David Ricardo’s Theory of Comparative Costs:
David Ricardo analysed the causes for and the benefits of international trade in terms of comparative costs. (David Ricardo’s theory of international trade is a modified and improved theory of international trade).
David Ricardo agreed with the analysis of Adam Smith the international trade would be mutually advantages if one country has absolute advantage over another country in one commodity, and the other country has an absolute advantage over the first country in another commodity.
He went further and pointed out that any two countries could very well gain by trading even if one of the countries is having an absolute advantage in both the products overx the other country, provided the extent of absolute advantage is different in the two commodities in question.
So, the central point of Ricardo’s theory of comparative costs is that two countries stand to gain by specializing in the production and export of those commodities in which they enjoy a higher comparative cost advantage or a lower comparative cost disadvantage in exchange for those commodities for the production of which they have lower comparative cost advantage or higher comparative cost disadvantage.
The theory of comparative costs of Ricardo can be explained with an example. Suppose in country A 5 units of labour produce 1 unit of product X, and 10 units of labour produce 1 unit of product Y, and in country B, 20 units of labour produce 1 unit of product X and 15 units of labour produce 1 unit of product Y. In this case, country A can produce both product X and product Y at lower cost than country B. But, in country A, the comparative cost advantage is higher in the production of product X than in the production of product Y, and in country B, the comparative cost disadvantage is lower in the production of product Y than in the production of product X.
In the given example, the opportunity cost of product X and product Y in country A and country will be as follows:
Country A Country B
Product X 5/10 = 0.5 90/15 = 1.33
Product Y 10/5 = 2 15/20 = 0.75
From the opportunity cost of the product it is clear that country A has comparative advantage in producing product X, and country B has comparative advantage in producing product Y. So, country A can speacilise in the production of product X and country B can specialize in the production of product Y and can gain from trading.
- There are only two countries, say, A and B, and there will be only two commodities, say, X and Y.
- There is the existence of the barter system under which one commodity will be exchanged for the other commodity.
- The cost of production of the two commodities is determined only by labour cost, i.e., the number of labour units involved in the production of each commodity, since labour is regarded as the only factor of production.
- All labour units all over the world are homogeneous
- The supply of labour is unchanged.
- The factors of production are perfectly mobile within a country, but are immobile between countries.