Comparative Cost Advantage Theory

Let us understand comparative cost theory. Let us quickly revise what is absolute cost advantage theory because on that basis you will understand what is comparative cost theory. So absolute cost advantage theory in that Adam Smith argued that international trade is beneficial for countries only if they enjoy absolute cost difference in production of commodity in which they specialize. So that was absolute cost advantage theory David Ricardo David Ricardo. He absolutely agreed with the absolute cost advantage theory. However, he argued that even though countries enjoy absolute cost advantage in production of both the commodities it is more beneficial to produce that commodities in which there is greater comparative cost advantage. So what David Ricardo is trying to say is that if a country is producing two commodities and it has comparative cost advantage in both the commodities then also that country should produce only that commodity in which it has greater comparative cost advantage. Okay, before we understand in detail about this theory, there are some assumptions of the Ricardo's theory. So let us understand that. The assumptions of Ricardo's theory. We just look at it one by one. Labor is the only factor of production, right? Here we are taking only labor as a factor of production and nothing more than that. Labor is completely mobile within the country but perfectly immobile between countries. That means laborers can move within the country but cannot move between countries means labor cannot move outside the country. Then perfect competition exists in commodity and factor markets. Now perfect competition just a quick way of making you understand what is perfect competition. So perfect competition is nothing but a situation prevailing in the market in which buyers and sellers are so numerous and well-informed that all the elements of monopoly are absent and the market price of the commodity is beyond the control of individual buyers and sellers. Okay, so it is nothing but opposite of monopoly, monopolistic market. Then technology is constant, transport cost is nil. These are all the assumptions of Ricardo's theory. Then trade between countries takes place on barter system. Okay, trade is free from restrictions meaning there are no trade barriers. Then trade takes place only between two countries and that too only for two commodities. So here in the process of trade, there are two countries that are involved and two commodities that are involved. Nothing, nothing more than that and full employment exists in the participating countries. Now, what do you mean by full employment? So full employment is nothing but a condition in which virtually all who are able and willing to work are employed. So this was about the assumption of Ricardo's theory. Now, this table is almost same like absolute cost advantage theory, but there is a difference, there is difference in numbers. So now let us understand comparative cost theory. Okay, so there are two commodities, spices and wheat. There are two countries that are involved, India and Japan. Okay, now in this table all the numbers are given as cost of production in labour units. So here what we understand is that to produce spice, India uses 20 labour units whereas Japan uses 40 labour units and in production of wheat India uses 40 labour units and Japan uses 50 labour units. Now here you one can see that India has comparative cost advantage in production of both the commodities that is spices and wheat. Why? Because in both spices and wheat the cost of production in labour units is less than Japan. But here now what David Ricardo is saying that instead of producing both the commodities, it would be more beneficial for the country to produce that commodity in which it enjoys greater comparative cost advantage. So here greater comparative cost advantage is in spices. How? Because the difference between spices in India and spices in Japan is more. Whereas in production of this commodity that is wheat, India uses 40 labour units and Japan uses 50 labour units, which is almost same, which is India uses almost 80% of what Japan uses. Whereas in production of spices India is using 50%, only 50% of what Japan is using. That is what is shown over here 50% and 80%. So India now will produce more of spices and export the excess to Japan. Whereas Japan has less comparative cost disadvantage, less comparative cost disadvantage in production of wheat. Because the difference is less. Though it has comparative cost disadvantage in both the commodities, it has less comparative cost disadvantage in production of wheat. Therefore, Japan will produce excess of wheat and export the surplus to India. So this is about the table. Once again, India is enjoying comparative cost advantage in production of both the commodities that is spices and wheat, both the commodities. But India is enjoying greater comparative cost advantage or more comparative cost advantage in production of spices. Because it is using only 50% of what Japan is using. Whereas in production of wheat, it is using 80% of what Japan is using in labour. Therefore, India will specialize in the production of spices and export the surplus to Japan and Japan will produce wheat in excess and export the surplus to India. So this was about the comparative cost theory. Now, let us understand critical evaluation of comparative cost advantage theory. We are going to critically evaluate this theory. So David Ricardo's theory of comparative cost is criticized mainly due to its theoretical assumptions because it doesn't have a practical approach in it. For example, let us start from the first point that is problem of labour mobility. Now, the assumption that was made in made by David Ricardo was that labour is perfectly mobile within its country, but perfectly immobile between countries. Now, this is not true because quite often there are number of workers who find it difficult to adjust in different parts of the country and therefore they can find in a particular area or region and also nowadays labourers do not face problem to move beyond the geographical boundaries of their country. So moving between countries is also quite easy. That is why problem of labour mobility is critically evaluated in this theory. So the main part is that labour is actually mobile. That means there is full mobility and full movement of labour, not only within the country, but also between countries. Okay, but also between countries. Let us go to the next point. Second point is ignores transport cost. Now, this makes the theory meaningless because no trade is possible without transport costs and transport costs vary from country to country, from product to product and also depends upon the mode of transportation and based on that countries may gain or lose comparative cost advantage depending upon the transport cost involved. So if the transport cost involved is high, then the countries may lose comparative cost advantage and if the transport cost is less, then countries may gain more comparative cost advantage. So and this transport cost is ignored is a very meaningless thing and because no trade is possible, no trade is possible without transport costs. Let us go to the next point. Third point, problem of constant technology. Now, the theory of comparative cost assumes that the technology is constant, but in reality technological changes takes place from time to time, but the rate and quality of technology changes may differ from industry to industry and from country to country and based on that technological development, the comparative cost ratios may also change and therefore a country may either gain or lose the comparative cost advantage. Let us go to the next point. Wrong assumption of full employment. Now, this theory assumes that full employment of factors of production that is labor, but full employment is not possible in developing countries and even in developed countries. Therefore, this assumption of full employment is meaningless and it makes the theory very much impractical. Let us go to the next point. Problem of free trade. The theory assumes that there is free trade between countries, but in real life situation, the foreign trade is subject to a lot of tariff and non-tariff barriers and developing countries, especially the developing countries find difficult to export their product in developed countries because they adopt a lot of protectionist barriers. Therefore, this assumption is also wrong. Let us go to the next point. Problem of homogeneous labor force. The meaning of the word homogeneous is uniform or same, but labor forces are not same because they differ in terms of skills, knowledge, aptitude. So, for instance, labor employed in textile industries may differ in terms of skills, knowledge, aptitude, etc. as compared to labor employed in IT or software industries. Also, the wages and working conditions of the labor force differs from industry to industry. So, there cannot be homogeneous labor force in a country because every labor is different in terms of its skills, knowledge, aptitude and so on and so forth. Let us go to the next point. Problem of perfect competition. So, perfect competition is an idealist concept and not a real concept. This is because perfect competition assumes that there is perfect knowledge, perfect knowledge on the part of sellers and buyers in respect of the market conditions, but in real life, especially the buyers, they do not have complete knowledge about the market conditions with respect to substitutes, quality, prices, etc. Also, perfect competition assumes that there is no government intervention in market matters. However, in reality, there is government intervention in the form of taxation and other regulations. Therefore, this assumption is also wrong. Let us go to the next point. Demand side ignored. The theory focused only on the supply side. Each country specializes in the production based on the comparative cost advantage and export the surplus to another country without knowing of the fact that there is demand for that commodity in that another country. For example, say India is going to export tea to Japan. Now, the main question over here is that, is there demand, is there demand for tea in Japan? If there is no demand only of tea for Japan, why, why would somebody go and supply that? Why would India supply it or export it? So, they are, this theory is just looking at from the side of supply, but the demand side is totally ignored. Let us go to the next point. Problem of extreme specialization. The theory supports specialization in only one type of commodity or one type of commodity. But in reality, this is not possible because countries produce a variety of commodities and a variety of products. Also, a country cannot go on producing a particular commodity as it is subject to market demands and other factors also like diseconomies of scale beyond a certain point of production. So, excess production cannot be done just in one commodity. Therefore, this assumption is also critically evaluated. Let us go to the next point. Rigid and static theory. The comparative cost advantage theory is based on certain given conditions which do not undergo any change. However, the real world is never static. Technology, quality of inputs, especially the labor, availability of factors of production do undergo a change over a period of time. So, this point is also critically evaluated. Now, conclusion. How can we conclude this theory? So, despite limitations, this theory has remained one of the basic principles, one of the basic principles of international trade. Today, countries are adopting liberalization, globalization and privatization that is LPG and tries to specialize in the production of those goods and services in which it enjoys maximum possible comparative advantage. However, this does not mean that countries can import all those goods and services in which they have less comparative cost advantage or have comparative cost disadvantage. Despite the comparative cost disadvantage, countries produce certain goods and services just to generate employment and meet the growing domestic demand. Right? So, this is how this theory can be concluded. Furthermore, a country cannot entirely depend on other countries for most of its requirement. They cannot depend on other countries for most of its requirements. At the same time, it is true, it is also true that the theory of comparative costs is still valid and applicable in international trade. So, this was all about the understanding of comparative cost theory, its assumptions and then critically evaluating comparative cost theory and also how can we conclude this comparative cost theory. So, this was all about it. Thank you.