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Comparative Cost Theory of International Trade
Trade benefits both producers and buyers and sellers. Sellers profit by selling the goods and services they produce, while buyers obtain the goods and services they need. Countries participating in international trade must base their production, export, and import of goods and services on certain economic principles or beliefs.
There are several established theories or beliefs regarding the most profitable approaches to international trade. Among these, the comparative cost theory is the most prevalent and is considered the main basis of international trade.
The comparative cost theory of international trade was propounded by the classical economist David Ricardo in 1817.
According to Ricardo, "Each country will specialize in the production of those commodities in which it has the greatest comparative advantage or the least comparative disadvantage."
Ricardo's comparative cost theory of international trade is based on the following assumptions:
(a) Trade occurs only between two countries and involves only two commodities.
(b) The cost of production and price of goods are measured in labor hours/days.
(c) Apart from natural resources, labor is the only factor of production used in production.
(d) Labor is perfectly mobile within a country but completely immobile between countries. Also, labor units are homogeneous within the same country.
(e) The law of constant returns to scale applies in production.
(f) Free trade exists between the two countries, meaning there are no restrictions on the import and export of goods and services.
(g) There are no transportation costs when transporting goods between the two countries.
According to this theory, differences in geographical conditions, natural resources, labor efficiency, etc., can lead to variations in the production cost of the same item across different countries. These differences in production costs drive trade between nations.
Each country can benefit by specializing in the production of goods in which it has a comparative advantage or a comparative disadvantage and participating in international trade.
Even if a country has the capacity to produce both goods at a lower cost, it should specialize only in the production of the good in which it has a lower comparative cost or a greater comparative advantage, rather than focusing on producing both goods. Similarly, even if another country has a disadvantage in producing both goods, it would be wise to specialize only in the production of the good in which it has a relatively smaller disadvantage.
For example, consider two countries, Nepal and India, involved in the production and trade of two goods: tea and coffee.
The production situation for these two goods is presented in Table 7.1 below:
Table 7.1 Comparative Cost Theory
| Countries | Coffee Production (kg) per worker | Tea Production (kg) per worker |
|---|---|---|
| India | 20 | 5 |
| Nepal | 18 | 3 |
According to Table 7.1, one person in India can produce 20 kg of coffee, while one person in Nepal can produce 18 kg of coffee. Similarly, one person in India can produce 5 kg of tea, while one person in Nepal can produce 3 kg of tea.
Observing this situation, it appears that one person can produce more of both goods in India than in Nepal. In this sense, India seems to have an advantage in producing both goods.
However, if India were to focus on producing only one good, which item would be more suitable? Which good would provide India with a greater comparative advantage? Which good would provide Nepal with a comparative advantage in production?
The answers to these questions can be clarified from the analysis below.
In the table, India foregoes the opportunity to produce 4 kg of coffee for every 1 kg of tea it produces. Nepal foregoes the opportunity to produce 6 kg of coffee for every 1 kg of tea it produces.
Thus, it appears that India has a greater comparative advantage in producing tea because it foregoes 4 kg of coffee to produce 1 kg of tea, compared to Nepal foregoing 6 kg of coffee. Therefore, it seems appropriate for India to specialize in tea production.
Looking at it from another perspective, Nepal can produce (18 ÷ 3 = 6) kg of coffee instead of 1 kg of tea.
In contrast, India can produce only (20 ÷ 5 = 4) kg of coffee instead of 1 kg of tea. Thus, just as it is better for India to produce 4 kg of coffee by foregoing 1 kg of tea, it appears that Nepal has a greater comparative advantage in producing coffee by foregoing 1 kg of tea and producing 6 kg of coffee.
From India's perspective, if coffee is produced in India, 1 kg of tea is equivalent to 4 kg of coffee. However, if coffee is imported from Nepal, 1 kg of tea can be exchanged for 6 kg of coffee.
Therefore, it is beneficial for both India to produce tea and Nepal to produce coffee.
Based on the above analysis, Nepal has a greater comparative advantage in coffee production than India. Therefore, it seems appropriate for Nepal to specialize in coffee production.
Criticisms of the Comparative Cost Theory
The comparative cost theory of international trade has been criticized as follows:
- Based on the False Assumption of Two Countries and Two Goods: The comparative cost theory of international trade is based on the assumption that trade occurs only between two countries and involves only two goods. However, in reality, international trade can involve more than two countries and various types of goods.
- Based Only on Labor Costs: The comparative cost theory of international trade considers labor cost as the only cost of production. However, in reality, the production of goods and services involves other factors of production such as land, capital, and organization along with labor, so the costs of these factors should also be included.
- Constant Returns to Scale in Production: The theory's assumption that only the law of constant returns to scale applies in all production is incorrect. In reality, increasing returns or decreasing returns are equally active in production.
- Exclusion of Transportation Costs: The comparative cost theory assumes that there are no transportation costs in international trade. However, countries involved in international trade have to bear transportation costs.
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