TYPES OF COST DIFFERENCES | MARTINS LIBRARY

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	Table of Contents Toggle 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.

 2. 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 elasticity’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 versa.