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. 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. 6. The various countries differ in respect of factor endowments suited for the production of different commodities. 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. Hence, it is quite unrealistic and improper to consider relative efficiency of labour alone. As constant costs are assumed, a straight line production possi­bility curve has been drawn. 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. In view of this he asserted that other factors could be validly ignored and for purpose of comparative costs relative efficiency of labour alone of different countries could be considered. Undoubtedly, he can do the dispensing work better than his dispenser. The slope of the production possibility curve AB shows the com­parative cost ratio of the two commodities in U.S.A. Privacy Policy3. To produce one unit of wheat the U.S.A. requires 3 man-hours, while India requires 12 man-hours. Ohlin attacked the comparative cost theory for its assumption that factors of production were perfectly mobile within a country but immobile between countries. 3. Disclaimer Copyright, Share Your Knowledge The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to … In an economic model, agents have a comparative advantage over others in producing a particular good if they can produce that good at a lower relative opportunity cost or autarky price, i.e. With price-ratio (or terms of trade) line tt, India would be in equilibrium at point R’ where its production possibilities curve AB is tangent to the terms of trade line tt. In contrast, another country may not have any useful absolute advantages. Likewise, 80 metres of cloth in U.S.A. has the opportunity cost of 60 kg. 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. In this way both countries are able to increase their level of consumption beyond what is possible in the absence of specialisation. However, it says that the trade between countries which don’t have absolute advantage can be explained by the law of comparative advantage. Before publishing your Articles on this site, please read the following pages: 1. It is noteworthy that unlike in case of constant opportunity costs, in case of increasing oppor­tunity costs, specialisation is not likely to be complete. 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. But that’s only a temporary fix. Likewise, although India has absolute disadvantage in the production of both wheat and cloth, the extent of its disadvantage is less in case of cloth. After trade the equilibrium of U.S. A. would lie at some point on the terms of the trade line D’T, depending upon its demand for goods. From these production possibilities, it follows that U.S.A. is more efficient in the production of both wheat and cloth. Labour is the only resource of production and prices of products are equal to their relative labour costs. 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 ? Similarly, a professor may be able to teach his own son who is reading in a lower class much better than any school teacher. However, this does not represent the real situation, where all resources do not produce equally well both of the two commodities. Comparative Advantage of International Trade. 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. It will be seen from Table 23.4 that total world output (i.e. TOS4. 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. Conditions of perfect competition prevail in both countries. 2. India is said to have comparative advantage in the production of cloth. Thus opportunity cost measures the ratio of marginal costs of the two commodities. During the late 18th century, economist Adam Smith developed the theory of absolute advantage, which became the most dominant of the international trade theories of its time. However, the fixation of terms of trade is a vital issue, for on it a country’s share of gains from trade depends. 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. 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. According to the international trade theory, even if a country has an absolute advantage over another, it can still benefit from specialization. Against the Ricardian doctrine of comparative cost it has also been said that it is based on the constant cost of production in the two trading countries. His contribu­tion lies in his inquiring into the question why comparative costs of commodities in different coun­tries differ and offering a satisfactory explanation of it in terms of different factor-proportions required for the production of various goods. The major purpose of the theory of comparative advantage is to illustrate the gains from international trade. In the absence of trade between the U.S.A. and India, depending on their labour costs one unit of wheat will be exchanged for 0.5 units of cloth in the U.S.A. and 1.33 units of cloth in India. He further expressed the view that comparative cost doctrine applied not only to international trade but also to inter-regional trade. As this is an unresolved matter, it considerably limits … 2. 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. Indeed, structural changes are being brought about in these economies. These opportunity costs reflect comparative advantage. Now, let us see how this principle applies to international specialisation. Even in his theory, popularly known as factor-proportions theory of international trade, comparative costs serve as a basis of international trade. Let us take two countries U.S.A. and India and two goods, wheat and cloth. In view of the changes in factor supplies and technology in developing countries, comparative costs of producing different com­modities are also changing. Instead, this domestic exchange rate is determined by the production possibilities (i.e. The classical theory of international trade is popularly known as the Theory of Comparative Costs or Advantage. Thus U.S.A. would now get the combination of the goods indicated by point R for its consumption while it would be producing only wheat. Their theory, also called the factor proportions theory Also called the Heckscher-Ohlin theory; the classical, country-based international theory states that countries would gain comparative advantage if they produced and exported goods that required resources or factors that they had in great supply and therefore were cheaper production factors. 1. Not because of any particular intrinsic benefit but new firms start to get the network benefits of being around other IT setups.’ 2. Let us see how the two countries will gain if they specialise and trade on the lines of comparative advantage. Suppose, with given resources, India can produce 20 kgs. The advantage of having a country specialise in the production of the good which it can produce more efficiently and exporting some of it in exchange for the imports of the good it can produce relatively less efficiently is that such specialisation increases the total supply of goods. Thus Heckscher and Ohlin supplemented the comparative costs theory by providing valid reasons for differences in comparative costs in various countries. The law of comparative advantage describes how, under free trade, an agent will produce more of and consume less of a good for which they have a comparative advantage. 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…. A country tends to specialise in the production of those goods for which it has got relative or comparative advantage. This advantage may come because of a country's infrastructure, labor force, technology or innovations, or natural resources. supply or cost conditions) and the demand for the goods. of wheat. When production of cloth is expanded productive resources less suited to the production of cloth are drawn into that industry. We show below in Table 23.4 the gain in wheat output that occurs when U.S.A. shifts its labour resources by reducing the production of cloth by one unit and India shifts its labour to cloth by reducing the production of wheat by one unit (the above data of man-hours cost of wheat and cloth are used). An individual can do a number of jobs but he cannot do them all alike. This is given in the Table 23.5. international trade. This is important not only for generalizing results 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. As an alternative, Ohlin has propounded a new theory which is known as the modern theory 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. Similarly, it can be shown that India will also gain from specializing in cloth and exchanging it for wheat with U.S.A. Indeed, a country produces a certain commodity and also imports a part of it. Share Your Word File However, comparative cost theory is still believed to be valid and important basis of international trade. The work of dispensing can be done by a low-paid person, while he can earn much more as a doctor. 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. Content Guidelines 2. The fundamental cause as to why international specialisation occurs is the differences in costs, which result from the differ­ences in the availability of the amount and the quality of resources, the prices of these resources or factors and the method of their use. The two differ basically in many respects. It will suffice to mention here that consumption of the two goods in India would take place at a certain point on the terms of trade line tt to the left of point R, say at point C. Of course, this consumption point C would be determined by the demand conditions in India. Similarly, in Fig. Comparative advantage not only affects the production decisions of trading nations, but it also affects the prices of the goods involved. It is evident from the above table that in U.S.A. opportunity cost of wheat is less than that of India, while in India opportunity cost of cloth is less than that of U.S.A. The following criticisms have been leveled against this theory: 1. This theory has subsequently become known as the Heckscher–Ohlin model (H–O model). Theory of Comparative Costs or Comparative Advantage: The fundamental cause of international specialisation and hence international trade is the difference in costs of production. It is worth mentioning that specialisation necessitates trade or exchange of goods with other countries. In the early 1900s, a theory of international trade was developed by two Swedish economists, Eli Heckscher and Bertil Ohlin. The proliferation of brand clothing labels. In case of increasing opportunity costs, the production possibility curve instead of being a straight line is concave to the origin, as shown in Figure 23.4. 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. In order to simplify our analysis, we make the following assumptions: 1. International trade involves the extension of the principle of specialisation or division labour to the sphere of international exchange. Despite the sound logical structure and vivid explanation of gains from trade, the comparative cost theory, especially the Ricardian version based on labour theory of value has been criticized. 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. This theory has been a victim of undue criticisms such as that it assumes the absence of transport costs, the existence of perfect competition and full employment, and further that it consid­ers two commodities, two countries model. We shall first explain the case when opportunity costs of the commodities in each country have been assumed to be constant. But still he employs a dispenser, and he himself specialises in examining the patients. He writes, “The comparative cost reasoning alone explains very little about international trade. In fact, it was this question which was raised by David Ricardo, a classical economist, who put forward the theory of comparative costs (advantage) as an explanation of the potential gain from international trade. According to him, prices of different goods and their quantities produced and consumed depend on both supply and demand conditions. of wheat has the opportunity cost of 2 metres of cloth and one metre of cloth has 0.50 kg. He, therefore, regards the theory of comparative advantage as cumbersome, unrealistic, and as a clumsy and dangerous tool of analysis. That is, U.S.A. has an absolute advantage in the production of both the commodities. 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. 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). Therefore, variable proportions of factors used in the production of different commodities make the labour theory of value inapplicable in determining comparative cost of commodities. According to the classical theory of international trade, every country will produce their commodities for the production of which it is most suited in terms of its natural endowments climate quality of soil, means of transport, capital, etc. Before publishing your Articles on this site, please read the following pages: 1. Share Your PPT File, Aggregate Demand and Aggregate Supply with Flexible Price Level. Again, it does not necessarily mean that the most efficient country will always take the lead. The different commodities require different factor proportions for their production. Voicing this criticism Else-worth remarks, “the comparative costs theorem, the way in which Ricardo set up his illustration, tended to obscure the problem of the terms of trade.”. Thus, it would be to the advantage of U.S.A. to specialise in the production of wheat and of India in the production of cloth. In the modern international trade theory, tastes or demand for goods in a country are shown through the medium of community indifference curves, the use of which we are avoiding at this stage. It is the relative differences in costs which determine the products to be produced by different countries. However, in case of wheat its efficiency is three times greater and in case of cloth two times greater as compared to India. Privacy Policy3. In this dynamic context, a developing economy may have a comparative disadvantage in producing a certain commodity but may attain a comparative advantage after a certain stage of its development. Success attracted more IT firms to that area. 3. Specialisation of IT in Silicon Valley – the US. Each country benefits by specializing in those occupations in which it is relatively efficient; each should export part of that production and take, in exchange, those goods in whose production it is, for whatever reason, at a comparative disadvantage. 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 presented in this paper is attractive for two reasons. 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. 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. In the first place, Ricardian version of comparative cost theory has been attacked on the ground that being based on labour theory of value, it considers only labour cost to measure the comparative costs of various goods. Suppose, D’T’ is the terms of trade line showing the price ratio settled between the two countries. Economists use the term comparative advantage when describing the opportunity cost of two producers. Comparative theory states that the value of pr… But it could not provide a satisfac­tory explanation of why comparative costs of producing commodities in various countries differ. Take the case of a doctor. Indeed, according to him, international trade is only a special case of inter-regional trade. Trade cannot be explained neatly by one single theory, and more importantly, our understanding of international trade theories continues to evolve. Mill, another noted classical economist, removed this shortcom­ing of the comparative cost theory by supplementing it with Reciprocal Demand Theory which explains the determination of terms of trade. Ricardo thought comparative costs of producing commodities in various countries differed due to the differences in efficiency of labour. 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. 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. 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. It has been pointed out that labour is not the only factor needed for the production of commodities, other factors such as capital, raw materials, land also contribute to production. (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. Given these trade possibilities, it would be ad­vantageous for India to increase the production of cloth, (or so to say specialise in cloth) by shifting to it some resources from wheat. Content Guidelines 2. Both the Absolute as well as Comparative international trade theories assume that the choice of the product that can prove itself to be of great advantage is led by free and open markets instead of using the resources available inland. Let us illustrate the theory of comparative cost (or comparative advantage) with a numerical example. 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