Comparative Costs Theory: Assumptions and Criticisms | Economics Optional Notes for UPSC PDF Download

Comparative Costs Theory

• The principle of comparative costs is based on the differences in production costs of similar commodities in different countries. Production costs differ in countries because of geographical division of labour and specialisation in production. Due to differences in climate, natural resources, geographical situation and efficiency of labour, a country can produce one commodity at a lower cost than the other.
• In this way, each country specialises in the production of that commodity in which its comparative cost of production is the least. Therefore, when a country enters into trade with some other country, it will export those commodities in which its comparative production costs are less, and will import those commodities in which its comparative production costs are high.
• This is the basis of international trade, according to Ricardo. It follows that each country will specialise in the production of those commodities in which it has greater comparative advantage or least comparative disadvantage. Thus a country will export those commodities in which its comparative advantage is the greatest, and import those commodities in which its comparative disadvantage is the least.

Assumptions of the Theory

• The Ricardian doctrine of comparative advantage is based on the following assumptions:
• There are only two countries, say A and B.
• They produce the same two commodities, X and Y.
• Tastes are similar in both countries.
• Labour is the only factor of production.
• All labour units are homogeneous.
• The supply of labour is unchanged.
• Prices of the two commodities are determined by labour cost, i.e.. the number of labour-units employed to produce each.
• Commodities are produced under the law of constant costs or returns.
• Trade between the two countries takes place on the basis of the barter system.
• Technological knowledge is unchanged.
• Factors of production are perfectly mobile within each country but are perfectly immobile between the two countries.
• There is free trade between the two countries, there being no trade barriers or restrictions in the movement of commodities.
• No transport costs are involved in carrying trade between the two countries.
• All factors of production are fully employed in both the countries.
• The international market is perfect so that the exchange ratio for the two commodities is the same.

Cost Differences

Given these assumptions, the theory of comparative costs is explained by taking three types of differences in costs: absolute, equal and comparative.

1. Absolute Differences in Costs

• There may be absolute differences in costs when one country produces a commodity at an absolute lower cost of production than the other.
  The absolute cost differences are illustrated in Table 78.1
  Table 78.1: Absolute Differences in Costs:
  The table reveals that country A can produce 10 X or 5F with one unit of labour and country В can produce 5X or 10К with one unit of labour.
• In this case, country A has an absolute advantage in the production of X (for 10 X is greater than 5 X), and country В has an absolute advantage in the production of Y (for 10 Y is greater than 5 Y).
  This can be expressed as 10X of A/5X of B > 1 > 5 Y of A/10Y of B.
  Trade between the two countries will benefit both, as shown in Table 78.2.
  Total Production 15 15 20 20 +5 +5
• Table 78.2 reveals that before trade both countries produce only 15 units arch of the two commodities by applying one labour-unit on each commodity. If A were to specialise in producing commodity X and use both units of labour on it, its total production will be 20 units of X. Similarly, if В were to specialise in the production of Y alone, its total production will be 20 units of Y. The combined gain to both countries from trade will be 5 units of X and Y.
• Figure 78.1 illustrates absolute differences in costs with the help of production possibility curves. Y_A X_A is the production possibility curve of country A which shows that it can produce either OX_A of commodity X or OY_A of commodity Y. Similarly, country В can produce OX_B of commodity X or 0Y_B of commodity Y. The figure also reveals that A has an absolute advantage in the production of commodity X (OX_A> OX_B), and country В has an absolute advantage in the production of commodity Y(OY_B > OY_A).
  
• Adam Smith based his theory of international trade on absolute differences in costs between two countries. But this basis of trade is not realistic because we find that there are many underdeveloped countries which do not possess absolute advantage in the production of commodities, and yet they have trade relations with other countries. Ricardo, therefore, emphasised comparative differences in costs.

2. Equal Differences in Costs

• Equal differences in cost arise when two commodities are produced in both countries at the same cost difference. Suppose country A can produce 10 X or 5 Y and country В can produce 8 X or 4 Y.
• In this case, with one unit of labour country A can produce either 10 X or 5 Y, and the cost ratio between A” and Y is 2 : 1. In country B, one unit of labour can produce either 8X or 4Y, and the cost ratio between the two commodities is 2 : 1.
• Thus the cost of producing X in terms of Y is the same in both countries. This can be expressed as
  10X of A/ 8X of B = 5Y of A/4Yof B = 1
• When cost differences are equal, no country stands to gain from trade. Hence international trade is not possible.

3. Comparative Differences in Costs

• Comparative differences in cost occur when one country has an absolute advantage in the production of both commodities, but a comparative advantage in the production of one commodity than in the other. The comparative cost differences are illustrated in Table 78.3.
  Table 78.3 Comparative Differences in costs:The table reveals that country A can produce 10X or 10Y, and country В can produce 6X or 8X.
• In this case, country A has an absolute advantage in the production of both X and Y, but a comparative advantage in the production of X. Country В is at an absolute disadvantage in the production of both commodities but its least comparative disadvantage is in the production of Y. This can be seen from the fact that before trade the domestic cost ratio of X and Y in country A is 10: 10 (or 1:1), while in country B, it is 6:8 (or 3:4). If they were to enter into trade, country A’s advantage over country В in the production of commodity X is 10X of A / 6X of B or 5/3, and in the production of Y, it is 10Y of A/8Y of B or 5/4. Since 5/3 is greater than 5/4, A’s advantage is greater in the production of commodity X, A will find cheaper to import commodity Y from country В in exchange for its X.
• Similarly, we can know the comparative disadvantage of country В in the production of both commodities. In the case of commodity X, country В’s position is 6X of B/10X of A or 3/5. In the case of commodity Y, it is 8Y of B/10Y of A or 4/5.
• Since 4/5 is greater than 3/5, B has least comparative disadvantage in the production of Y. It will trade its Y for X of country A.
• In other words, country A has a comparative advantage in the production of commodity A’, and В has least comparative disadvantage in the production of Y. Thus, trade is beneficial for both countries. The comparative advantage position of both countries is illustrated in Figure 78.2.
  Let PQ be the production possibility curve of country A and RS of country B. The curve PQ shows that country A has an absolute advantage in the production of both commodities X and Y respectively over country B. This is due to the fact that the production possibility curves RS of country В lies below the production possibility curve PQ of country A. Country В produces OR units of commodity Y and OS units of commodity X.
• To show comparative advantage position in trade, draw a line RT parallel to line PQ. Now country A has a comparative advantage in the production of commodity X only because it exports ОТ (> OS) units relatively to country B. On the other hand, country В has a comparative disadvantage in the production of commodity Y only. This is because, if it gives up resources required to produce OS units of X, it would be able to produce commodity Y by an amount less than OR. Thus country A has a comparative advantage in the production of commodity X, and country В has a comparative disadvantage in the production of commodity Y.

Its Criticisms

The principle of comparative advantage has been the very basis of international trade for over a century until after the First World War. Since then critics have been able only to modify and amplify it. As rightly pointed out by Professor Samuelson, “If theories, like girls, could win beauty contests, comparative advantage would certainly rate high in that it is an elegantly logical structure.”
But the theory is not free from some defects. In particular, it has been criticised by Bertin Ohlin and Frank D. Graham.
We discuss some of the important criticisms as under:

Unrealistic Assumption of Labour Cost

• The most severe criticism of the comparative advantage doctrine is that it is based on the labour theory of value. In calculating production costs, it takes only labour costs and neglects non-labour costs involved in the production of commodities. This is highly unrealistic be- cause it is money costs and not labour costs that are the basis of national and international transactions of goods.
• Further, the labour cost theory is based on the assumption of homogeneous labour. This is again unrealistic because labour is heterogeneous—of different kinds and grades, some specific or specialised, and other non-specific or general.

No Similar Tastes

The assumption of similar tastes is unrealistic because tastes differ with different income brackets in a country. Moreover, they also change with the growth of an economy and with the development of its trade relations with other countries.

Static Assumption of Fixed Proportions

• The theory of comparative costs is based on the assumption that labour is used in the same fixed proportions in the production of all commodities. This is essentially a static analysis and hence unrealistic. 
• As a matter of fact labour is used in varying proportions in the production of commodities. For instance, less labour is used per unit of capital in the production of steel than in the production of textiles. Moreover, some substitution of labour for capital is always possible in production.

Unrealistic Assumption of Constant Costs

• The theory is based on another weak assumption that an increase of output due to international specialisation is followed by constant costs. But the fact is that there are either increasing costs or diminishing costs. 
• If the large scale of production reduces costs, the comparative advantage will be increased. On the other hand, if increased output is the result of increased cost of production the comparative advantage will be reduced, and in some cases it may even disappear.

Ignores Transport Costs

Ricardo ignores transport costs in determining comparative advantage in trade. This is highly unrealistic because transport costs play an important role in determining the pattern of world trade. Like economies of scale, it is an independent factor of production. For instance, high transport costs may nullify the comparative advantage and the gain from international trade.

Factors not fully Mobile Internally

• The doctrine assumes that factors of production are perfectly mobile internally and wholly immobile internationally. This is not realistic because even within a country factors do not move freely from one industry to another or from one region to another.
• The greater the degree of specialisation in an industry, the less is the factor mobility from one industry to another. Thus factor mobility influences costs and hence the pattern of international trade.

Two-Country Two-Commodity Model is Unrealistic

The Ricardian model is related to trade between two countries on the basis of two commodities. This is again unrealistic because, in actuality, international trade is among countries trading many commodities.

Unrealistic Assumption of Free Trade

Another serious weakness of the doctrine is that it assumes perfect and free world trade. But, in reality, world trade is not free. Every country applies restrictions on the free movement of goods to and from other countries. Thus tariffs and other trade restrictions affect world imports and exports. Moreover, products are not homogeneous but differentiated. By neglecting these aspects, the Ricardian theory becomes unrealistic.

Unrealistic Assumption of Full Employment

Like all classical theories, the theory of comparative advantage is based on the assumption of full employment. This assumption also makes the theory static. Keynes falsified the assumption of full employment and proved the existence of underemployment in an economy. Thus the assumption of full employment makes the theory unrealistic.

Self-Interest Hinders its Operation

The doctrine does not operate if a country having a comparative disadvantage does not wish to import a commodity from the other country due to strategic, military or development considerations. Thus often self-interest stands in the operation of the theory of comparative costs.

Neglects the Role of Technology

The theory neglects the role of technological innovations in international trade. This is unrealistic because technological changes help in increasing the supply of goods not only for the domestic market but also for the international market. World trade has gained much from innovations and research and development (R & D).

One-Sided Theory

The Ricardian theory is one-sided because it considers only the supply side of international trade and neglects the demand side. In the words of Professor Ohlin, “It is, indeed, nothing more than an abbreviated account of the conditions of supply.”

Impossibility of Complete Specialisation

• Professor Frank Graham has pointed out that complete specialisation will be impossible on the basis of comparative advantage in producing commodities entering into international trade. He explains two cases in support of his argument: one, relating to a big country and a small country; and two, relating to a commodity of high value and low value.
• To take the first case, suppose there are two countries which enter into trade on the basis of comparative advantage, of these, one is big and the other is small. The small country will be able to specialise completely as it can dispose of its surplus commodity to the bigger one. But the big country will not be able to specialise fully because (a) being big, the small country will not be in a position to meet its requirements fully, and (b) if it specialises completely in a particular commodity its surplus will be so large that the smaller country will not be able to import the whole of it.
• In the second case of commodities having incomparable value, the country producing in high-value commodity will be able to specialise while that producing in low-value commodity will not be able to do the same. This is because the former country will be in a position to have a larger gain than the latter country. Thus, according to Graham, “The classical conclusion of complete specialisation between two countries can hold ground only … by assuming trade between two countries of equal opportunity, consumption value and between two countries of approximately equal economic performance.”

A Clumsy and Dangerous Tool

• Professor Ohlin has criticised the classical theory of international trade on the following grounds: (i) The principle of comparative advantage is not applicable to international trade alone, rather it is applicable to all trade. To Ohlin, “International trade is but a special case of inter­-local or interregional trade.” Thus there is little difference between internal trade and international trade, (ii) Factors are immobile not only internationally but also within different regions. This is proved by the fact that wages and interest rates differ in different regions of the same country. 
• Further labour and capital can also move between countries in a limited way, as they do within a region, (iii) It is a two-country two- commodity model based on the labour theory of value which is sought to be applied to actual conditions involving many countries and many commodities. He, therefore, regards the theory of comparative advantage as cumbersome, unrealistic, and as a clumsy and dangerous tool of analysis. As an alternative, Ohlin has propounded a new theory which is known as the Modern theory of International Trade.

Incomplete Theory

It is an incomplete theory. It simply explains how two countries gain from international trade. But it fails to show how the gains from trade are distributed between the two countries.

Conclusion

Despite these weaknesses, the theory has stood the test of the times. Its basic structure has remained intact, even though many refinements have been made over it. To conclude with Professor Samuelson, “Yet for all its over simplifications, the theory of comparative advantages has in it a most important glimpse of truth. Political economy has found few more pregnant principles. A nation that neglects comparative advantage may have to pay a heavy price in terms of living standards and potential rates of growth.”