JOMO KENYATTA UNIVERSITY OF

AGRICULTURE AND TECHNOLOGY

PRODUCTION ECONOMICS

HCOB 2505

ABDIRASHID M. HASSAN

The Theory of Comparative Costs

COMPARATIVE COST THEORY: DAVID RICARDO
INTRODUCTION
The classical theory of International Trade, also known as the Theory of Comparative
Costs, was first formulated by Ricardo, and later improved John Stuart Mill, Cairnes,
and Bastable. Its best exposition is to be found in the works of Tausig and Haberler.

COMPARATIVE COST THEORY

The principle of comparative cost is based on the differences in production costs of
similar commodities in different countries. Production costs differ because of
geographical division of labour and specialization 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.
Each country specializes in that commodity in which its comparative cost is the least.
Therefore when a country enters into trade it will export those commodity in which
it’s comparative costs are less and will import those commodities in which
comparative costs are high. It follows that each country will specialize in this
commodity in which it has greatest advantage or the least comparative advantage.
This is the basis of international trade, according to Ricardo. It follows that each
country will specialize 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.

The assumptions of the theory

The Ricardian doctrine of comparative advantage is based on the following
assumptions:
1. There are two countries.
2. There are two commodities.
3. There is similar taste in both the countries.
4. Labour is the only factor.
5. The supply of labour is unchanged.
6. All units of labour are homogeneous
7. Price of the two commodities is determined by labour costs.
 8. Commodities are reduced under the law of constant cost.
9. Technical knowledge is unchanged.
10. Factors of production are perfectly mobile within each country but are
immobile between each country.
11. All the factors are fully employed.
12. There are no trade barriers.
13. There is a perfect competition both in commodity and factor market.
14. Trade between two countries takes place on barter system.
15. There is no transport cost.
16. Production is subject to constant returns to scale.

Cost differences
Given these assumptions, the theory of comparative costs is explained by taking three
types of differences in cost: Absolute, Equal and Comparative

Absolute Differences in Cost

There may be absolute differences in costs when one country produces a commodity
at an absolute lower cost of production than the other. 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 there are many underdeveloped
countries which do not posses absolute advantage in the production of commodities,
yet they have trade relations with other countries. Ricardo, therefore, emphasised
comparative differences in costs.

Equal Differences in Costs

Equal differences in costs arise when two commodities are produces in both countries
at the same cost difference. When cost differences are equal, no country stands to gain
from trade and international trade is not possible.

Comparative Differences in Costs

A comparative difference in costs arises when one country has an absolute advantage
in the production of both commodities, but a comparative advantage in the production
of one commodity than the other.
Ricardo's Example:-
On the basis of above assumptions, Ricardo explained his comparative cost difference
theory, by taking an example of England and Portugal as two countries
& Wine and Cloth as two commodities.
As pointed out in the assumptions, the cost is measured in terms of labour hour.
The principle of comparative advantage expressed in labour hours by the following
table.

Portugal requires less hours of labour for both wine and cloth. One unit of wine in
Portugal is produced with the help of 80 labour hours as above 120 labour hours
required in England. In the case of cloth too, Portugal requires less labour hours than
England. From this it could be argued that there is no need for trade as Portugal
produces both commodities at a lower cost. Ricardo however tried to prove that
Portugal stands to gain by specialising in the commodity in which it has a greater
comparative advantage. Comparative cost advantage of Portugal can be expressed in
terms of cost ratio.

• Cost ratios of producing Wine and Cloth

Portugal has advantage of lower cost of production both in wine and cloth. However
the difference in cost, that is the comparative advantage is greater in the production of
wine (1.5 — 0.66 = 0.84) than in cloth (1.11 — 0.9 = 0.21).
Even in the terms of absolute number of days of labour Portugal has a large
comparative advantage in wine, that is, 40 labourers less than England as compared to
cloth where the difference is only 10, (40 > 10). Accordingly Portugal specialises in
the production of wine where its comparative advantage is larger. England specialises
in the production of cloth where its comparative disadvantage is lesser than in wine.

• Comparative Cost Benefits Both Participants

Let us explain Ricardian contention that comparative cost benefits both the
participants, though one of them had clear cost advantage in both commodities. To
prove it, let us work out the internal exchange ratio.

Let us assume these 2 countries enter into trade at an international exchange rate
(Terms of Trade) 1: 1.
At this rate, England specialising in cloth and exporting one unit of cloth gets one unit
of wine. At home it is required to give 1.2 units of cloth for one unit of wine. England
thus gains 0.2 of cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth.
Similarly Portugal gets one unit of cloth from England for its one unit of wine as
against 0.89 of cloth at home thus gaining extra cloth of 0.11. Here both England and
Portugal gain from the trade i.e. England gives 0.2 less of cloth to get one unit of wine
and Portugal gets 0.11 more of cloth for one unit of wine.
In this example, Portugal specialises in wine where it has greater comparative
advantage leaving cloth for England in which it has less comparative disadvantage.
Thus comparative cost theory states that each country produces & exports those goods
in which they enjoy cost advantage & imports those goods suffering cost
disadvantage.
Limitations of Ricardian Comparative Cost theory
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 only
able to modify and amplify it. As rightly pointed out by Professor Samuelson, “If
theories, like girls, could win beauty contests, comparative advantage theory would
certainly rate high in that it’s an elegant and logical structure.”
However the theory is not free from some defects, Ricardo's theory was subjected to
number of criticisms.

1. Restrictive Model
Ricardo's Theory is based on only two countries and only two commodities. But
international trade is among many countries with many commodities.

2. Labour Theory of Value

Value of goods is expressed in terms of labour content. Labour Theory of value
developed by classical economists has too many limitations and thus is not applicable
to the reality.
Value of goods and services in the real world is expressed in money i.e. the prices are
the values expressed in units of money.

3. Full employment
The assumption of full employment helps the theory to explain trade on the basis of
comparative advantage. The reality is far from full employment. Cost of production,
even in terms of labour, may change as the countries, at different levels of
employment move towards full employment.

4. Ignore transport cost

Another serious defect is that the transport costs are not consider in determining
comparative cost differences.
5. Demand is ignored
The Ricardian theory concentrates on the supply of goods. Each country specialises in
the production of the commodity based on its comparative advantage. The theory
explains international trade in terms of supply and takes demand for granted.

6. Mobility of factor of production

As against the assumptions of perfect immobility between the countries, we witness
difficulties in the mobility of labour and capital within a country itself. At the same
time their mobility between nations was never totally absent.

7. No Free Trade
Ricardian theory assumes free trade i.e. no restriction on the movement of goods
between the countries. Though it is unrealistic to assume not to have any restriction.
what the real world witnesses is a lot tariff and non-tariff barriers on international
trade. Poor countries find it difficult to enjoy the comparative advantage in the
production of labour intensive commodities due to the protectionist policies followed
by developed countries.

8. Complete specialisation
The comparative advantage theory comes to conclusion of complete specialisation. In
the Ricardian example, England is specialising fully on cloth and Portugal on wine.
Such complete specialisation is unrealistic even in two countries and two
commodities model. It is possible if two countries happens to be almost identical in
size and demand. Again, a complete specialisation in the production of less important
commodity is not possible due to insufficient demand for it.

9. Static Theory
The modern economy is dynamic and the comparative cost theory is based on the
assumptions of static theory. It assumes fixed quantity of resources. It does not
consider the effect of growth.

10. Not applicable to developing countries

Ricardian theory is not applicable to developing countries as these countries are
nowhere near to full employment. They are in the process of change in quality of their
labour force, quality of capital, technology, tapping of new resources etc. In other
words developing countries exhibit all the characteristics of dynamic economy.

11. Constant Returns to Scale

Another drawback of the Ricardian principle of comparative costs is that assumes
constant Returns to scale and thus constant cost of production in both the countries.
The doctrine holds that if England specialises in cloth; there is no reason why it
should produce wine. Similarly if Portugal has a comparative advantage in producing
wine, it will not produce cloth; but import all cloth from England. If we examine the
pattern of international trade in practice, we find it is not so. A time will come when it
will not be reasonable for Portugal to import cloth from England because of
increasing cost of production. Moreover, in actual practice a country produces a
particular commodity and also imports a part of it. This phenomenon has not been
explained by the theory of comparative costs.
References
Modern Economic Theory, K.K. Dewett
Modern Economics, Robert Mudida Focus Publications Ltd
Principle of Economics