ICom Notes Class 12 Banking Theory of Comparative Costs and Comparative Advantage

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Theory of Comparative Costs

The classical theory of International trade commonly known as the principle of comparative cost was first enunciated by David Ricardo. The theory went through many additions improvements and refinements at the hands of economists like Mill, Cairns & Bastable.

An individual is able to perform many tasks but he does not perform them all. He selects that work which pays him the most. A doctor can also do the work of a dispenser but he does not do it. The same principle works in international trade. Considering the climatic conditions, distribution of material resources, geographical concern etc. Every country seems to be better suited for the production of certain articles rather than for others to employ its resources more remuneratively it will be to the advantages of each country as well as to the world.

THEORY

In its simplest form the theory may be stated as, ‘’It pays countries to specialize in the production of those goods in which they possess the greatest comparative disadvantage.’’

EXPLANATION

Ricardo argued that two countries can gain very well by trading even if one the countries is having an absolute advantage in the production of both the commodities over the country. The condition is ‘’Provided the extent of absolute advantage is different in the two commodities in question’’ i.e. the comparative advantage is greater or comparative is less in respect of one good than in that of the other. In this connection we compare not the cost of production of one commodity with the other rather we compare the ratio between the cost of production of the two commodities concerned in one country with the ratio of their cost of production in the other country.

EXAMPLE

Suppose there are two countries A and B and there are two commodities wheat and rice. Suppose a unit of labour produces 10 tons of wheat or 20 tons of rice in country A. The same unit can produce 6 tons of wheat and 18 tons of rice in country B. According to this situation country A is having an absolute advantage in the production of both commodities over B. But she is at a greater comparative advantage in the production of wheat country B is at a disadvantage in both. Commodities the comparative disadvantage is less than case of rice. Hence the ratio would be

In A it is 10 : 20 i.e. 1 : 2

In B it is 06 : 18 i.e. 1 : 3

Therefore, A will specialize in wheat and B in rice and international trade will become possible and profitable. This is the law of comparative advantage or costs.

Theory of Comparative Advantage

The comparative cost theory is based on the following assumptions:

• Labour is regarded as the sole factor of production and the cost of production only consists of labour cost.
• Production is subject to the law of constant returns.
• Factors of production are assumed to the perfectly mobile within a country but immobile between countries.

CRITICISM

The theory of comparative cost is criticized on the following grounds.

Assumption of Constant Cost

The classical economists were of the opinion that additional quantities & a commodity could be obtained with the same expenditure of cost per unit us previously But this is not valid assumptions lost ratios are subject to change where specialization between the two countries has gone a pace.

Some Static Assumptions

The comparative cost theory in a number of static assumptions of fixed costs industrial production functions between trading countries and fixed supply of land, labour, capital etc. It cannot be applied 100% to the real world.

Assumption of perfect mobility inside and immobility outside a country

This assumptions seems to be un-applicable to todays modern world of communication and technology the development of cheap quick and safe means of transport and communication has broken down this immobility to a great extent.