost of producing Y-commodity in countries A and B are respectively a3 and a4. Share Your PDF File This two-country, two-commodity model can be analysed through the Table 2.3. As such, when trade takes place, A specialises in X and exports its surplus to В and В specialises in У and exports its surplus to A. Ricardo argues that if there is equal cost difference, it is not advantageous for trade and specialisation for any country in consideration (see Table 2). Similarly, the country’s imports will be of goods having relatively less comparative cost advantage or greater disadvantage. Image Guidelines 5. (x) There is full employment of resources in both the countries. It implies that output changes exactly in the same ratio in which the factor inputs are varied. But this labour theory of value has been abandoned by the modern economists. The Classical Theory of the International Trade, also known as the Theory of Comparative Costs, was first formulated by Ricardo, and later improved by John Stuart Mill, Cairnes, and Bastable. It was formulated by David Ricardo in 1815. Difference Between Absolute Advantage vs Comparative Advantage. We may illustrate this principle after stating its assumptions first. It is the relative differences in costs which determine the products to be produced by different countries. Share Your PPT File, International Liquidity: Meaning and Aspects | Economics. This theory can be explained as following: A. Thus the comparative costs principle confers gain upon both the countries. Content Filtrations 6. Comparative Advantage Theory is the ability of a country to produce particular goods or services at lower opportunity cost as compared to the other countries. For countries like Iceland or land-locked countries in Sub-Saharan Africa, this transport costs could be quite significant. Intro - Classical Theory of International Trade ↓ In 1817, David Ricardo, an English political economist, contributed theory of comparative advantage in his book 'Principles of Political Economy and Taxation'.This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade. The theory explains the emergence of international trade. Table 2 Cost of Production in Labour Units: On account of equal cost difference, the comparative cost ratio is the same for both the countries, so there is no reason for undertaking specialisation. Comparative advantage, economic theory, first developed by 19th-century British economist David Ricardo, that attributed the cause and benefits of international trade to the differences in the relative opportunity costs (costs in terms of other goods given up) of producing the same commodities among countries. Every country has a fixed endowment of resources and all units of each particular resource are identical. In this article we will discuss about the David Ricardo’s theory of comparative cost advantage. It does not mean that Japan will specialise in both rice and computers and India will have nothing to export. Costs of production are measured in terms of the labour units involved. Prohibited Content 3. The comparative cost theory explained that different countries would specialise in the pro­duction of goods on the basis of comparative costs and that they would gain from trade if they export those goods in which they have comparative advantage and import those goods from abroad in respect of which other countries enjoyed comparative advantage. The benefits of buying its good or service outweigh the disadvantages. Comparative advantage is when a country produces a good or service for a lower opportunity cost than other countries. One country may be more efficient than another, as measured by factor inputs per unit of output, in the production of every possible commodity, but so long as it is not equally more efficient in every commodity, a basis for trade exists. However, A possesses a comparative cost advantage in producing X. Disclaimer 9. If, however, there is an equal cost difference, i.e., Xa/Xb = Ya/Yb will be no international trade between the two countries. Absolute Advantage is the ability with which an increased number of goods and services can be produced and that too at a better quality as compared to competitors whereas Comparative Advantage signifies the ability to manufacture goods or services at a relatively lower opportunity cost.. It means country A has absolute cost advantage over B in respect of both the commodities. It should be noted that, to know the comparative advantage, we have to compare the ratio of the costs of production of one commodity in both countries (i.e., 10/15 in the case of X in our example) with the ratio of the cost of producing the other commodity in both countries (i.e., 20/25 in the case of У in our example). Now, to illustrate and elucidate comparative cost difference, let us take some hypothetical data and examine them as follows. (vii) Transport costs are absent so that production cost, measured in terms of labour input alone, determines the cost of producing a given commodity. The Ricardian comparative costs analysis is based upon the following assumptions: (i) There is no intervention by the government in economic system. Adam Smith’s theory of absolute cost advantage in international trade was evolved as a strong reaction of the restrictive and protectionist mercantilist views on international trade. In case of country B, the gain from trade amounts to 0.25 unit of X for each unit of Y. Image Courtesy : img.docstoccdn.com/thumb/orig/130458705.png TOS4. Ricardo emphasised that under all conditions, it, is the comparative cost advantage which lies at the root of specialisation and trade (see Table 3). Welcome to EconomicsDiscussion.net! This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. The theory of comparative advantage shows that even if a country enjoys an absolute advantage in the production of goods Normal Goods Normal goods are a type of goods whose demand shows a direct relationship with a consumer’s income. Comparative advantage theory. The principle of comparative cost states that (a) international trade takes place between two countries when the ratios of comparative cost of produc­ing goods differ, and (b) each country would specialise in producing that commodity in which it has a comparative advantage. Indeed, the relative gains of the two countries will be conditioned by the terms of trade and one is likely to gain proportionately more than the other but it is definite that both will gain. Historical Overview. In Fig. However, comparative cost theory is still believed to be valid and important basis of international trade. Criticisms of comparative advantage theory. After trade, the world market price (the price an international consumer must pay to purchase a good) of both goods will fall between the opportunity costs of both countries. The classical theory of international trade is popularly known as the Theory of Comparative Costs or Advantage. is perhaps the most important concept in international trade theory. International trade involves the extension of the principle of specialisation or division labour to the sphere of international exchange. The concept of comparative advantage was first formulated by economist David Ricardo as an explanation of the benefits of international trade for countries. In other words, production is governed by constant returns to scale. Costs of trade. For, comparatively, country A’s labour cost involved in producing 1 unit of X is only 66 per cent of B’s labour cost involved in producing X, as against that of 80 per cent in the case of Y. However, it says that the trade between countries which don’t have absolute advantage can be explained by the law of comparative advantage. In our illustration, since country A has comparative cost advantage in commodity X, as per Ricardo s theorem, this country should tend to specialise in X and export its surplus to country В in exchange for У (i.e., import of У from B). 2. It means the country A has comparative cost advantage in the production of X-commodity. Being dissatisfied with the application of classical labour theory of value in the case of foreign trade. Comparative Cost advantage theory in Economics |International trade Edu tainment. The comparative cost principle underlines the fact that two countries will stand to gain through trade so long as the cost ratios for two countries are not equal. The idea of comparative costs advantage is drawn in view of deficiencies observed by Ricardo in Adam Smith’s principles of absolute cost advantage in explaining territorial specialisation as a basis for international trade. The theory of comparative advantage A country has a comparative advantage when it can produce a good at a lower opportunity cost than another country; alternatively, when the relative productivities between goods compared with another country are the highest. The theory is based upon some assumption such as: 1. Share Your Word File Unrealistic assumption of constant costs: The theory is based on another weak assumption that an … It is also one of the most commonly misunderstood principles. Suppose India produces computers and rice at a high cost while Japan produces both the commodities at a low cost. Content Guidelines 2. To state in algebraic terms: If in country A, the labour cost of commodity X is Xa and that of У is Ya, and in B, it is Xb and Yb respectively, then absolute differences in cost can be expressed as: (Which means that country A has an absolute advantage over country В in commodity X and country В has over A in commodity У). Businesses also may have a comparative advantage over their competitors … On the other hand, country В has least comparative disadvantage in production of Y, though she has absolute cost disadvantage in both X and Y. Plagiarism Prevention 4. The law of comparative advantage refers to an economic law used in international trading that argues that a nation should produce goods and services that have the lowest opportunity cost. Correspondingly, since country В has least cost disadvantage in producing У, she should specialise in У and export its surplus to A and import X. (vi) Labour is perfectly mobile within the country but perfectly immobile among different countries. (xi) Trade between two countries takes place on the basis of barter. There will be some costs of trade. Similarly, in country В, IX = 0.6 У domestically, after trade, its gain is 0.4Y. David Ricardo believed that the international trade is governed by the comparative cost advantage rather than the absolute cost advantage. ... increasingly international economy, the theory … The classical theory of international trade is popularly known as the Theory of Comparative Costs or Advantage. Based on this uncomplicated example, the supporting argument is simple: specialization and free exchange among nations yield higher real income for the participants. As Adam Smith pointed out, if there is an absolute cost difference, a country will specialise in the production of a commodity having an absolute advantage (see Table 1). In algebraic terms, let labour cost of producing X-commodity in country A is a1 and in country B is a2. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. The theory of comparative advantage is perhaps the most important concept in international trade theory. On the basis of Table 2.3, country A specialises in the production of X commodity, while country B specialises in the production of Y commodity. Ricardo considered what goods and services countries should produce, and suggested that they should specialise by allocating their scarce resources to produce goods and services for which they have a comparative cost advantage. In relative terms, however, country A has comparative advantage in specialising in the production and export of commodity X while country B will specialise in the production and export of commodity Y. He, therefore, regards the theory of comparative advantage as cumbersome, unrealistic, and as a clumsy and dangerous tool of analysis. The theory neglects the role of technological innovations in international trade. Theory of Comparative Costs or Comparative Advantage: The fundamental cause of international specialisation and hence international trade is the difference in costs of production. Content Guidelines 2. Comparative cost advantage If a country can produce both commodities with less cost than another country but in different ratio, the country is … TOS 7. Ricardian theory of comparative advantage has the merit of demonstrating that international trade is possible even when a country is able to produce all goods at cheaper cost, provided the cost advantage is comparatively more in some goods than in the others. It implies that factors supplies, techniques of production and tastes and preferences are given and constant. New trade theory. The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value of exports and imports in an economy over a certain period. Ricardo’s theory pleads the case for free trade. Table 3 Cost of Production in Labour Units: It will be seen that country A has an absolute cost advantage in both the commodities X and Y. Ricardo, improving upon Adam Smith’s exposition, developed the theory of international trade based on what is known as the Principle of Comparative Advantage (Cost). He upheld in this theory the necessity of free trade as the only sound guarantee for progressive expansion of trade and increased prosperity of nations. Comparative Advantage and Free Trade . In the absence of trade, domestically in country A, IX = 0.5У. In country A, domestic exchange ratio between X and Y is 12 : 10, i.e., 1 unit of X = 12/10 or 1.20 units of Y. 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