IIMS ASSMNT

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Demand

Demand is defined as the quantity of a good or service that consumers are willing and able to

buy at a given price in a given time period. Each of us has an individual demand for

particular goods and services and the level of demand at each market price reflects the value that

consumers place on a product and their expected satisfaction gained from purchase andconsumption.

The Factors of demand

The demand function can be written as

D = f (Pn, Pn«Pn-1, Y, T, P, E) Where:Pn = Price of the good itself

Pn«Pn-1 = Prices of other goods ± e.g. prices of Substitutes and Complements

Y = Consumer incomes ± including both the level and distribution of income

T = Tastes and preferences of consumers

P = The level and age-structure of the population

E = Price expectations of consumers for future time periods

Production Function

Let us begin with the production function, a function summarizing the process of conversion of

factors into a particular commodity. We might propose a production function for a good y of thefollowing general form, first proposed by Philip Wicksteed (1894):

y = (x1, x2, ..., xm)which relates a single output y to a series of factors of production x1, x2, ..., xm. Note that in

writing production functions in this form, we are excluding joint production, i.e. that a particular process of production yields more than one output (e.g. the production of wheat grain oftenyields a co-product, straw; the production of omelettes yields the co-product broken egg shells).

Using Ragnar Frisch's (1965) terms, we are concentrating on "single-ware" rather than "multi-ware" production.

Marginal Productivity

The assumptions given earlier imply that, for any given production function y = (x1, x2, .., xm), it is a generally the case that, at least up to some maximum point:

y/xi = i 0



for all factor inputs i = 1, 2, ..., m. In other words, adding more units of any factor input willincrease output (or at least not reduce it). This is the heart of assumption (A.3). However , it is

also common in Neoclassical theory to also impose (A.5) , i.e. to assume "quasi-concavity" of the production function. It is often the case in economics that the quasi-concavity assumption

implies that:

2

y/xi

2

= ii < 0for all i = 1, .., m, i.e. diminishing marginal productivity of ith factor.It is worthwhile to spend a few moments on the diminishing marginal productivity assumption.

This means more we add of a particular factor input , all others f actors remaining const ant , theless the employment of an additional unit of that factor input contributes to output as a whole.

This concept performs the same function in production functions as diminishing marginal utilitydid in utility functions. Conceptually, however , they are quite distinct.

(i) The Law of Diminishing Returns

The idea of diminishing marginal productivity was simultaneously introduced for applications of

factors to a fixed plot of land by T.R. Malthus (1815),

Robert Torrens (1815),

Edward West (1815) and David Ricardo (1815). It was applied more generally to other factors of production by

proto-marginalists such as J.H. von Thünen (1826), Mountiford Longfield (1834) and HeinrichMangoldt (1863). The apotheosis of the concept is found in the work of John Bates Clark (1889,

1891, 1899) and, more precisely, in Philip H. Wicksteed (1894). It was originally called the" Law of Diminishing Returns", although in order to keep this distinct from the idea of decreasing

returns to scale, we shall refer to it henceforth as the " Law of Diminshing M arginal Productivity"Let us first be clear about the definition of the marginal productivity of a factor. Letting xi

denote a unit increase in factor xi, then the marginal product of that factor is y/xi, i.e. thechange in output arising from an increase in factor i by a unit. Mathematically, however , it is

more convenient to assume that x is infinitesimal. This permits us to express the marginal product of the factor x

ias the first partial derivative of the production function with respect to

that factor -- thus the marginal product of the ith factor is simply y/xi = i. If we do not wishto assume that factor units are infinitely divisible or if we do not assume that the production

function is differentiable, we cannot express the marginal product mathematically as a derivative.[We should note that both Carl Menger (1871) and John A. Hobson (1900, 1911) defined

"marginal product" differently: rather than being the output gained by an enterprise from theaddition of a factor unit, Hobson defined it as the output l ost by the enterprise by the withdrawal

of a factor unit. This caused a problem for the "adding up" issue in the marginal productivitytheory of distribution, although, as was clarified later , when marginal product is not defined so

discretely, it does not make a difference which measure we use. For a useful discussion of thedilemma involving the measurement of the "marginal unit", see the discussion in Fritz Machlup

(1937). Finally, we must note that a far more novel and interesting definition of marginal productivity was introduced by Joseph M. Ostroy (1980, 1984) where the concept is redefined in

terms of contributions to tradeable surpluses, and thus both widened and deepened in scope.]However , assuming marginal products exist and are well defined, then why diminishing? Taking

Clark's famous analogy:"Put one man only on a square mile of prairie , and he will get a rich return. Two laborers on the

same ground will get less per man; and, if you enlarge the force to ten, the last man will perhapsget wages only."



(J.B. Clark , 1890: p.304.)The implication, then, is that as we increase the amount of labor applied to a particular fixed

amount of land, each additional unit will increase total output but by small er and small er increments. When the field is empty, the first laborer has absolutely free range and produces as

much as his body can reasonably do, say ten bushels of corn. When you add a second laborer to

the same field,

total output may increase,

say to eighteen bushels of corn. Thus,

the marginal product is eight.Why? The basic idea is that by adding the second man, the field gets "crowded" and the men

begin to get in each other's way. If that explanation does not seem credible, think of the units of labor in terms of labor-hours for a single man: in the first hour , a particular man produces ten; in

the second hour he produces eight, etc. The diminution can be explained in this case as an"exhaustion" effect.

Taking another example, suppose we apply a man to a set of shoe-making tools and a givenswathe of leather; let us say he can produce ten pairs of shoes in a day. Add a second man to this

without adding more shoe-making tools or increasing the leather , and one can easily envisagethat more shoes get made in a day, but that the work of the shoe-makers slows down as they pick

up the same tools in an alternating sequence of turns and perhaps fight over them a bit.For other factors, different stories are told. In Ricardo's original story, the land is subject to

diminishing marginal returns because of the assumption that land has different degrees of fertility and the most fertile acres are used first, and the less fertile ones added later. We can

conceive this more simply in that increasing the amount of land without increasing the amount of labor that works on it will lead to less output per worker.

However it is justified, many Neoclassical theorists basically accept diminishing marginal productivity a s an axiom - "the diminishing marginal productivity of labor , when it is used in

connection with a fixed amount of capital, is a universal phenomenon. This fact shows itself inany economy, primitive or social." (Clark , 1899: p.49). However much early economists tried to

claim it to be a natural law, this "axiom" turns out to be closer to a rather debatable assumption(cf. Karl Menger , 1954).

Nonetheless, it is important to clearly note a few matters in relation to this. Firstly, the idea thatmarginal product is always diminishing can be disputed (and will be disputed). Francis A.

Walker (1891) took J.B. Clark to task for not recognizing the possibility of increasing marginal productivity (albeit, see Clark (1899: p.164)).

Secondly, as Pareto (1896, 1902) was quick to point out, it is not always true that if one adds aunit of a factor to an existing production process, output will increase. "If a pit has to be dug, the

addition of one more man will make little difference to the day's output unless you give the mana spade" (Cassel, 1918: p.179). This difficulty is even more clear if we see the problem in terms

of the marginal product of capital: if a pit has to be dug, the addition of one more spade willmake no difference to output unless you add a man to use it. Thus, one must be very careful

when pronouncing the idea of marginal productivity since we may need to produce in fixed , constant factor proportions.

Thirdly, it is important to underline that the marginal product is not, properly speaking, thecontribution of the marginal unit by itsel f . Some commentators (e.g. E.v. Böhm-Bawerk , 19??;

cf. Robertson, 1931) seem to have gone on to make arguments that seem to imply , in the contextof our example, that the second man produces eight bushels of corn. Of course, this is not

necessarily true. The second man may very well produce nine or ten or eleven and still the totaloutput increases only to eighteen because the first man reduces his output to nine, or eight or



seven in the presence of the second. In our example, output increases from ten bushels toeighteen bushels when one adds the second man not because the second man only adds eight , but

rather because his presence on the field makes the situation such that the total output of both menis eighteen. Notice that the contribution per man is reduced: the average product is actually nine.

This may very well be how much each of the two laborers contributes. But this is not what

interests us: what we wish to note is that byadding the second man

,

output was increased byeight . Thus, the marginal product of the second man is eight. But his actual contribution may bevery different than this.

Finally, and above everything, it is very important to note that in deriving the marginal productof a factor , we are holding all other f actors fi xed . Specifically, in our earlier example, labor

varied and land (and indeed all other factors) was fixed. Thus, diminishing marginal productivityhas nothing to do with "returns to scale", i.e. the increase in output when we increase all factors.

If we increased both land and labor in our example, then there might very well be no reduction inoutput per man (indeed, there is actually no reason for it, but we shall return to this later).

(ii) The Law of Variable Proportions

Marginal productivity is not obvious in the production function Y = (L, K) in Figure 2.1 as

both inputs are varying there. We must first fix one of the factors and let the other factor vary.This is shown in Figure 2.2, by the "reduced" production function Y = (L, K 0), where only

labor (L) varies while capital is held fixed at K 0. To obtain this from the former , we mustfiguratively "slice" the hill in Figure 2.1 vertically at the level K 0. Thus, Figure 2.2, which

represents the reduced production function Y = (L, K 0), is a vertical section of the hill inFigure 2.1. A reduced production function where all factors but one are held constant are often

referred to as the "tot al product " curve.

Figure 1 - Total Product Curve



The total product curve in Figure 1 can be read in conjunction with the average and marginal

product curves in Figure 2. The total product curve is originally due to Frank H. Knight (1921: p.100), and much of the subsequent analysis is due to him and John M. Cassels (1936). Although

both these sets of curves have long been implicit in much earlier discussions (e.g. Edgeworth,

1911),

average and marginal products were confused by early Neoclassicals with surprisingfrequency. The particular shape of the total product curve shown in Figure 1 exhibits what has been baptized by John M. Cassels (1936) as the Law of V ariabl e Proportions -- effectively what

Ragnar Frisch (1965: p.120) quirkily renamed the ul tr a- pa ssum law of production.The marginal product of the factor L is given by the sl ope of the total product curve, thus MPL =

Y/ L = d (L, K 0)/dL. As we see, at low levels of L up to L2 in Figure 1, we have rising marginal productivity of the factor. At levels of L above L2 we have diminishing marginal

productivity of that factor. Thus, marginal productivity of L reaches its maximum at L2. We canthus trace out a marginal product of L curve, MPL, in Figure 2. The labels there correspond to

those of Figure 1. Thus the MPL curve in Figure 2 rises until the inflection point L2, and fallsafter it. It becomes negative after L5 - which would be equivalent to the "top" of the reduced

production function,

what Frisch (1965: p.89) calls a "strangulation point". A negative marginal product is akin to a situation when one adds the fiftieth worker to a field whose only

accomplishment is to get in everyone else's way - and thus does not increase output at all butactually reduces it.

The slope of the different r a ys through the origin (O1, O2, O3, etc.) in Figure 1 reflect aver a ge products of the factor L, i.e. APL = Y/L. The steeper the ray, the higher the average product.

Thus, at low levels of output such as Y1, the average product represented by the slope of O1 israther low, while at some levels of output such as Y3, the average product (here the slope of O3)

is much higher. Indeed, as we can see, average product is at its highest at Y3, what is sometimescalled the e xtensive margin of production. Notice that at Y2 and Y4 we have the same average

product (i.e. the ray O2 passes through both points). The average product curve APL corresponding to Figure 2.2 is also drawn in Figure 2.



Figure 2 -Marginal Product and Average Product curves

As we can see in Figure 1, the slope of the total product curve is equal to the slope of the ray

from the origin at L3, thus average product and marginal product are equal at this point (as shownin Figure 2). We also know that as the ray from the origin associated with L3 is the highest, thus

average product curve intersects the marginal product curve, MPL = APL, exactly where theaverage product curve is at its maximum. Notice that at values below L3, MPL > APL, marginal

product is greater than average product whereas above L3, we have the reverse, MPL < APL.

BREAK EVEN ANALYSIS

The Break-even Point

is, in general, the pointat which the gains equal

the losses. A break- even point defines when

investment willgenerate a positive

return. The point wheresales or revenues equal

expenses. Or also the point where total



equal total revenues. There is no profit made or loss incurred at the break-even point. This isimportant for anyone that manages a business, since the break-even point is the lower limit of

profit when prices are set and margins are determined.

Achieving Break-even today does not return the losses occurred in the past. Also it does not

build up a reserve for future losses. And finally it does not provide a return on your investment(the reward for exposure to risk).

The Break-even method can be applied to a product , an investment, or the entire company'soperations and is also used in the options world. In options , the Break-even Point is the market

price that a stock must reach for option buyers to avoid a loss if they exercise. For a Call, it is thestrike price plus the premium paid. For a Put, it is the strike price minus the premium paid.

Benefits of Break-even Analysis

The main advantage of break-even analysis is that it explains the relationship between cost ,

production volume and returns. It can be extended to show how changes in fixed cost-variablecost relationships, in commodity prices, or in revenues, will affect profit levels and break-even points. Break-even analysis is most useful when used with partial budgeting or capital budgeting

techniques. The major benefit to using break-even analysis is that it indicates the lowest amountof business activity necessary to prevent losses.

Limitations of break-even analysis

y It is best suited to the analysis of one product at a time;y It may be difficult to classify a cost as all variable or all fixed; and

y analysis after the cost and income functions have changed.

Theory of Cost

Short run cost and Long run Cost :

In economic theory, a distinction is made between short run and long run. By short run we mean a time

period during which all factors of production are not variable. On the other hand by long run we mean a

time period during which all factors are variable. Hence, it is assumed that the short run cost has two

components±fixed cost and variable cost. But in the long run all costs are variable costs. All factors arevariable in the long run and hence there is no fixed cost in the long run. For example , plant size is fixed in

the short run. The level of output is changed in the short run by changing the degree of utilisation of the plant. But in the long run, the plant size can be varied. As all factors are variable is the long run and asthey can be adjusted to their optimum levels, the long run cost cannot exceed the short run cost.

Short run costs are relevant when the firm has to decide whether to produce more in the immediate future , keeping the plant size unchanged. On the other hand, long run costs become relevant when the firm has to

decide whether to set up a new plant.



Shape of Long run Average Cost Curve or, Derivation of Long run Average Cost Curve :

We can get long run average cost curve from the short run average cost curves. Let us see how we can get

it. We know that the long run is an aggregation of some short periods. For each short period, we have a

short run average cost curve. Suppose that our long run consists of three short periods.

In our figure 5.8,

we have drawn three short run average cost curves± SAC1,

SAC2 and SAC3. From thefigure it is seen that for output level less than OM1, SAC1 < SAC1 < SAC2. For output level greater than

OM1 but less then OM2, SAC2 < SAC3. For output level greater than OM2, SAC3 < SAC2. Eachaverage cost curve represents a given plant size. In the long run, The firm can vary the plant size.

So, to produce a given level of output, the firm will build up a suitable plant size which will produce that

output at the minimum possible cost. Hence, the long run average cost curve will be formed by taking the portions of SAC1 upto P1, of SAC2 from P1 to P2 and the right portion of SAC3 beyond P2. In other words, the bold portions of the three SAC curves will form the long run average cost curve.

Now, if we assume that there is an infinite number of plant sizes , the Each point of the LAC curve will bea point on a short run average cost curve. The LAC curve will be the envelope of the SAC curves (LAC <

SAC). WE have shown this in figure 5.9. In this figure,

SAC1,

SAC2,

SAC3 etc. are the short run averagecost curves and LAC is the long run average cost curve. It is tangent to each SAC curve at some point.When the level of output is OM, the LAC is minimum and it is tangent to the minimum point of the curveSAC3. To the left of it, the LAC curve is tangent to the falling portions of the SAC curves. To the right of

P, the LAC curve is tangent to the rising portions of the SAC curves. We see that the LAC curve is U-

shaped i.e., it first falls, reaches a minimum and then rises. This U-shape of the LAC curve is due to theoperation of the law of returns to scale.



The falling portion of the LAC curve is due to increasing returns to scale and the rising portion is due to

decreasing returns to scale. Point P shows the appearance and disappearance of constant returns to scale.To the left of P, internal economies are greater than internal diseconomies and there are net internal

economies. That is why LAC falls upto P. To the right of P, internal economies are less SAC than internaldiseconomies LAC and there are net internal LMC diseconomies. Hence, LAC rises beyond P. At P all

the internal economies are reaped or enjoyed. Hence, point P is called the optimum point and OM is

called the optimum size of the firm.

It should be noted that though the LAC curve is U-shaped, its U-shape will not be so pronounced as theshort run average cost curves. Since the LAC curve contains all the SAC curves, it will be flatter than the

SAC curves.

We should further note that if the LAC curve is U-shaped , it cannot pass through the minimum points of

all the SAC curves. It passes through the minimum point of only one of the SAC curves. The LAC curve

can pass through the minimum points of all the SAC curves if we assume that there are constant returns toscale in the production process. In that case, as the scale of the production process changes the SAC shifts

but their minimum points lie on a horizontal straight line. This straight line will be the LAC curve. This isshown in figure 5.10. Here our LAC curve is a horizontal straight line. The LAC curve will be of this

shape if the production function is homogeneous of degree one i.e., subject to constant returns to scale.Here LAC will coincide with LMC, and LTC will be a straight line passing through the origin.

THE MEANING OF NATIONAL INCOME

The total income of the nation is called ³national income´. The aggregate economic performanceof the whole economy is measured by the national income data. In fact, national income data

provide a summary statement of a country¶s aggregate economic activity.

In real terms, national income is the flow of goods and services produced in an economy in a

year or a particular period of time.

In national income accounting, the concept of national income has been interpreted in three ways

: (1) National Product, (2) National Dividend, (3) National Expenditure.



METHODS OF ESTIMATING NATIONAL INCOME

In national income estimates, by definition, we have to count all those goods and services

produced in the country and exchanged against money during a year. Thus, whatever is producedis either used for consumption or for saving. Thus, national output can be computed at any of

three levels,

viz.,

production,

distribution and expenditure. Accordingly,

we have three methodsof estimating national income : (i) the census of products methods, (ii) the cense of income

method, and (iii) the expenditure method.

The Census of ProductsMethods or OutputMethod

This method measures the output of the country. It is called the inventory method. Under thismethod, from the census of production, the gross value of output in different sectors like

agriculture, industry, trade and commerce, etc., is obtained for the entire economy during a year.The value so obtained is actually the GNP at market prices.

In using this method,

it is necessary to take utmost care to avoid double counting. Economistshave suggested two alternative approaches to avoid the possibility of double counting in the

measurement of GNP, viz., (i) the final goods method, and (ii) the value added method.

1. The Final Goods Method : In this method of estimating GNP, only the final values of

goods and services are computed ignoring all intermediate transactions. Intermediate goodsare involved in the process of producing final goods -- the final flow of output purchased

by consumers. Thus, the value of final output includes the value of intermediate products.Hence, to avoid double-counting, only final values relating to final demand of the

consumers should be reckoned. For example, the price of bread incorporates the cost of wheat, flour , etc. Here, wheat and flour are both intermediate products and are not treated

as the final consumer¶s demand. Their values are paid up during the process of production.In the value of final product, bread, the values of these intermediate goods are hidden.

Hence, a separate accounting of the values of intermediate goods, along with theaccounting of the value of final product, would mean double-counting. To avoid this, the

computation of value of only the final product has been suggested.

2. The Value Added Method : In the ³value added´ method a summation of the increase in

value (the value added), at each separate production stage, leading to output in final form, gives the value of GNP.

To avoid double-counting of intermediate goods, one must carefully estimate the value added at

each stage of the production process. From the total value created at a given stage,

we shouldthus subtract all the costs of materials and intermediate goods not produced in that stage. Or , thevalue of inputs, at a given stage, should be deducted from the value of output. Even the value of

inputs purchased from other firm or sectors should be subtracted. In short , GNP is obtained asthe sum total of values added by all the different stages of the production process till final output

is reached in the hands of consumers to meet the final demand.

Census of IncomeMethod



In this method, the total of all money incomes such as wages, salaries, rent, profit received by persons and enterprises in the country during the year are totalled up. In practice, income figures

are obtainable mostly from income-tax returns, books of accounts, reports, published accounts aswell as estimates for small income.

The following classification of incomes is considered as comprehensive (a) Wages and salaries,

(b) Supplemental labour income (Social security, etc.) (c) Earnings of self-employed or

professional incomes, (d) Dividends, (e) Undistributed profits, (f) Interest, (g) Rent and (h) Profitof state enterprises. However , transfer payments like gifts, subsidies, etc. are to be deducted from

the total of factor income. Thus, National Income is equal to the factor incomes minus transfer payments.

This method is also called the Factor Cost Method. Thus, the national income of a country, atfactor cost, is equivalent to the sum total of the disbursements of their (factors) income. To this,

net income accrued from the Foreign Sector is added ± i.e. net differences between exports andimports as well as net income from aboard. The symbolic expression of this method is as follows

:

Y= § (w + r + i + T) + [(X ± M) + (R ± P)], where

w = wages, r = rent, i = interest, T = profits.

However , certain precautions are necessary while following this method :

1. All transfer payments (government and personal) which do not represent earnings from

productive services, such as social security benefits like unemployment allowances, pension, charity, personal gifts, etc., are not be included. Similarly, earnings from

gambling,

lottery prize-winning,

etc.,

being transfer incomes,

are to be excluded. Likewise,

scholarships received by students are also transfer incomes and hence should not be

included.

2. All unpaid services (like services of a housewife) are to be excluded. Thus , only those

services for which payments are made should be included.

3. Financial investments such as equity shares, etc. and sales of on property (including land)

are to be excluded, as they do not and anything to the real national income. Thus, allcapital gains and losses which are related to wealth, but nor real income, should excluded.

4. Direct tax revenue to the government should be subtracted from the total income as it isonly a transfer of income. Or else, it should not reckoned at all.

5. Similarly, government subsidies should be deducted from profit of the subsidisedindustries.

6. Add undistributed profit of companies, income from government property, and profits from public enterprises.



In India, the National Income Committee used the income method adding up the net incomearising from trade, transport, public administration, professional and liberalists, and domestic

services. Since, under India conditions, due to lack of popularity of personal accounting practices, it is difficult to ascertain the personal income of individuals, the use of income method

is not practicable.

The Bowley-Robertson Committee had suggested the adoption of Census of Products Method for

major sectors of India, and the Census of Income Method for some minor sectors, while the National Income Committee relied mainly upon the Census of Income Method. However , none

of above methods alone is perfect. Therefore, a combination of this method will give a morecorrect perspective of the estimate. Hence, the CSO use combined process of the two methods to

a better result.

The expenditure or OutlayMethod

National income on the expenditure side is equal to the value of consumption plus investment. In

this method we have to : (i) estimate private and public expenditure on consumer good andservices, (ii) add the value of investment in fixed capital and stocks, with due consideration for net positive or negative inventories, and (iii) add the value of exports and deduct the value of

imports.

To express it is symbolic terms,

Y= § (C+I +G) + [(X ± M) + (R ± P)],

where

C = Consumption expenditure,

I = Investment expenditure,

and

G= Government purchases.

THE THEORY OF COMPARATIVE ADVANTAGES

(The Classical Theory of International Trade)

The classical theory of international trade is popularly known as the Theory of ComparativeCosts or Advantage. It was formulated by david Ricardo in 1815.

The classical approach, in terms of comparative cost advantage, as presented by Ricardo basically seeks to explain how and why countries gain by trading.

The idea of comparative costs advantage is drawn in view of deficiencies observed by Ricardo inAdam Smith¶s principles of absolute cost advantage in explaining territorial specialisation as a

basis for international trade.



Being dissatisfied with the application of classical labour theory of value in the case of foreigntrade, Ricardo developed a theory of comparative cost advantage to explain the basis of

international trade as under:

Ricardo¶s Theorem

Ricardo stated a theorem that, other things being equal, a country tends to things being equal, acountry tends to specialize in and export those commodities in the production of which it has

maximum comparative disadvantage. Similarly, the country¶s imports will be of goods havingrelatively less comparative cost advantage or greater disadvantage.

The RicardianModel

To explain his theory of comparative costs advantage, Ricardo constructed a two-country, two-

commodity, but one factor model with the following assumptions:

1. Labour is the only productive factor.

2. Costs of production are measured in terms of the labour units involved.

3. Labour is perfectly mobile within a country but immobile internationally.

4. Labour is homogeneous.

5. There is unrestricted or free trade.

6. There are constant return to scale.

7. There is full employment equilibrium.

8. There is perfect competition.

Under these assumptions, let us assume that there are two countries A and B and two goods X

and Y to be produced.

Now, to illustrate and elucidate comparative cost difference, let us take some hypothetical data

and examine them as follows.

Absolute Cost Difference

As Adam Smith pointed out, if there is an absolute cost difference, country will specialise in the production of a commodity having an absolute advantage (see Table 1).



It follows country A has an absolute advantage over Bin the Production Of X while B has anabsolute advantage in producing Y. As such, when trade takes place, A specialiscs in X and

exports its surplus to B and B specialises in Y and exports its surplus to A.

Equal Cost Difference

Ricardo argues that if there is equal cost difference, it is not advantageous for trade and

specialises for any country in consideration (see table 2).



On account of equal cost difference, the comparative cost ratio is the same for both the countries,

so there no reason for undertaking specialisation. Hence,

the trade between two countries will nottake place.

Comparative Cost Difference

Ricardo emphasizes that under all condition, it is the comparative cost advantage which lies atthe root of specialisation and trade (see Table 22.3).

It will be seen that country A has an absolute cost advantage in both the commodities X and Y.However , possesses a comparative cost advantage in producing X. For , comparatively, country

A¶s labour cost involved in producing 1 unlit of X is only 66 per cent of B¶s labour cost

involved in producing X,

as against that of 80 per cent the case of Y.

On the other hand, country B has least comparative disadvantage in production of Y , though she

has absolute cost disadvantage in both X and Y.

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 Y in our example). To state in algebraic terms:

If in country A, the labour cost of commodity X is Xa and that of is Ya, and in B, it is Xb and Yb

respectively, then absolute differences in cost can be expressed as:

Xa/Xb < 1 Ya/Yb

(which means that country A has an absolute advantage over country B in commodity X andcountry B has over A in commodity Y). And, comparative differences in costs are expressed as:

Xa/Xb < Ya/Yb <1



(which implies that country A possesses an advantage over B in both X and Y, but it has morecomparative advantage in X than in y). If , however , there is an equal cost difference, i.e., Xa/Xb

= Ya/Yb, there will be no international trade between the two countries.

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 Bin exchange for Y(i.e., import of Y from B). Correspondingly, since country B has least cost

Disadvantage in producing Y, she should specialise in yand export its surplus to A and import X.

Gain Attributes of International Trade

It further follows that when countries A and B enter into trade , both will gain. In the absence of trade, domestically in country A,1X = 0.5Y. Now, if after trade, assuming the terms of trade to

be 1X = 1Y, country Against 0.5 unit more. Similarly, in country B, 41X = 0.6 Y domestically, after trade, its gain is 0.4Y.

In short,

³each country can consume more by trading than in isolation with given amount of resources,´ 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 willgain .

In fact, the principle of comparative costs shows that it is possible for both the countries to gainfrom trade, even if one of them is more efficient than the other in all lines of production. T5he

theory implies that comparative costs are different in different countries because the abundanceof factors which may be necessary for the production of each commodity does not bear the same

relation to the demand for each commodity in different countries. Thus, specialisation based oncomparative cost advantage clearly represents a gain to the trading countries in so far as it

enables more of each variety of goods to be produced cheaply by utilising the abundant factorsfully in the country concerned and to obtain relatively cheaper goods through mutual

international exchange.

Ricardo¶s theory pleads the case for free trade. He stresses that free-trade is the pre-requisite of

gains and improvement of world¶s welfare, free trade ³by increasing the general mass of production diffuses general benefit and binds together by one common tie of interest and

intercourse, the universal society of nations throughout the civilized world.´

To sum up, what goods will be exchanged in international trade is the main question solved by

Ricardo¶s theory of comparative costs. The theory is lucidly summarized by Kindleberger as

follows:

³the basis for trade, so far as supply is concerned, is found in differences in comparative costs.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 inevery commodity a basis for trade exists. It will pay the country to produce more on the

assumption of full employment equilibrium condition for each of the trading countries. This isfar from being a reality in any reality in any country of the present world. Moreover , a poor



country is characterized by chromic unemployment, under-employment and ³disguised´unemployment.

4. In a planned developing Economy there is a regulation on Market Mechanism and Freecompetition: The principle of comparative costs assumes perfect competition. This is of course,

an unrealistic phenomenon throughout the world. In a developing economy,

where planning isadopted, a further blow is struck at the freely working price mechanism as assumed the doctrine.

5. A poor Country Y has not Perfect Mobility of Labour due to Market Imperfections: Further , the Ricardian theory assumes that labour is perfectly mobile within a region. This is not true for

any region whether it is developed or underdeveloped. However , due to market imperfections, transport bottle necks, ignorance, personal attachment and such other factors, labour is relatively

less mobile in an under developed country than in a developed country. As such, the theory hasleast applicability to poor countries.

6. Poor Countries have to be more and more Self-sufficient: Many poor countries also face

foreign exchange crises and adverse balance of payments; hence regulation of foreign trade(specially imports) becomes an economic necessity for them and as such they cannot acce0pt intoto the doctrine of comparative costs. These countries have to be more and more self-sufficient,

self-reliant and resort to import substitution rather than specialising merely in the production of primary products according to the comparative costs advantage principle.

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