Comparative Cost advantage theory in Economics |International trade Edu tainment. The comparative differences in costs can be measured as: The Table 2.3 satisfies the condition specified for comparative difference in costs; In case a1/a2 = a3/a4, there are equal differences in costs and there is no possibility of trade between the two countries. Similarly, in country В, IX = 0.6 У domestically, after trade, its gain is 0.4Y. Comparative Advantage and Free Trade . Our mission is to provide an online platform to help students to discuss anything and everything about Economics. His theory concluded that a country could increase its income by specializing in certain products and services and selling these on the international market. Similarly, the country’s imports will be of goods having relatively less comparative cost advantage or greater disadvantage. Given the same amount of productive resources, A can produce larger quantities of both the commodities than the country B. is perhaps the most important concept in international trade theory. Comparative advantage theory. In relative terms, however, country A has comparative advantage in specialising in the production and export of commodity X while country B will specialise in the production and export of commodity Y. Prohibited Content 3. Comparative Advantage Theory is the ability of a country to produce particular goods or services at lower opportunity cost as compared to the other countries. Intro - Classical Theory of International Trade ↓ In 1817, David Ricardo, an English political economist, contributed theory of comparative advantage in his book 'Principles of Political Economy and Taxation'.This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade. The factors of production are perfect… Comparative advantage is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners. Privacy Policy 8. 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. Table 3 Cost of Production in Labour Units: It will be seen that country A has an absolute cost advantage in both the commodities X and Y. Comparative cost theory explained above is based upon labour theory of value. Absolute advantage refers to the uncontested superiority … Content Filtrations 6. Ricardo developed a theory of comparative cost advantage to explain the basis of international trade as under: Ricardo stated a theorem that, other things being equal, a country tends to specialise in and export those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage. Unrealistic assumption of constant costs: The theory is based on another weak assumption that an … The theory of comparative advantage thus provides a strong argument for free trade —and indeed for more of a laissez-faire attitude with respect to trade. It was formulated by David Ricardo in 1815. Adam Smith’s theory of absolute cost advantage in international trade was evolved as a strong reaction of the restrictive and protectionist mercantilist views on international trade. In algebraic terms, let labour cost of producing X-commodity in country A is a1 and in country B is a2. Now, to illustrate and elucidate comparative cost difference, let us take some hypothetical data and examine them as follows. He, therefore, regards the theory of comparative advantage as cumbersome, unrealistic, and as a clumsy and dangerous tool of analysis. Criticisms of comparative advantage theory. Copyright 10. Suppose India produces computers and rice at a high cost while Japan produces both the commodities at a low cost. It means country A has absolute cost advantage over B in respect of both the commodities. The classical theory of international trade is popularly known as the Theory of Comparative Costs or Advantage. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. 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. Share Your Word File In fact, the principle of comparative costs shows that it is possible for both the countries to gain from trade, even if one of them is more efficient than the other in all lines of production. Adam Smith’s theory of absolute cost advantage in international trade was evolved as a strong reaction of the restrictive and protectionist mercantilist views on international trade. Image Courtesy : img.docstoccdn.com/thumb/orig/130458705.png If Japan can produce rice at a relatively lesser cost than computers, it will decide to specialise in the production and export of computers and India, which has less comparative cost disadvantage in the production of rice than computers will decide to specialise in the production of rice and export it to Japan in exchange of computers. The theory is lucidly summarised by Kindle-Berger as follows: “The basis for trade, so far as supply is concerned, is found in differences in comparative costs. The theory explains the emergence of international trade. Report a Violation, 11 Criticisms to the Theory of Comparative Costs, Difference between Absolute and Comparative Advantage of International Trade. The costs of trade can diminish the benefits of comparative advantage. This two-country, two-commodity model can be analysed through the Table 2.3. Ricardian theory of comparative advantage has the merit of demonstrating that international trade is possible even when a country is able to produce all goods at cheaper cost, provided the cost advantage is comparatively more in some goods than in the others. Suppose, there are two countries I & II and two commodities A and B. (ix) Money is non-existent and prices of different goods are measured by their real cost of production. The theory is propounded by and is associated with the name of David Ricardo, a renowned Swedish economist. It was formulated by David Ricardo in 1815. Balance of Trade. If trade takes place and two countries agree to exchange 1 unit of X for 1 unit of Y, the gain from trade for country A amounts to 0.20 units of Y for each unit of X. 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 У in our example). The benefits of buying its good or service outweigh the disadvantages. Costs of production are measured in terms of the labour units involved. Content Guidelines 2. Accordingly, country A will specialise in the production and export of X commodity, while country B will specialise in the production and export of Y-commodity. Comparative advantage, economic theory, first developed by 19th-century British economist David Ricardo, that attributed the cause and benefits of international trade to the differences in the relative opportunity costs (costs in terms of other goods given up) of producing the same commodities among countries. Free trade “by 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 civilised world.”. 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 in every commodity, a basis for trade exists. In Fig. Difference Between Absolute Advantage vs Comparative Advantage. Ricardo’s theory pleads the case for free trade. International trade involves the extension of the principle of specialisation or division labour to the sphere of international exchange. Now, if after trade, assuming the terms of trade to be IX — 1Y, country A gains 0.5 unit more. The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to … (x) There is full employment of resources in both the countries. The labour theory of value does not hold good because the wages of labour are not brought to equality throughout the country. Theory of Comparative Cost Advantage ... Trade Theory Heckscher Ohlin Theory … The absolute differences in costs can be measured as: It shows that country A has absolute advantage in producing X and country B has an absolute advantage in commodity Y. The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value of exports and imports in an economy over a certain period. Theory of Comparative Advantage of International Trade: by David Ricardo! The principle of comparative cost states that (a) international trade takes place between two countries when the ratios of comparative cost of produc­ing goods differ, and (b) each country would specialise in producing that commodity in which it has a comparative advantage. 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 В in exchange for У (i.e., import of У from B). The concept of comparative advantage was first formulated by economist David Ricardo as an explanation of the benefits of international trade for countries. Based on this uncomplicated example, the supporting argument is simple: specialization and free exchange among nations yield higher real income for the participants. The theory of comparative advantage is perhaps the most important concept in international trade theory. We may illustrate this principle after stating its assumptions first. (15) Incomplete Theory: It is an incomplete theory. Gain from Trade: The comparative cost principle underlines the fact that two countries will stand to … In short, “each country can consume more by trading than in isolation with a given amount of resources. Before publishing your articles on this site, please read the following pages: 1. The law of comparative advantage refers to an economic law used in international trading that argues that a nation should produce goods and services that have the lowest opportunity cost. It means the country A has comparative cost advantage in the production of X-commodity. The Ricardian comparative costs analysis is based upon the following assumptions: (i) There is no intervention by the government in economic system. – Explained. Every country has a fixed endowment of resources and all units of each particular resource are identical. Hence, the trade between two countries will not take place. 2. From the point of view of B, it can produce the same quantity OB of Y, if it gives up the production of smaller quantity OB1 of X. Ricardo emphasised that under all conditions, it, is the comparative cost advantage which lies at the root of specialisation and trade (see Table 3). Comparative advantage. Comparative cost advantage If a country can produce both commodities with less cost than another country but in different ratio, the country is … Opportunity cost measures a trade-off. Labour is perfectly mobile within a country but immobile internationally. The classical theory of international trade is popularly known as the Theory of Comparative Costs or Advantage. Historical Overview. To sum up, what goods will be exchanged in international trade is the main question solved by Ricardo’s theory of comparative costs. (vii) Transport costs are absent so that production cost, measured in terms of labour input alone, determines the cost of producing a given commodity. There will be some costs of trade. 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). The theory is stated in real terms: in terms of the labour cost: ADVERTISEMENTS: It is held that … 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 will gain. The comparative cost principle underlines the fact that two countries will stand to gain through trade so long as the cost ratios for two countries are not equal. Adam Smith propounded the theory of absolute cost advantage as the basis of foreign trade; under such circumstances an exchange of goods will take place only if each of the two countries can produce one commodity at an absolutely lower production cost than the other country. Comparative advantage is one of the most important concepts in economic theory and a fundamental tenet of the argument that all actors, at all times, can … He upheld in this theory the necessity of free trade as the only sound guarantee for progressive expansion of trade and increased prosperity of nations. Image Guidelines 5. And, comparative differences in costs are expressed as: (Which implies that country A possesses an absolute advantage over В in both X and (Y, but it has more comparative advantage in X than in Y). Disclaimer 9. For, comparatively, country A’s labour cost involved in producing 1 unit of X is only 66 per cent of B’s labour cost involved in producing X, as against that of 80 per cent in the case of Y. The Classical Theory of the International Trade, also known as the Theory of Comparative Costs, was first formulated by Ricardo, and later improved by John Stuart Mill, Cairnes, and Bastable. If signifies that country B has less comparative disadvantage in the production of Y commodity. TOS4. The concept of comparative advantage is of great significance in international trade. Differences Between Absolute and Comparative Advantage. (vi) Labour is perfectly mobile within the country but perfectly immobile among different countries. If, however, there is an equal cost difference, i.e., Xa/Xb = Ya/Yb will be no international trade between the two countries. is perhaps the most important concept in international trade theory. The theory of comparative advantage A country has a comparative advantage when it can produce a good at a lower opportunity cost than another country; alternatively, when the relative productivities between goods compared with another country are the highest. The theory of comparative advantage shows that even if a country enjoys an absolute advantage in the production of goods Normal Goods Normal goods are a type of goods whose demand shows a direct relationship with a consumer’s income. (ii) Perfect competition exists both in the commodity and factor markets. Comparative advantage is a key principle in international trade and forms the basis of why free trade is beneficial to countries. Doing Addition: How to do Addition Using a Fast Calculating Method? Before publishing your Articles on this site, please read the following pages: 1. As in the absolute cost advantage theory, this theory also says that international trade is solely due to differences in the productivity of labour in different countries. He upheld in this theory the necessity of free trade as the only sound guarantee for progressive expansion of trade and increased prosperity of nations. On the other hand, country В has least comparative disadvantage in production of Y, though she has absolute cost disadvantage in both X and Y. Economics, International Trade, Theories, Theory of Comparative Cost Advantage. (v) Labour is the only factor of production and the cost of producing a commodity is expressed in labour units. Correspondingly, since country В has least cost disadvantage in producing У, she should specialise in У and export its surplus to A and import X. The theory of comparative advantage A country has a comparative advantage when it can produce a good at a lower opportunity cost than another country; alternatively, when the relative productivities between goods compared with another country are the highest. Being dissatisfied with the application of classical labour theory of value in the case of foreign trade. If country A gives up OB quantity of Y and diverts resources to the production of X, it can produce OC1 quantity of X, which is more than OB1. The labour cost of producing Y-commodity in countries A and B are respectively a3 and a4. It does not mean that Japan will specialise in both rice and computers and India will have nothing to export. In country A, domestic exchange ratio between X and Y is 12 : 10, i.e., 1 unit of X = 12/10 or 1.20 units of Y. Alternatively, 1 unit of Y= 10/12 or 0.83 units of X. He stresses that free-trade is the pre-requisite of gains and improvement of world’s welfare. The theory of comparative advantage states that if countries specialise in producing goods where they have a lower opportunity cost – then there will be an increase in economic welfare. As such, when trade takes place, A specialises in X and exports its surplus to В and В specialises in У and exports its surplus to A. Ricardo argues that if there is equal cost difference, it is not advantageous for trade and specialisation for any country in consideration (see Table 2). The costs include external costs such as trade and transport costs. Comparative advantage is a term associated with 19th Century English economist David Ricardo. Note, this is different to absolute advantage which looks at the monetary cost of producing a good. David Ricardo believed that the international trade is governed by the comparative cost advantage rather than the absolute cost advantage. Merits of Ricardian Theory of Comparative Advantage: 1. It can be contrasted with the concept of comparative advantage, which refers to the ability to produce a particular good at a lower opportunity cost. (viii) There are only two commodities to be exchanged between the two countries. 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. It is the relative differences in costs which determine the products to be produced by different countries. In the absence of international trade, the domestic exchange ratio between X and Y commodities in these two countries are: Country A: 1 unit of X = 12/10 or 1-20 units of Y, Country B: 1 unit of Y = 12/16 or 0-75 unit of X. As Adam Smith pointed out, if there is an absolute cost difference, a country will specialise in the production of a commodity having an absolute advantage (see Table 1). Comparative advantage, economic theory, first developed by 19th-century British economist David Ricardo, that attributed the cause and benefits of international trade to the differences in the relative opportunity costs (costs in terms of other goods given up) of … Share Your PPT File, International Liquidity: Meaning and Aspects | Economics. Historical Overview. Plagiarism Prevention 4. Content Guidelines 2. But this labour theory of value has been abandoned by the modern economists. However, it says that the trade between countries which don’t have absolute advantage can be explained by the law of comparative advantage. Theory of Comparative Costs or Comparative Advantage: The fundamental cause of international specialisation and hence international trade is the difference in costs of production. New trade theory. The concept of absolute advantage was propounded by Adam smith when talking about international trade. Under these assumptions, let us assume that there are two countries A and В and two goods X and Y to be produced. 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. Disclaimer Copyright, Share Your Knowledge David Ricardo developed the classical theory of comparative advantage in 1817 to explain why countries engage in international trade even when one country's workers are more efficient at producing every single good than workers in other countries. A nation with a comparative advantage makes the trade-off worth it. As an alternative, Ohlin has propounded a new theory which is known as the Modern theory of International Trade. (iii) There are static conditions in the economy. The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to explain how and why countries gain by trading. From the above cost ratios, it follows that country A has comparative cost advantage in the production of X and B has comparatively lesser cost disadvantage in the production of Y. 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