(xi) Trade between two countries takes place on the basis of barter. The concept of comparative advantage was first formulated by economist David Ricardo as an explanation of the benefits of international trade for countries. (x) There is full employment of resources in both the 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. 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. Content Filtrations 6. The concept of comparative advantage is of great significance in international trade. 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. 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. Historical Overview. 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. Content Guidelines 2. But containerisation has helped reduce the cost of trade. Being dissatisfied with the application of classical labour theory of value in the case of foreign trade. The country may not be the best at producing something. 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. Image Courtesy : img.docstoccdn.com/thumb/orig/130458705.png 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. Comparative advantage is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners. 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. Comparative Cost advantage theory in Economics |International trade Edu tainment. 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. 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 … Thus, specialisation based on comparative cost advantage clearly represents a gain to the trading countries in so far as it enables more of each variety of goods to be produced cheaply by utilising the abundant factors fully in the country concerned and to obtain relatively cheaper goods through mutual international exchange. Historical Overview. The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to … Doing Addition: How to do Addition Using a Fast Calculating Method? ... increasingly international economy, the theory … 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. Similarly, the country’s imports will be of goods having relatively less comparative cost advantage or greater disadvantage. ... by specializing in those areas with the lowest opportunity costs and trading with other countries. Note, this is different to absolute advantage which looks at the monetary cost of producing a good. Ricardo emphasised that under all conditions, it, is the comparative cost advantage which lies at the root of specialisation and trade (see Table 3). Unrealistic assumption of constant costs: The theory is based on another weak assumption that an … Disclaimer Copyright, Share Your Knowledge Given the same amount of productive resources, A can produce larger quantities of both the commodities than the country B. Thus the comparative costs principle confers gain upon both the countries. Similarly, in country В, IX = 0.6 У domestically, after trade, its gain is 0.4Y. Prohibited Content 3. For countries like Iceland or land-locked countries in Sub-Saharan Africa, this transport costs could be quite significant. The theory implies that comparative costs are different in different countries because the abundance of factors which may be necessary for the production of each commodity does not bear the same relation to the demand for each commodity in different countries. 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). (viii) There are only two commodities to be exchanged between the two countries. 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. Businesses also may have a comparative advantage over their competitors … Differences Between Absolute and Comparative Advantage. Plagiarism Prevention 4. Gain from Trade: The comparative cost principle underlines the fact that two countries will stand to … The theory is stated in real terms: in terms of the labour cost: ADVERTISEMENTS: It is held that … Criticisms of comparative advantage theory. The theory explains the emergence of international trade. In algebraic terms, let labour cost of producing X-commodity in country A is a1 and in country B is a2. The benefits of buying its good or service outweigh the disadvantages. He, therefore, regards the theory of comparative advantage as cumbersome, unrealistic, and as a clumsy and dangerous tool of analysis. The costs include external costs such as trade and transport costs. The costs of trade can diminish the benefits of comparative advantage. The concept of absolute advantage was propounded by Adam smith when talking about international trade. A nation with a comparative advantage makes the trade-off worth it. Difference Between Absolute Advantage vs Comparative Advantage. It is the relative differences in costs which determine the products to be produced by different 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. But this labour theory of value has been abandoned by the modern economists. (vii) Transport costs are absent so that production cost, measured in terms of labour input alone, determines the cost of producing a given commodity. 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. (15) Incomplete Theory: It is an incomplete theory. (iv) Production function is homogeneous of the first degree. It was formulated by David Ricardo in 1815. Merits of Ricardian Theory of Comparative Advantage: 1. 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. In the absence of trade, domestically in country A, IX = 0.5У. Comparative advantage is a term associated with 19th Century English economist David Ricardo. Comparative advantage is when a country produces a good or service for a lower opportunity cost than other countries. In country B, the domestic exchange ratio is 16 : 12, i.e., 1 unit of X = 16/12 or 1.33 units of Y. Alternatively, 1 unit of Y = 16/12 or 0.75 unit of X. 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. 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. 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. Report a Violation, 11 Criticisms to the Theory of Comparative Costs, Difference between Absolute and Comparative Advantage of International Trade. Comparative advantage. Ricardo considered what goods and services countries should produce, and suggested that they should specialise by allocating their scarce resources to produce goods and services for which they have a comparative cost advantage. Balance of Trade. 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. As an alternative, Ohlin has propounded a new theory which is known as the Modern theory of International Trade. TOS4. – Explained. 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). His theory concluded that a country could increase its income by specializing in certain products and services and selling these on the international market. It does not mean that Japan will specialise in both rice and computers and India will have nothing to export. 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. 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. 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. Share Your PDF File It implies that factors supplies, techniques of production and tastes and preferences are given and constant. 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. Opportunity cost measures a trade-off. 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). 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. Economics, International Trade, Theories, Theory of Comparative Cost Advantage. It implies that output changes exactly in the same ratio in which the factor inputs are varied. 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. If each country now specializes in one producing good then assuming constant returns to scale, the output will double. 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