Question

David ricardo comparative cost advantage theory theory in business economics

Answer 1

Comparative Advantage:

 David Ricardo developed the theory of international trade based on what is known as the Principle of Comparative Advantage (Cost). International trade involves the extension of the principle of specialisation or division labour to the sphere of international exchange.

As a person specialises in the trade in which he has best advantages, a country also specialises in the production of the commodity in which it has the best natural advantages. A country may produce many things at a time, but it may have comparative advantages in the production of some commodities (say, tea or jute as in India) over others and it will specialise in those goods.

Similarly, another country would produce those goods (say, machineries and engineering goods as in Ger­many or Japan) in which it has comparative advantage. If these two coun­tries produce goods according to their respective areas of comparative advantage, each country would be able to produce the goods at the lowest cost; and both these countries will gain from trading with each other. This is the substance of the principle of comparative advantage (cost).

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. We may illustrate this principle after stating its assumptions first.

Assumptions of the Theory:

The classical version of the principle of comparative cost is based on several assumptions:

(a) Trade takes place between two coun­tries only, say A and B.

(b) They are trading with only two commodities, say, jute and cotton,

(c) The cost of production of these two goods in both the countries is expressed in terms of labour only,

(d) The production of these two goods in both the countries taken place at constant costs,

ADVERTISEMENTS:

(e) There is no transport cost, or the transport cost, if any, is so small a part of product prices that it is ignored.

Illustration:

Ricardo was concerned about the position where a country was able to produce every commodity at an absolutely lower real cost than another country. He suggested that in this case each country should special­ise in the production of those goods where its comparative advantage was greatest.

This can be explained by using the division of labour as an example. If A is ten times more efficient than B as a surgeon and twice as efficient as a road sweeper, then A should devote all his efforts to surgery and leave all the roads sweeping to B.

Ricardo developed his theory by comparing two countries, England and Portugal, and two commodities, wine and cloth. Table 1 shows that Portugal was more efficient in the production of both goods, but Ricardo argued that both countries could benefit if they specialised where their advantage was comparatively high and then traded.

Portugal’s labour costs were lower than England’s in both cloth and wine, but the comparative advantage was greater in wine. The cost ratios were 9:10 for cloth and 8:12 for wine. Thus, it cost England roughly 1.1 times as much labour to produce cloth as it did Portugal, but 1.5 times as much to produce wine.

Ricardo showed that both countries would benefit if England specialised in cloth and Portugal in wine and; if after specialisation, a unit of wine is exchanged for a unit of cloth. England would gain 20 hours since it costs her 100 hours to produce cloth but 120 to produce wine.

Portugal would also benefit because she would trade a unit of wine which took 80 hours to produce and receive a unit of cloth which would have taken her 90 hours to produce. Hence, Portugal gains 10 hours.

In Ricardo’s own words (referring to Portugal):

“It would be advantageous for her to export wine in exchange for cloth. She would obtain more cloth from England than she could produce by diverting a portion of her capital from the cultivation of wines to the manufacture of cloth”.

In the above example, Portugal has an absolute advantage in the produc­tion of both the commodities since the input requirements for both the commodities are less than those of England. But Portugal has a comparative cost advantage in wine. However, a situation of equal advantage, where one country is superior to another in the same ratio in all products, rules out the possibility of gainful trade.

Ricardo’s theory is a simple one. It ignores factors such as transport costs and assumes that goods are homogeneous. It also ignores intra-firm trade, such as that between subsidiaries of a multinational firm. Nevertheless, its conclusion is clear. Countries should specialise where their advantage is comparatively greatest (or, comparative disadvantage is least) and then trade.