comparative cost advantage theory of international trade

02 Jan comparative cost advantage theory of international trade

The theory is based upon some assumption such as: 1. 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. According to comparative cost advantage theory of international trade, each country exports the commodity in which it has cost advantage and imports the commodity in which it has cost disadvantage. Whatever the criticisms are in regards to the comparative advantage theory, its effect on international trade is unavoidable. Historical Overview. The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value of exports and imports in an economy over a certain period. We may illustrate this principle after stating its assumptions first. From the above cost ratios, it follows that country A has comparative cost advantage in the production of X and B has comparatively lesser cost disadvantage in the production of Y. 2. The benefits of buying its good or service outweigh the disadvantages. The concept of absolute advantage was propounded by Adam smith when talking about international trade. Privacy Policy3. The country may not be the best at producing something. TOS4. – Explained. The idea of comparative costs advantage is drawn in view of deficiencies observed by Ricardo in Adam Smith’s principles of absolute cost advantage in explaining territorial specialisation as a basis for international trade. 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). 3. As an alternative, Ohlin has propounded a new theory which is known as the Modern theory of International Trade. 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. It means country A has absolute cost advantage over B in respect of both the commodities. Now, to illustrate and elucidate comparative cost difference, let us take some hypothetical data and examine them as follows. It implies that factors supplies, techniques of production and tastes and preferences are given and constant. The theory is propounded by and is associated with the name of David Ricardo, a renowned Swedish economist. From the point of view of B, it can produce the same quantity OB of Y, if it gives up the production of smaller quantity OB1 of X. He upheld in this theory the necessity of free trade as the only sound guarantee for progressive expansion of trade and increased prosperity of nations. David Ricardo believed that the international trade is governed by the comparative cost advantage rather than the absolute cost advantage. The costs include external costs such as trade and transport costs. 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 labour theory of value does not hold good because the wages of labour are not brought to equality throughout the country. 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. 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. The classical theory of international trade is popularly known as the Theory of Comparative Costs or Advantage. Ricardo emphasised that under all conditions, it, is the comparative cost advantage which lies at the root of specialisation and trade (see Table 3). Given the same amount of productive resources, A can produce larger quantities of both the commodities than the country B. 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. Theory of Comparative Advantage of International Trade: by David Ricardo! 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