Comparative Cost Advantage Theory

The Comparative Cost Advantage Theory of Trade was developed by British political
economist, David Ricardo in his book “The Principles of Political Economy and
Taxation” published in 1817. According to Comparative Advantage Theory, a country
has a comparative advantage if it can produce a good at a lower opportunity cost than
another country. A lower opportunity cost means it has to forego less of other goods
in order to produce it.

David Ricardo believed that the international trade is governed by the comparative
cost advantage rather than the absolute cost advantage. A country will specialise in
that line of production in which it has a greater relative or comparative advantage in
costs than other countries and will depend upon imports from abroad of all such
commodities in which it has relative cost disadvantage.

Suppose India produces computers and rice at a high cost while Japan produces both
the commodities at a low cost. It does not mean that Japan will specialise in both rice
and computers and India will have nothing to export. 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 Ricardian comparative costs analysis is based upon the following

assumptions:

(i) There is no intervention by the government in economic system.

(ii) Perfect competition exists both in the commodity and factor markets.
(iii) There are static conditions in the economy. It implies that factors supply,
techniques of production and tastes and preferences are given and constant.
(iv) Production function is homogeneous of the first degree. It implies that output
changes exactly in the same ratio in which the factor inputs are varied. In other
words, production is governed by constant returns to scale.
(v) Labour is the only factor of production and the cost of producing a commodity is
expressed in labour units.
(vi) Labour is perfectly mobile within the country but perfectly immobile among
different countries.
(vii) Transport costs are absent so that production cost, measured in terms of labour
input alone, determines the cost of producing a given commodity.
(viii) There are only two commodities to be exchanged between the two countries.
(ix) Money is non-existent and prices of different goods are measured by their real
cost of production.
(x) There is full employment of resources in both the countries.
(xi) Trade between two countries takes place on the basis of barter.

Given the above assumptions, the theory of comparative Cost Advantage can be
explained with the following table as below:

The above Table shows that the US has an absolute advantage in producing clothing
(5>4) and also aeroplanes (12>1). Brazil does not have an absolute advantage in
anything. However, that doesn’t mean the US should be the only producer. We
should look at comparative advantage based on opportunity cost.
The above opportunity cost table shows that, the US has a comparative advantage in
producing aeroplanes. This is because the opportunity cost of producing aeroplanes
(5/12=0.41) is lower than that of Cloth (12/5=2.4) in US. Therefore, US should
specialise in producing aeroplanes even though it has absolute advantage in both
cloth and aeroplanes. In contrast, Brazil has a comparative advantage in producing
Cloth. Brazil produces clothing, the opportunity cost is 1/5 = 0.25 aeroplanes as the
one shown in above table. This is because the opportunity cost of producing cloth
(¼=0.25) is lower than that of aeroplanes (4/1=4) in Brazil. Therefore, Brazil should
specialise in producing clothing even though it doesn’t have an absolute advantage.
Therefore, we conclude that based on comparative cost advantage analysis, both US
and Brazil will be benefited by trading each other.

Criticisms of the Theory

As with many other economic ideas there are criticisms to be levelled at comparative
cost advantage theory:
(i) It is much more complicated in the real world in deciding in which goods
countries have a comparative cost advantage. This is so because there are a
large number of goods and many countries.
(ii) The theory ignores the effects of transport costs. However, once transport
costs are added any comparative advantage may be lost.
(iii) Modern theories, no longer based on Ricardo’s labour theory, have
established that the only necessary condition for the possibility of gains
from trade is that price ratios should differ between countries.
(iv) Ricardo ignored the role of demand completely and explained trade from
supply side.
(v) Ricardo’s analysis is based on the labour theory of value as costs are
expressed in terms of labour hours. However, the classical labour theory
itself has lost its relevance.
(vi) The theory applied their principle in case of trade with two countries only
and with two commodities only. So, the principle has a limited scope of
application in practice. It cannot explain multi-lateral trade.
Source:
• https://www.economicsdiscussion.net/economic-theories/comparative-costs-
theory/david-ricardos-theory-of-comparative-cost-advantage-
economics/30673
• https://jncollegeonline.co.in/attendence/classnotes/files/1627266992.pdf