Comparitive Advantage Theory Full

7/30/2019 Comparitive Advantage Theory Full

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Adam Smith in his book 'Wealth of Nation' argued that international trade is advantageous for all the participating

countries only if they enjoy absolute differences in the cost of production of the commodity which they specialise.

As in the case of individuals where each specialises in the production of that commodity in which he has an

absolutely superiority in terms of cost, so also each country specialises in production of goods based on absolute

advantage.

The principle of absolute difference in cost can be explained with the help of table given below. Let us assume

that we have 2 countries, I and II specialising in the production of X and Y.

In country I, one day's labour produces 20x or 10y. The internal exchange rate is 2 : 1. In country II, one day's

labour produce 10x or 20y which gives us the domestic exchange rate of 1 : 2. Country I has the absolute

advantage in the production of X (as 20 > 10) and country II in Y ( as 10 < 20). If these countries enter into trade

with the international exchange of 1 : 1, both countries stand to benefit. Country I will have 1y for 1x as

against1/2y for 1x within the country. Similarly country II will have 1x for 1y as against

1/2x for 1y within the

country.

Based on this example, according to Adam Smith, it can be pointed out that international trade to be beneficial,

each country must enjoy absolute difference in cost of production.

2. Equal Difference in Cost :-

Adam Smith, in order to strengthen his argument in favour of absolute difference in cost pointed out that trade is

not possible if countries operate under equal difference in cost instead of absolute difference.

The above table gives us the internal exchange rate 2x : 1y in both countries. Since the exchange ratio between

X and Y in both countries is the same; none of them will benefit by entering into international trade.

Based on this example, according to Adam Smith, for international trade to be beneficial countries must enjoy

absolute difference in cost. Trade would not take place when the difference in cost is equal.

3. Comparative Difference in Cost :-

David Ricardo agreed that absolute difference in cost gives a clear reason for trade to take place. He, however,

went further to argue that even that the country has absolute advantage in the production of both commodities it

is beneficial for that country to specialise in the production of that commodity in which it has a greater

comparative advantage. The other country can be left to specialise in the production of that commodity in which it
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has less comparative advantage. According to Ricardo the essence for international trade is not the absolute

difference in cost but comparative difference in cost.

David Ricardo stated a theory that other things being equal a country tends to specialise in and exports those

commodities in the production of which it has maximum comparative cost advantage or minimum comparative

disadvantage. Similarly the country's imports will be of goods having relatively less comparative cost advantageor greater disadvantage.

1. Ricardo's Assumptions :-

Ricardo explains his theory with the help of following assumptions :-

1. There are two countries and two commodities.

2. There is a perfect competition both in commodity and factor market.

3. Cost of production is expressed in terms oflabouri.e. value of a commodity is measured in terms of labour

hours/days required to produce it. Commodities are also exchanged on the basis of labour content of each

good.

4. Labour is the only factor of production other than natural resources.

5. Labour is homogeneous i.e. identical in efficiency, in a particular country.

6. Labour is perfectly mobile within a country but perfectly immobile between countries.

7. There is free trade i.e. the movement of goods between countries is not hindered by any restrictions.

8. Production is subject to constant returns to scale.

9. There is no technological change.

10. Trade between two countries takes place on barter system.

11. Full employment exists in both countries.

12. There is no transport cost.

2. Ricardo's Example :-

On the basis of above assumptions, Ricardo explained his comparative cost difference theory, by taking an

example ofEngland and Portugal as two countries & Wine and Cloth as two commodities.

As pointed out in the assumptions, the cost is measured in terms of labour hour. The principle of comparative

advantage expressed in labour hours by the following table.
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Portugal requires less hours of labour for both wine and cloth. One unit of wine in Portugal is produced with the

help of 80 labour hours as above 120 labour hours required in England. In the case of cloth too, Portugal requires

less labour hours than England. From this it could be argued that there is no need for trade as Portugal produces

both commodities at a lower cost. Ricardo however tried to prove that Portugal stands to gain by specialising in

the commodity in which it has a greater comparative advantage. Comparative cost advantage of Portugal can be

expressed in terms of cost ratio.

Cost ratios of producing Wine and Cloth

Portugal has advantage of lower cost of production both in wine and cloth. However the difference in cost, that is

the comparative advantage is greater in the production of wine (1.5 0.66 = 0.84) than in cloth (1.11 0.9 =

0.21).

Even in the terms of absolute number of days of labour Portugal has a large comparative advantage in wine, that

is, 40 labourers less than England as compared to cloth where the difference is only 10, (40 > 10). Accordingly

Portugal specialises in the production of wine where its comparative advantage is larger. England specialises in

the production of cloth where its comparative disadvantage is lesser than in wine.

Comparative Cost Benefits Both Participants

Let us explain Ricardian contention that comparative cost benefits both the participants, though one of them had

clear cost advantage in both commodities. To prove it, let us work out the internal exchange ratio.

Let us assume these 2 countries enter into trade at an international exchange rate (Terms of Trade) 1 : 1.

At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine. At home it is

required to give 1.2 units of cloth for one unit of wine. England thus gains 0.2 of cloth i.e. wine is cheaper from

Portugal by 0.2 unit of cloth.

Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of cloth at home thus

gaining extra cloth of 0.11. Here both England and Portugal gain from the trade i.e. England gives 0.2 less ofcloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit of wine.
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In this example, Portugal specialises in wine where it has greater comparative advantage leaving cloth for

England in which it has less comparative disadvantage.

Thus comparative cost theory states that each country produces & exports those goods in which they enjoy cost

advantage & imports those goods suffering cost disadvantage.

Comparative cost theory inspite of all limitations has remained as a basic principle of international trade. Today

when the world is moving towards greater liberalisation and globalisation each country specialises in production

of goods and services on the basis of comparative cost advantage and enters into international trade.

Image Credits Sodaro K.

Prof. Gottfried Haberler, Frank William Taussig and others attempted to prove the practical

importance and acceptability of comparative cost theory.

It is argued that :-

1. The two commodities two countries model can be extended to all the commodities and all the countries. Each

country then will specialises in the production of those commodities in which it enjoys comparative advantage

and export them to others and import the required goods from others where they are available at a lower pricethan at home.
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2. The theory which was explained in terms oflabourcan also be expressed in terms of money as it is possible

to express the total cost in terms of money. Specialisation 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, specialisation will still take place on the basis of

cost advantage under increasing and decreasing cost.

4. Assumptions of "no transport cost" makes the comparative advantage theory, it is argued very unrealistic. It is

pointed out that after adding transport cost to the cost of production, each country will produce those goods in

which it will have cost advantage. After adding transport cost, for example, India may not enjoy the cost

advantage against USA or Mexico but it certainly will have the advantage for selling them in the neighbouring

countries.

5. 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 other restrictive

assumptions.

The supporter of Ricardian theory argued that all the restrictive assumptions of the comparative cost theory could

be relaxed and make the theory practical in the real world situation where each country specialises in the

production of those goods and services in which it has comparative cost advantage under the changing

conditions.

The doctrine of comparative advantage inspite of its limitations, has remained as the basic principle of

international trade. Today when the world is moving towards greater liberalisation and globalisation, each country

specialises in the production of goods and services on the basis of comparative cost advantage and enters intc

international trade. Each country attempts to lower its cost of production of internationally traded goods .to get an

advantage in the global market. Therefore, it could be argued that Ricardian explanation of the basis of

international trade is valid and applicable to the real world.

Conclusion

On the basis of competitive cost advantage, countries can enter into international trade. Each country attempts to

lower its cost of production of internationally traded goods to get in advantage in the global market.

So Ricardian explanation of basic of international trade is valid and applicable to the real world situation.

What determines comparative advantage?

Comparative advantage is a dynamic concept. It can and does change over time. Some businessesfind they have enjoyed a comparative advantage in one product for several years only to faceincreasing competition as rival producers from other countries enter their markets.

For a country, the following factors are important in determining the relative costs of production:

The quantity and quality of factors of production available (e.g. the size and efficiency ofthe available labour force and the productivity of the existing stock of capital inputs). If aneconomy can improve the quality of its labour force and increase the stock of capitalavailable it can expand the productive potential in industries in which it has an advantage.

Investment in research & development (important in industries where patents give somefirms significant market advantage) - for more information on this have a look atthis page
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Movements in the exchange rate. An appreciation of the exchange rate can cause exportsfrom a country to increase in price. This makes them less competitive in internationalmarkets.

Long-term rates of inflation compared to other countries. For example if average inflationin Country X is 4% whilst in Country B it is 8% over a number of years, the goods andservices produced by Country X will become relatively more expensive over time. This

worsens their competitiveness and causes a switch in comparative advantage. Import controls such as tariffs and quotas that can be used to create an artificial

comparative advantage for a country's domestic producers- although most countries agreeto abide by international trade agreements.

Non-price competitiveness of producers (e.g. product design, reliability, quality of after-sales support)

Gains from Trade :The Theory

of Compa rati ve Advan tageThe theory of comparative advantage was originally advanced by the19th-centuryeconomist David Ricardo as an explanation for why nations

trade with one another.The theory claims that economic well-being is

enhanced if each countrys citizens pro-duce that which they have acomparative advantage in producing relative to the citi-zens of other

countries, and then trade products. Underlying the theory are

theassumptions of free trade between nations and that the factors of

production (land,buildings, labor, technology, and capital) are relatively

immobile. Consider the exam-ple described in Exhibit A.1 as a vehicle

for explaining the theory.Exhibit A.1 assumes two countries, Aand B,which each produce only food and tex-tiles, but they do not trade with

one another. Country Aand B each have 60,000,000units of input. Each

country presently allocates 40,000,000 units to the production of food and

20,000,000 units to the production of textiles. Examination of the

exhibitshows that Country Acan produce five pounds of food with oneunit of production orthree yards of textiles. Country B has an absolute

advantage over Country Ain the pro-duction of both food and textiles.

Country B can produce 15 pounds of food or fouryards of textiles with

one unit of production. When all units of production are em-ployed,Country Acan produce 200,000,000 pounds of food and 60,000,000 yardsof textiles. Country B can produce 600,000,000 pounds of food and

80,000,000 yards of textiles. Total output is 800,000,000 pounds of food

and 140,000,000 yards of textiles.Without trade, each nations citizens

can consume only what they produce.While it is clear from the

examination of Exhibit A.1 that Country B has an absoluteadvantage in

the production of food and textiles, it is not so clear that Country A(B)hasa relative advantage over Country B (A) in producing textiles (food).

Note that inusing units of production, Country Acan tradeoff one unit


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of production needed toproduce five pounds of food for three yards of

textiles. Thus, a yard of textiles has an opportunity cost

of 5/3

1.67 pounds of food, or a pound of food has an opportunitycost of 3/5

.60 yards of textiles. Analogously, Country B has an opportunity cost

of 15/4

3.75 pounds of food per yard of textiles, or 4/15

.27 yards of textiles perpound of food. When viewed in terms of

opportunity costs it is clear that Country Aisrelatively more efficient in

producing textiles and Country B is relatively more effi-cient in

producing food. That is, Country As(Bs) opportunity cost for producingtex-tiles (food) is less than Country Bs(As). A

relative efficiency that shows up via alower opportunity cost is referred to as a comparative

advantage.Exhibit A.2 shows that when there are no restrictions or

impediments to free trade,such as import quotas, import tariffs, or costlytransportation, the economic well-beingof the citizens of both countries is

enhanced through trade. Exhibit A.2 shows thatCountry Ahas shifted

20,000,000 units from the production of food to the productionof textileswhere it has a comparative advantage and that Country B has

shifted10,000,000 units from the production of textiles to the production

of food where it hasa comparative advantage. Total output is now850,000,000 pounds of food and160,000,000 yards of textiles. Suppose

that Country Aand Country B agree on a priceof 2.50 pounds of food

for one yard of textiles, and that Country Asells Country

B50,000,000 yards of textiles for 125,000,000 pounds of food. With free

trade, ExhibitA.2 makes it clear that the citizens of each country have

increased their consumptionof food by 25,000,000 pounds and textiles by10,000,000 yards.


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Following are the important limitations of

Ricardian Comparative Cost Theory.

1. Restrictive Model

Ricardo's Theory is based on only two countries and only two commodities. But international trade is among

many countries with many commodities.

2. Labour Theory of Value

Value of goods is expressed in terms of labour content. Labour Theory of value developed by classical

economists has too many limitations and thus is not applicable to the reality.

Value of goods and services in the real world is expressed in money i.e. the prices are the values expressed in

units of money.

3. Full employment

The assumption of full employment helps the theory to explain trade on the basis of comparative advantage. The

reality is far from full employment. Cost of production, even in terms of labour, may change as the countries, atdifferent levels of employment move towards full employment.

4. Ignore transport cost

Another serious defect is that the transport costs are not consider in determining comparative cost differences.

5. Demand is ignored

The Ricardian theory concentrates on the supply of goods. Each country specialises in the production of the

commodity based on its comparative advantage. The theory explains international trade in terms of supply and

takes demand for granted.

6. Mobility of factor of production

As against the assumptions of perfect immobility between the countries, we witness difficulties in the mobility of

labour and capital within a country itself. At the same time their mobility between nations was never totally

absent.


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7. No Free Trade

Ricardian theory assumes free trade i.e. no restriction on the movement of goods between the countries. Thoughit is unrealistic to assume not to have any restriction. what the real world witnesses is a lot tariff and non-tariff

barriers on international trade. Poor countries find it difficult to enjoy the comparative advantage in the production

of labour intensive commodities due to the protectionist policies followed by developed countries.

8. Complete specialisation

The comparative advantage theory comes to conclusion of complete specialisation. In the Ricardian example,

England is specialising fully on cloth and Portugal on wine. Such complete specialisation is unrealistic even in

two countries and two commodities model. It is possible if two countries happens to be almost identical in size

and demand. Again, a complete specialisation in the production of less important commodity is not possible due

to insufficient demand for it.

9. Static Theory

The modern economy is dynamic and the comparative cost theory is based on the assumptions of static theory. It

assumes fixed quantity of resources. It does not consider the effect of growth.

10. Not applicable to developing countries

Ricardian theory is not applicable to developing countries as these countries are nowhere near to full

employment. They are in the process of change in quality of their labour force, quality of capital, technology,

tapping of new resources etc. In other words developing countries exhibit all the characteristics of dynamic

economy.

11. Constant Returns to Scale

Another drawback of the Ricardian principle of comparative costs is that assumes constant Returns to scale and

thus constant cost of production in both the countries. The doctrine holds that if England specialises in cloth;

there is no reason why it should produce wine. Similarly if Portugal has a comparative advantage in producing

wine, it will not produce cloth; but import all cloth from England. If we examine the pattern of international trade in

practice, we find it is not so. A time will come when it will not be reasonable for Portugal to import cloth from

England because of increasing cost of production. Moreover, in actual practice a country produces a particular

commodity and also imports a part of it. This phenomenon has not been explained by the theory of comparative

costs.

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Comparitive Advantage Theory Full