Thus, with increases U.S.A. specialising in the production of wheat and India in cloth, through reallocation of labour between wheat and cloth, the total produc­tion will increase. In India one kg. When the U.S.A. and India specialise in wheat and cloth respectively and trade takes place between them, the U.S.A. will gain if it has to give less than can get more than 0.5 units of cloth from India for one unit of wheat and India will gain if it 1.33 units of cloth to the U.S.A. for import of one unit of wheat. This can be shown by superimpos­ing the opportunity cost curve CD of India over the opportunity cost of U.S.A., in such a way that point D is joined with point B of U.S.A. Let us make in-depth study of the critical appraisal and factors for the variation of comparative cost theory of international trade. This is because, he argued that given the same techno­logical development, the proportions in which other factors could be combined with labour would be the same. (i) According to the classical economists, there was need for a separate theory of international trade because international trade was fundamently different from internal trade. Likewise, 80 metres of cloth in U.S.A. has the opportunity cost of 60 kg. The opportunity cost of a commodity, say wheat, is amount of another commodity, say cloth, which a country has to give up to produce an additional unit of wheat. It will be much better if after compar­ing the costs of the various goods which it can produce it selects those in which the comparative costs are lower or in which it enjoys comparative advantage. But it will not produce all of them since it will simply not be paying to do so. Suppose, D’T’ is the terms of trade line showing the price ratio settled between the two countries. To sum up, bereft of the labour theory of value and expressed in terms of opportunity costs comparative cost theory is still a valid explanation of international trade. Incomplete theory: It is an incomplete theory. Similarly, a professor may be able to teach his own son who is reading in a lower class much better than any school teacher. A comparative advantage in trade is the advantage that one country has over another in the production of a particular good or service. Thus, specialisation, according to the comparative advantage, would lead to the increase in production of both wheat and cloth and the two countries would gain from trading with each other by exporting the goods in which they specialize. But it will not produce all of them since it will simply not be paying to do so. It may be noted that in case of constant opportunity costs, there is complete specialisation, that is, of the two goods a country produces only one commodity, that is, either wheat or cloth after specialisation and trade. Globalisation has led to increased variety for consumers. 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. Indeed, according to him, international trade is only a special case of inter-regional trade. On the other hand, as more factors of production are drawn from wheat for allocating them to the production of cloth, per unit cost of wheat falls. When production of cloth is expanded productive resources less suited to the production of cloth are drawn into that industry. A country can produce numerous goods. Content Guidelines 2. It may be mentioned here that Ohlin’s criticisms do not invalidate comparative cost theory. Indeed, structural changes are being brought about in these economies. Share Your PPT File, Aggregate Demand and Aggregate Supply with Flexible Price Level. 2. In the above analysis of opportunity cost version of the comparative cost theory we have assumed that opportunity costs are constant. Introduction Both comparative and absolute advantage are theories of international trade. Suppose the price-ratio line in the foreign market (or what is also called terms of trade line) is given by the price line tt in Figure 23.4. Theory of comparative cost which is the important doctrine of classical economics is still valid and widely acclaimed as the correct explanation of international trade. But if the hour that he devotes to the teaching of his son is devoted to coaching of a student for the degree examination, he will get much more payment than he has to pay a tutor whom he may employ for coaching his son. 5. It is indeed nothing more than an abbreviated account of the condition of supply”. This specialisation is very gainful. 6. It will be seen from this figure that slope of the price- ratio line tt indicates higher price for cloth and lower one for wheat as compared to domestic price-ratio line pp’ since according to tt more wheat can be ob­tained for a given amount of cloth. Therefore, it would be advantageous for India and U.S.A. to specialise in cloth and wheat re­spectively. According to Ricardo, if a country has an advantage over two products, it will have an absolute advantage over the one produced with better efficiency, and relative advantage over the one produced with less efficiency. Each individual compares the cost and the income of the various jobs that he could take up and of these he selects that one which is most profitable. Comparative theory states that the value of pr… Note that this criticism about the static character of the comparative cost theory does not invali­date it. On the other hand, India is less efficient in the production of both wheat and cloth, its inefficiency is comparatively less in cloth. Taussig tried to defend Ricardo by pointing out that even if labour theory of value was defective and even if other factors made important contributions to the production of goods, comparative costs could still be based on labour cost alone, if it is assumed that the trading countries are at the same stage of technological development. It is worth mentioning that specialisation necessitates trade or exchange of goods with other countries. How­ever, Ricardo argued that the two countries can still gain from specializing and trading between them if they produce according to their comparative advantage. But the pattern of international trade shows that this is far from reality. Suppose, with given resources, India can produce 20 kgs. Since U.S.A. has a comparative advantage in the production of wheat it will specialise in wheat and would produce OB or 60 units of wheat, whereas India has comparative advantage in the production of cloth and will specialise in cloth production. It is thus evident that the U.S.A. is more efficient in the production of both the commodities as it produces them at a lower labour cost than India. The work of dispensing can be done by a low-paid person, while he can earn much more as a doctor. Cost ratios in the two countries may become equal before either country completely specialises in the production of a single commodity. In a two-commodity world when one country can produce both of them at a lower cost than another, it will pay to it to specialise in the production of a commodity which it can produce at comparatively lower cost and import the other commodity for which it has a comparatively higher costs. In this way both countries are able to increase their level of consumption beyond what is possible in the absence of specialisation. According to this theory, the international trade between two countries is possible only if each of them has absolute or comparative cost advantage in the production of at least one commodity. Comparative advantage describes the economic reality of the work gains from trade for indiv However, Taussig’s defense of Ricardian version of comparative cost theory is poor and invalid. We shall explain what would be the basis of trade between these two countries and how the two would gain from specializing and trading with each other on the basis of comparative advantage or comparative cost. In the equilib­rium situation, the two goods would be produced in such quantities where: MRTCW stands for marginal rate of transformation between the two goods. That is, U.S.A. has an absolute advantage in the production of both the commodities. He pointed out that immobility of factors between countries could not serve as a basis for international trade, since immobility of factors is not peculiar the relations between countries but is also present between different regions of the same country. Disclaimer Copyright, Share Your Knowledge Our mission is to provide an online platform to help students to discuss anything and everything about Economics. However, it may be noted that even if the phenomenon of increasing costs is taken into account, foreign trade can still be explained in terms of differences in comparative costs. Let us illustrate the theory of comparative cost (or comparative advantage) with a numerical example. In Figure 23.4 suppose the price-ratio line between wheat and cloth, as determined by demand and supply conditions, is pp’. But this labour theory of value has been abandoned by the modern economists. The theory correctly explains the gain from trade accruing to the participating countries if they specialise ac­cording to their comparative costs. Indeed, every theory makes some such simplifying assumptions in order to bring out the economic forces that have an important bearing on the subject under investigation. The first one is that it allows us to consider both sources of com-parative advantage, technology and factor endowment—within a unifying yet highly tractable framework. On the other hand, if U.S.A. has a comparative advantage in the production of wheat, it will produce all wheat and no cloth. It is alleged that comparative cost theory is static in character as it is based on fixed supplies of factors of production, the given technology, and the fixed and identical production functions in the trading countries. Welcome to EconomicsDiscussion.net! Haberler and others broke away from this labour-cost version and reformulated the comparative cost theory in terms of opportunity costs which takes into consider­ation all factors. Its conclusions cannot therefore be applied in the context of a dynamic economy, especially in the present-day developing countries where resources are being developed, technology is being improved, production functions are undergoing a change. The various trading partners are not at the same stage of technological development and therefore the factor proportions used for the production of commodities in different countries are vastly dif­ferent. The domestic price-ratio (that is, the rate of which two goods would be exchanged in the absence of trade) are not determined by the production possibility curve alone. Content Guidelines 2. The factors of production are perfect… Theory of Comparative Costs of International Trade! Both the countries will be better off if the U.S.A. specialises in the production of wheat and exports it to India for import of cloth and India specialises in the production of cloth and exports it to the U.S.A. and import wheat from it. 23.1 where on the X-axis wheat and on the Y-axis cloth have been measured, Now, line AB repre­sents the production possibility curve in India between wheat and cloth. According to the international trade theory, even if a country has an absolute advantage over another, it can still benefit from specialization. It will be to the advantage of each country as well as of the world as a whole that each country specialises in the production of those commodities for which it has comparative advantage. Therefore, it is the total money costs incurred on labour as well as other factors that should be considered for assessing comparative costs of various commodities. Let us see how the two countries will gain if they specialise and trade on the lines of comparative advantage. 4. It will be seen from the slopes of the production possibility curves of the two countries that while India can produce cloth at the lower comparative cost, the U.S.A. can pro­duce wheat at a comparatively cheaper cost. The following criticisms have been leveled against this theory: 1. This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade. of wheat or 40 meters of cloth, whereas with the same resources, the U.S.A. can produce 60 kgs of wheat and 80 metres of cloth. Hence any exchange ratio between 0.5 and 1.33 units of cloth against one unit of wheat represents a gain for both the countries. is perhaps the most important concept in international trade theory. According to him, prices of different goods and their quantities produced and consumed depend on both supply and demand conditions. Now, the question is what will be the source of gain from specialisation in the present case. Thus, of the two commodities cloth and wheat, if India has a comparative advantage in the production of cloth, it will produce all cloth and no wheat. Labour is the only resource of production and prices of products are equal to their relative labour costs. Comparative advantage It can be argued that world output would increase when the principle of comparative advantage is applied by countries to determine what goods and services they should specialise in producing. Again, it does not necessarily mean that the most efficient country will always take the lead. Opportu­nity cost version of comparative costs theory does consider the case of increasing costs. International trade itself involves “two or more economic systems in an exchange of goods and services which transcend international boundaries” (Menipaz and Menipaz, 2011). Specialisation of IT in Silicon Valley – the US. If U.S.A. can trade with another country, say India, at a different price-ratio than this, it will then gain from the trade. at a lower relative marginal cost prior to trade. It will be much better if after comparing the costs of the various articles that it can produce, it selects those in which the comparative costs are lower or in which it enjoys relative advantage. Firms competing in the model of monopolistic competition and heavy branding. In case of cloth, to produce one unit of it 6 hours of labour are needed in the USA, while 9 hours are needed in India. Indeed, a country produces a certain commodity and also imports a part of it. The Chinese will pay less for a bicycle an… Internal trade is not exactly the same as the international trade. 2. In … Before publishing your Articles on this site, please read the following pages: 1. A country can produce many goods. Privacy Policy3. Modern theory of international trade differs from the classical comparative cost theory in many ways and is also superior to the latter. From these production possibilities we can calculate the opportunity cost of wheat and cloth in the two countries. This indicates as we shift resources from the production of wheat to the production of cloth, marginal opportunity cost of cloth (that is, the amount of wheat forgone for a unit of cloth) goes on increasing and vice versa. It is the relative differences in costs which determine the products to be produced by different countries. Comparative Advantage of International Trade. Instead, this domestic exchange rate is determined by the production possibilities (i.e. 2. For example, the world price of a bicycle will be between 5/3 shirt and 2 shirts, thereby decreasing the price the Italians pay for a shirt while allowing the Italians to profit. 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 further expressed the view that comparative cost doctrine applied not only to international trade but also to inter-regional trade. This is given in the Table 23.5. Taking two countries, two commodities model as used by Ricardo we give in table 23.3 labour requirements per unit of cloth and wheat in the U.S.A. and India. Political leaders are always under pressure from their local constituents to protect jobs from international competition by raising tariffs. Welcome to EconomicsDiscussion.net! These merits of the theory have led Professor Samuelson to remark, “If theories, like girls, could win beauty contents, comparative advantage would certainly rate high in that it is an elegantly logical structure.” He further writes, “the theory of comparative advantage has in it a most important glimpse of truth…. Comparative cost theory explained above is based upon labour theory of value. The two differ basically in many respects. This theory holds that there are benefits to be gained from importing as well as exporting. TOS4. It only pinpoints the need for reformulating and refining it so as to make it applicable to the dynamic conditions of the developing countries. This assumption of constant costs leads them to conclude that different countries would completely specialise in the production of a single product on the basis of their comparative costs. It is worthwhile to note that J.S. The theory of comparative advantage presented in this paper is attractive for two reasons. A country tends to specialise in the production of those goods for which it has got relative or comparative advantage. It will be seen from Fig. As this is an unresolved matter, it considerably limits … The English economist David Ricardo published in 1817 the book" Principles of Political Economy and Taxation n", work in which it raises its economic theory. Disclaimer Copyright, Share Your Knowledge Economists use the term comparative advantage when describing the opportunity cost of two producers. From these production possibilities, it follows that U.S.A. is more efficient in the production of both wheat and cloth. Comparative cost theory of international trade This theory is developed by a classical economist David Ricardo. Only in the situation of increasing costs, countries would not have complete specialisation. This is important not only for generalizing results How does the total joint output of the two countries increases if U.S.A. specialises in wheat for which it has comparative advantage and India in cloth for which it enjoys comparative advantage ? Even in his theory, popularly known as factor-proportions theory of international trade, comparative costs serve as a basis of international trade. Suppose R is such point on the terms of trade line D’T. 23.2 production possibility curve between wheat and cloth of India is CD. When resources are not equally efficient in the production of the two commodities we may have the situation of increasing costs. It will be seen from Table 23.3 and 23.4 that if U.S. A. reduces the production of cloth by one unit 6 man-hours of labour will be released and if these are used for the production of wheat it will gain 2 units of wheat production. The fundamental cause of international specialisation and hence international trade is the difference in costs of production. Share Your PDF File The credit of providing an adequate and valid answer to this question goes to Heckscher and Ohlin who explained that comparative costs of different commodities in the two countries vary because of the following factors: 1. The slope of the production possibility curve AB shows the com­parative cost ratio of the two commodities in U.S.A. In order to simplify our analysis, we make the following assumptions: 1. This video is all about the Comparative cost theory of international trade based on Neb’s Grade 12’s management students from their Economics subject. joint output of the two countries) will rise by 1 unit of wheat and 0.33 units of cloth as a result of the above shift of man-hours to the products of their comparative advantage. Considering the differences in costs of producing different goods, every country seems to be better suited for the production of certain goods rather than the others. 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 terms of trade which will be settled between the two will lie between the production possibility curve CD’ of India and the production possibility curve AB of U.S.A. Even though the U.S.A. is more efficient in the production of both wheat and cloth, she will still gain by having specialisation and trading with India. The principle of comparative advantage in international trade Comparative advantage is typically used with international trade to quantify the benefits of importing and exporting products from particular countries. 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