Explain Ricardo's comparative cost advantage theory of International trade?

Main Topics of This Post:-

1. Introduction (Ricardian comparative cost advantage theory).

2. Assumption.

3. Explain with table and figure

4. Gain from trade 

5. Criticism

6. Leontief Paradox.

7. Nations trade.

1. Introduction:

Ricardo's comparative cost advantage theory of International trade---

According to Ricardo, "The international trade is governed by the comparative cost advantage rather than absolute cost cost advantage. A country will specialize in the production of those commodities which has comparative cost advantage and import those of commodities which it has comparative cost disadvantage. 

2. Assumption:

  The Ricardian comparative cost advantage theory is based on the following assumptions---

(i) Similar taste in both countries. 

(ii) Supply of labour is fixed, 

(iii) All units of labour are homogenous, 

(iv) It assumes constant return to scale, 

(v) Perfect competition exist in both countries, 

(vi) There are only two countries, two commodities and one factors of production (i.e. Labour) 

(vii) Trade between two countries take place on the basis of barter system. 

(viii) Non-existences of money, transport cost is zero. 

Given these assumption Ricardo shows that trade is possible between two countries when country has an absolute advantage in the production of both commodities but a comparative advantage in production of one commodity than the other. The theory of comparative cost advantage can be explain with the help of following table-

3. Explain with table and figure:

The above table shows that country 'A' has an absolute cost advantage in producing both the commodities through smaller inputs of labour than in country 'B'. In relative terms however country 'A' has comparative advantage in production and export of commodity 'x' while country 'B' has comparative advantage in production and export of commodity 'y'. 

In country 'A' domestic exchange ratio between 'x' and 'y' is 8:9 i.e.

1 unit of 'x'= 8/9 or 0.89 unit of 'y'. 

Alternatively, 

1 unit of 'y'= 9/8 or 1.12 unit of 'x'.

In country 'B', domestic exchange ratio is 12:10 

1 unit of 'y'= 10/20 or 0.83 unit of 'x'. 

Alternatively, 

1 unit of 'x' =12/10 or 1.2 unit of 'y'. 

From the above cost ratios, it follows that country 'A' has comparative cost advantage in the production in the production of 'x' and country 'B' has comparatively lesser cost disadvantage in the production of 'y'. 

The comparative advantage position (Ricardian Comparative cost advantage theory) of both can be explain through the following figure-

In Figure 'AM' and 'BN' are the PPC of country 'A' and 'B' respectively. Country 'A' can produce larger quantities of both commodities than the country 'B' with same resources. If the curve 'BL' is drawn parallel to 'AM', the curve 'BL' can represent the PPC of country 'A'. If country 'A' gives up 'OB' quantity of 'y' and divert resources to the production of 'x',  'A' can produce 'OL' amount of commodity 'x' which is more than 'ON'. It means the country 'A' has comparative cost advantage in production of 'x' commodity. From 'B's point of view, it can produce the same quantity i.e.'OB' of 'y', if it gives up 'ON' of 'x'. It signifies that country 'B' hass lesser comparative cost disadvantage in production of 'y'. 

4. Gain from trade: 

If trade takes place and two countries are agree to exchange 1 unit of 'x' for 1 unit of 'y', the gain from trade for country 'A' will be amount to (1-0.89) =0.11 unit of 'y' for each unit of 'x'. 

In case of country 'B' gain from trade will be amounts to (1-0.83) =0.17 unit of 'x' from each unit of 'y'. Thus, according to comparative advantage theory of trade is beneficial for both countries. 

5.Criticism: 

The Ricardian comparative cost advantage theory is criticised on the following grounds ---

(i) This theory assumes only labour cost of production and neglect money cost, 

(ii) The assumption of similar taste is unrealistic because taste are differ in different countries. 

(iii) Ricardo ignores transport cost in determining comparative advantage in trade which also unrealistic. 

(iv) The Ricardian theory is one sided because it consider only supply side of international trade and neglects the demand side. 

(v) Like classical theory this theory also based on assumption of full employment which is unrealistic.

6. Leontief Paradox:

At first w.w. Leontief in 1953 attempt to verify the Heckcher Ohlin theory of international trade. According to Hekcher Ohlin theory countries that are rich in capital will export capital intensive good or commodity. 

But Leontief in his study shows a paradoxical conclusion that United State which was capital abundant and labour scarce country so, according to Heckcher Ohlin theories US should export capital intensive good or commodity. But exported labour intensive good or commodity and imported capital intensive good or commodity. Thus result of Leontief study is known as Leontief paradox. 

Leontief made use of 1947 input output data related to US economy. He combined 200 groups of industries into 50 sectors of which 38 traded their products directly on international market. His study shows that import replacement industries was 30% higher than the US export industries. It means that in the US import comparative industries are relatively more capital intensive than the export industries. Thus according to Leontief countries that are rich in capital will export labour intensive good or commodity and countries that are labour abundant will export capital intensive good or commodity which is Incosistance with the statement.

7. Why do nations trade?

The basic reason for different nations entering into trade is that no nations has the capacity to produce by itself all the commodities and services that are required by it's people. There has been an unequal distribution of productive resources by the nature on the surface of earth. Countries differ in respect of climate conditions, mineral products, forests, mines labour, technological capabilities and managerial and entrepreneurial skills availability. Given those diversities no has the potential to produce all the commodities in the most efficient manner or at least cost. 

As for example-India which can produce textiles at the lower cost while Japan can produce electronic goods and automobiles at a low prices. So, India export textiles to Japan and in returns import those electronic goods, in the production of which they have comparative cost disadvantages.