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.
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 elasti
city’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.
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.
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