Demand

Demand is defined as the quantity of a good or service that consumers are willing and able to
buy at a given price in a given time period. Each of us has an individual demand for
particular goods and services and the level of demand at each market price reflects the value that
consumers place on a product and their expected satisfaction gained from purchase and
consumption.

The Factors of demand

The demand function can be written as
D = f (Pn, Pn…Pn-1, Y, T, P, E)
Where:
Pn = Price of the good itself

Pn…Pn-1 = Prices of other goods – e.g. prices of Substitutes and Complements

Y = Consumer incomes – including both the level and distribution of income

T  = Tastes and preferences of consumers

P = The level and age-structure of the population

E = Price expectations of consumers for future time periods

Production Function

Let us begin with the production function, a function summarizing the process of conversion of
factors into a particular commodity. We might propose a production function for a good y of the
following general form, first proposed by Philip Wicksteed (1894):
y = (x1, x2, ..., xm)
which relates a single output y to a series of factors of production x 1, x2, ..., xm. Note that in
writing production functions in this form, we are excluding joint production, i.e. that a particular
process of production yields more than one output (e.g. the production of wheat grain often
yields a co-product, straw; the production of omelettes yields the co-product broken egg shells).
Using Ragnar Frisch's (1965) terms, we are concentrating on "single-ware" rather than "multi-
ware" production.

Marginal Productivity

The assumptions given earlier imply that, for any given production function y =  (x 1, x2, .., xm),
it is a generally the case that, at least up to some maximum point:
y/xi = i  0
for all factor inputs i = 1, 2, ..., m. In other words, adding more units of any factor input will
increase output (or at least not reduce it). This is the heart of assumption (A.3). However, it is
also common in Neoclassical theory to also impose (A.5), i.e. to assume "quasi-concavity" of the
production function. It is often the case in economics that the quasi-concavity assumption
implies that:
2y/xi2 = ii < 0
for all i = 1, .., m, i.e. diminishing marginal productivity of ith factor.
It is worthwhile to spend a few moments on the diminishing marginal productivity assumption.
This means more we add of a particular factor input, all others factors remaining constant, the
less the employment of an additional unit of that factor input contributes to output as a whole.
This concept performs the same function in production functions as diminishing marginal utility
did in utility functions. Conceptually, however, they are quite distinct.

(i) The Law of Diminishing Returns

The idea of diminishing marginal productivity was simultaneously introduced for applications of
factors to a fixed plot of land by T.R. Malthus (1815), Robert Torrens (1815), Edward West
(1815) and David Ricardo (1815). It was applied more generally to other factors of production by
proto-marginalists such as J.H. von Thünen (1826), Mountiford Longfield (1834) and Heinrich
Mangoldt (1863). The apotheosis of the concept is found in the work of John Bates Clark (1889,
1891, 1899) and, more precisely, in Philip H. Wicksteed (1894). It was originally called the
"Law of Diminishing Returns", although in order to keep this distinct from the idea of decreasing
returns to scale, we shall refer to it henceforth as the "Law of Diminshing Marginal Productivity"
Let us first be clear about the definition of the marginal productivity of a factor. Letting xi
denote a unit increase in factor xi, then the marginal product of that factor is y/xi, i.e. the
change in output arising from an increase in factor i by a unit. Mathematically, however, it is
more convenient to assume that  x is infinitesimal. This permits us to express the marginal
product of the factor xi as the first partial derivative of the production function with respect to
that factor -- thus the marginal product of the ith factor is simply y/x i = i. If we do not
wish to assume that factor units are infinitely divisible or if we do not assume that the production
function is differentiable, we cannot express the marginal product mathematically as a derivative.
[We should note that both Carl Menger (1871) and John A. Hobson (1900, 1911) defined
"marginal product" differently: rather than being the output gained by an enterprise from the
addition of a factor unit, Hobson defined it as the output lost by the enterprise by the withdrawal
of a factor unit. This caused a problem for the "adding up" issue in the marginal productivity
theory of distribution, although, as was clarified later, when marginal product is not defined so
discretely, it does not make a difference which measure we use. For a useful discussion of the
dilemma involving the measurement of the "marginal unit", see the discussion in Fritz Machlup
(1937). Finally, we must note that a far more novel and interesting definition of marginal
productivity was introduced by Joseph M. Ostroy (1980, 1984) where the concept is redefined in
terms of contributions to tradeable surpluses, and thus both widened and deepened in scope.]
However, assuming marginal products exist and are well defined, then why diminishing? Taking
Clark's famous analogy:
"Put one man only on a square mile of prairie, and he will get a rich return. Two laborers on the
same ground will get less per man; and, if you enlarge the force to ten, the last man will perhaps
get wages only."
(J.B. Clark, 1890: p.304.)
The implication, then, is that as we increase the amount of labor applied to a particular fixed
amount of land, each additional unit will increase total output but by smaller and smaller
increments. When the field is empty, the first laborer has absolutely free range and produces as
much as his body can reasonably do, say ten bushels of corn. When you add a second laborer to
the same field, total output may increase, say to eighteen bushels of corn. Thus, the marginal
product is eight.
Why? The basic idea is that by adding the second man, the field gets "crowded" and the men
begin to get in each other's way. If that explanation does not seem credible, think of the units of
labor in terms of labor-hours for a single man: in the first hour, a particular man produces ten; in
the second hour he produces eight, etc. The diminution can be explained in this case as an
"exhaustion" effect.
Taking another example, suppose we apply a man to a set of shoe-making tools and a given
swathe of leather; let us say he can produce ten pairs of shoes in a day. Add a second man to this
without adding more shoe-making tools or increasing the leather, and one can easily envisage
that more shoes get made in a day, but that the work of the shoe-makers slows down as they pick
up the same tools in an alternating sequence of turns and perhaps fight over them a bit.
For other factors, different stories are told. In Ricardo's original story, the land is subject to
diminishing marginal returns because of the assumption that land has different degrees of
fertility and the most fertile acres are used first, and the less fertile ones added later. We can
conceive this more simply in that increasing the amount of land without increasing the amount of
labor that works on it will lead to less output per worker.
However it is justified, many Neoclassical theorists basically accept diminishing marginal
productivity as an axiom - "the diminishing marginal productivity of labor, when it is used in
connection with a fixed amount of capital, is a universal phenomenon. This fact shows itself in
any economy, primitive or social." (Clark, 1899: p.49). However much early economists tried to
claim it to be a natural law, this "axiom" turns out to be closer to a rather debatable assumption
(cf. Karl Menger, 1954).
Nonetheless, it is important to clearly note a few matters in relation to this. Firstly, the idea that
marginal product is always diminishing can be disputed (and will be disputed). Francis A.
Walker (1891) took J.B. Clark to task for not recognizing the possibility of increasing marginal
productivity (albeit, see Clark (1899: p.164)).
Secondly, as Pareto (1896, 1902) was quick to point out, it is not always true that if one adds a
unit of a factor to an existing production process, output will increase. "If a pit has to be dug, the
addition of one more man will make little difference to the day's output unless you give the man
a spade" (Cassel, 1918: p.179). This difficulty is even more clear if we see the problem in terms
of the marginal product of capital: if a pit has to be dug, the addition of one more spade will
make no difference to output unless you add a man to use it. Thus, one must be very careful
when pronouncing the idea of marginal productivity since we may need to produce in fixed,
constant factor proportions.
Thirdly, it is important to underline that the marginal product is not, properly speaking, the
contribution of the marginal unit by itself. Some commentators (e.g. E.v. Böhm-Bawerk, 19??;
cf. Robertson, 1931) seem to have gone on to make arguments that seem to imply, in the context
of our example, that the second man produces eight bushels of corn. Of course, this is not
necessarily true. The second man may very well produce nine or ten or eleven and still the total
output increases only to eighteen because the first man reduces his output to nine, or eight or
seven in the presence of the second. In our example, output increases from ten bushels to
eighteen bushels when one adds the second man not because the second man only adds eight, but
rather because his presence on the field makes the situation such that the total output of both men
is eighteen. Notice that the contribution per man is reduced: the average product is actually nine.
This may very well be how much each of the two laborers contributes. But this is not what
interests us: what we wish to note is that by adding the second man, output was increased by
eight. Thus, the marginal product of the second man is eight. But his actual contribution may be
very different than this.
Finally, and above everything, it is very important to note that in deriving the marginal product
of a factor, we are holding all other factors fixed. Specifically, in our earlier example, labor
varied and land (and indeed all other factors) was fixed. Thus, diminishing marginal productivity
has nothing to do with "returns to scale", i.e. the increase in output when we increase all factors.
If we increased both land and labor in our example, then there might very well be no reduction in
output per man (indeed, there is actually no reason for it, but we shall return to this later).

(ii) The Law of Variable Proportions

Marginal productivity is not obvious in the production function Y =  (L, K) in Figure 2.1 as
both inputs are varying there. We must first fix one of the factors and let the other factor vary.
This is shown in Figure 2.2, by the "reduced" production function Y =  (L, K 0), where only
labor (L) varies while capital is held fixed at K0. To obtain this from the former, we must
figuratively "slice" the hill in Figure 2.1 vertically at the level K0. Thus, Figure 2.2, which
represents the reduced production function Y =  (L, K 0), is a vertical section of the hill in
Figure 2.1. A reduced production function where all factors but one are held constant are often
referred to as the "total product" curve.

Figure 1 - Total Product Curve

The total product curve in Figure 1 can be read in conjunction with the average and marginal
product curves in Figure 2. The total product curve is originally due to Frank H. Knight (1921:
p.100), and much of the subsequent analysis is due to him and John M. Cassels (1936). Although
both these sets of curves have long been implicit in much earlier discussions (e.g. Edgeworth,
1911), average and marginal products were confused by early Neoclassicals with surprising
frequency. The particular shape of the total product curve shown in Figure 1 exhibits what has
been baptized by John M. Cassels (1936) as the Law of Variable Proportions -- effectively what
Ragnar Frisch (1965: p.120) quirkily renamed the ultra-passum law of production.
The marginal product of the factor L is given by the slope of the total product curve, thus MP L =
 Y/ L = d (L, K0)/dL. As we see, at low levels of L up to L 2 in Figure 1, we have rising
marginal productivity of the factor. At levels of L above L 2 we have diminishing marginal
productivity of that factor. Thus, marginal productivity of L reaches its maximum at L 2. We can
thus trace out a marginal product of L curve, MP L, in Figure 2. The labels there correspond to
those of Figure 1. Thus the MPL curve in Figure 2 rises until the inflection point L 2, and falls
after it. It becomes negative after L 5 - which would be equivalent to the "top" of the reduced
production function, what Frisch (1965: p.89) calls a "strangulation point". A negative marginal
product is akin to a situation when one adds the fiftieth worker to a field whose only
accomplishment is to get in everyone else's way - and thus does not increase output at all but
actually reduces it.
The slope of the different rays through the origin (O1, O2, O3, etc.) in Figure 1 reflect average
products of the factor L, i.e. APL = Y/L. The steeper the ray, the higher the average product.
Thus, at low levels of output such as Y 1, the average product represented by the slope of O 1 is
rather low, while at some levels of output such as Y3, the average product (here the slope of O3)
is much higher. Indeed, as we can see, average product is at its highest at Y 3, what is sometimes
called the extensive margin of production. Notice that at Y2 and Y4 we have the same average
product (i.e. the ray O2 passes through both points). The average product curve APL
corresponding to Figure 2.2 is also drawn in Figure 2.
  
Figure 2 - Marginal Product and Average Product curves

As we can see in Figure 1, the slope of the total product curve is equal to the slope of the ray
from the origin at L3, thus average product and marginal product are equal at this point (as shown
in Figure 2). We also know that as the ray from the origin associated with L 3 is the highest, thus
average product curve intersects the marginal product curve, MPL = APL, exactly where the
average product curve is at its maximum. Notice that at values below L3, MPL > APL, marginal
product is greater than average product whereas above L3, we have the reverse, MPL < APL.

BREAK EVEN ANALYSIS

The Break-even Point is, in general, the point at which the gains equal the losses. A break-even
point defines when an investment will generate a positive return. The point where sales or
revenues equal expenses. Or also the point where total costs equal total revenues. There is no
profit made or loss incurred at the break-even point. This is important for anyone that manages a
business, since the break-even point is the lower limit of profit when prices are set and margins
are determined.

Achieving Break-even today does not return the losses occurred in the past. Also it does not
build up a reserve for future losses. And finally it does not provide a return on your investment
(the reward for exposure to risk).
 The Break-even method can be applied to a product, an investment, or the entire company's
operations and is also used in the options world. In options, the Break-even Point is the market
price that a stock must reach for option buyers to avoid a loss if they exercise. For a Call, it is the
strike price plus the premium paid. For a Put, it is the strike price minus the premium paid.

 Benefits of Break-even Analysis

The main advantage of break-even analysis is that it explains the relationship between cost,
production volume and returns. It can be extended to show how changes in fixed cost-variable
cost relationships, in commodity prices, or in revenues, will affect profit levels and break-even
points. Break-even analysis is most useful when used with partial budgeting or capital budgeting
techniques. The major benefit to using break-even analysis is that it indicates the lowest amount
of business activity necessary to prevent losses.

 Limitations of break-even analysis

 It is best suited to the analysis of one product at a time;

 It may be difficult to classify a cost as all variable or all fixed; and
 analysis after the cost and income functions have changed.

Theory of Cost
Short run cost and Long run Cost :

In economic theory, a distinction is made between short run and long run. By short run we mean a time
period during which all factors of production are not variable. On the other hand by long run we mean a
time period during which all factors are variable. Hence, it is assumed that the short run cost has two
components–fixed cost and variable cost. But in the long run all costs are variable costs. All factors are
variable in the long run and hence there is no fixed cost in the long run. For example, plant size is fixed in
the short run. The level of output is changed in the short run by changing the degree of utilisation of the
plant. But in the long run, the plant size can be varied. As all factors are variable is the long run and as
they can be adjusted to their optimum levels, the long run cost cannot exceed the short run cost.

Short run costs are relevant when the firm has to decide whether to produce more in the immediate future,
keeping the plant size unchanged. On the other hand, long run costs become relevant when the firm has to
decide whether to set up a new plant.

Shape of Long run Average Cost Curve or, Derivation of Long run Average Cost Curve :

We can get long run average cost curve from the short run average cost curves. Let us see how we can get
it. We know that the long run is an aggregation of some short periods. For each short period, we have a
short run average cost curve. Suppose that our long run consists of three short periods.

In our figure 5.8, we have drawn three short run average cost curves– SAC1, SAC2 and SAC3. From the
figure it is seen that for output level less than OM1, SAC1 < SAC1 < SAC2. For output level greater than
OM1 but less then OM2, SAC2 < SAC3. For output level greater than OM2, SAC3 < SAC2. Each
average cost curve represents a given plant size. In the long run, The firm can vary the plant size.

So, to produce a given level of output, the firm will build up a suitable plant size which will produce that
output at the minimum possible cost. Hence, the long run average cost curve will be formed by taking the
portions of SAC1 upto P1, of SAC2 from P1 to P2 and the right portion of SAC3 beyond P2. In other
words, the bold portions of the three SAC curves will form the long run average cost curve.

Now, if we assume that there is an infinite number of plant sizes, the Each point of the LAC curve will be
a point on a short run average cost curve. The LAC curve will be the envelope of the SAC curves (LAC <
SAC). WE have shown this in figure 5.9. In this figure, SAC1, SAC2, SAC3 etc. are the short run average
cost curves and LAC is the long run average cost curve. It is tangent to each SAC curve at some point.
When the level of output is OM, the LAC is minimum and it is tangent to the minimum point of the curve
SAC3. To the left of it, the LAC curve is tangent to the falling portions of the SAC curves. To the right of
P, the LAC curve is tangent to the rising portions of the SAC curves. We see that the LAC curve is U-
shaped i.e., it first falls, reaches a minimum and then rises. This U-shape of the LAC curve is due to the
operation of the law of returns to scale.

The falling portion of the LAC curve is due to increasing returns to scale and the rising portion is due to
decreasing returns to scale. Point P shows the appearance and disappearance of constant returns to scale.
To the left of P, internal economies are greater than internal diseconomies and there are net internal
economies. That is why LAC falls upto P. To the right of P, internal economies are less SAC than internal
diseconomies LAC and there are net internal LMC diseconomies. Hence, LAC rises beyond P. At P all
the internal economies are reaped or enjoyed. Hence, point P is called the optimum point and OM is
called the optimum size of the firm.

It should be noted that though the LAC curve is U-shaped, its U-shape will not be so pronounced as the
short run average cost curves. Since the LAC curve contains all the SAC curves, it will be flatter than the
SAC curves.

We should further note that if the LAC curve is U-shaped, it cannot pass through the minimum points of
all the SAC curves. It passes through the minimum point of only one of the SAC curves. The LAC curve
can pass through the minimum points of all the SAC curves if we assume that there are constant returns to
scale in the production process. In that case, as the scale of the production process changes the SAC shifts
but their minimum points lie on a horizontal straight line. This straight line will be the LAC curve. This is
shown in figure 5.10. Here our LAC curve is a horizontal straight line. The LAC curve will be of this
shape if the production function is homogeneous of degree one i.e., subject to constant returns to scale.
Here LAC will coincide with LMC, and LTC will be a straight line passing through the origin.

THE MEANING OF NATIONAL INCOME

The total income of the nation is called “national income”. The aggregate economic performance
of the whole economy is measured by the national income data. In fact, national income data
provide a summary statement of a country’s aggregate economic activity.

In real terms, national income is the flow of goods and services produced in an economy in a
year or a particular period of time.

In national income accounting, the concept of national income has been interpreted in three ways
: (1) National Product, (2) National Dividend, (3) National Expenditure.

METHODS OF ESTIMATING NATIONAL INCOME

In national income estimates, by definition, we have to count all those goods and services
produced in the country and exchanged against money during a year. Thus, whatever is produced
is either used for consumption or for saving. Thus, national output can be computed at any of
three levels, viz., production, distribution and expenditure. Accordingly, we have three methods
of estimating national income : (i) the census of products methods, (ii) the cense of income
method, and (iii) the expenditure method.

The Census of Products Methods or Output Method

This method measures the output of the country. It is called the inventory method. Under this
method, from the census of production, the gross value of output in different sectors like
agriculture, industry, trade and commerce, etc., is obtained for the entire economy during a year.
The value so obtained is actually the GNP at market prices.

In using this method, it is necessary to take utmost care to avoid double counting. Economists
have suggested two alternative approaches to avoid the possibility of double counting in the
measurement of GNP, viz., (i) the final goods method, and (ii) the value added method.

1. The Final Goods Method : In this method of estimating GNP, only the final values of goods
and services are computed ignoring all intermediate transactions. Intermediate goods are
involved in the process of producing final goods -- the final flow of output purchased by
consumers. Thus, the value of final output includes the value of intermediate products.
Hence, to avoid double-counting, only final values relating to final demand of the
consumers should be reckoned. For example, the price of bread incorporates the cost of
wheat, flour, etc. Here, wheat and flour are both intermediate products and are not treated
as the final consumer’s demand. Their values are paid up during the process of production.
In the value of final product, bread, the values of these intermediate goods are hidden.
Hence, a separate accounting of the values of intermediate goods, along with the
accounting of the value of final product, would mean double-counting. To avoid this, the
computation of value of only the final product has been suggested.

2. The Value Added Method : In the “value added” method a summation of the increase in
value (the value added), at each separate production stage, leading to output in final form,
gives the value of GNP.

To avoid double-counting of intermediate goods, one must carefully estimate the value added at
each stage of the production process. From the total value created at a given stage, we should
thus subtract all the costs of materials and intermediate goods not produced in that stage. Or, the
value of inputs, at a given stage, should be deducted from the value of output. Even the value of
inputs purchased from other firm or sectors should be subtracted. In short, GNP is obtained as
the sum total of values added by all the different stages of the production process till final output
is reached in the hands of consumers to meet the final demand.

Census of Income Method

In this method, the total of all money incomes such as wages, salaries, rent, profit received by
persons and enterprises in the country during the year are totalled up. In practice, income figures
are obtainable mostly from income-tax returns, books of accounts, reports, published accounts as
well as estimates for small income.
The following classification of incomes is considered as comprehensive (a) Wages and salaries,
(b) Supplemental labour income (Social security, etc.) (c) Earnings of self-employed or
professional incomes, (d) Dividends, (e) Undistributed profits, (f) Interest, (g) Rent and (h) Profit
of state enterprises. However, transfer payments like gifts, subsidies, etc. are to be deducted from
the total of factor income. Thus, National Income is equal to the factor incomes minus transfer
payments.

This method is also called the Factor Cost Method. Thus, the national income of a country, at
factor cost, is equivalent to the sum total of the disbursements of their (factors) income. To this,
net income accrued from the Foreign Sector is added – i.e. net differences between exports and
imports as well as net income from aboard. The symbolic expression of this method is as follows
:

Y=  (w + r + i + ) + [(X – M) + (R – P)], where

w = wages, r = rent, i = interest,  = profits.

However, certain precautions are necessary while following this method :

1. All transfer payments (government and personal) which do not represent earnings from
productive services, such as social security benefits like unemployment allowances,
pension, charity, personal gifts, etc., are not be included. Similarly, earnings from
gambling, lottery prize-winning, etc., being transfer incomes, are to be excluded. Likewise,
scholarships received by students are also transfer incomes and hence should not be
included.

2. All unpaid services (like services of a housewife) are to be excluded. Thus, only those
services for which payments are made should be included.

3. Financial investments such as equity shares, etc. and sales of on property (including land) are
to be excluded, as they do not and anything to the real national income. Thus, all capital
gains and losses which are related to wealth, but nor real income, should excluded.

4. Direct tax revenue to the government should be subtracted from the total income as it is only
a transfer of income. Or else, it should not reckoned at all.

5. Similarly, government subsidies should be deducted from profit of the subsidised industries.

6. Add undistributed profit of companies, income from government property, and profits from
public enterprises.

In India, the National Income Committee used the income method adding up the net income
arising from trade, transport, public administration, professional and liberalists, and domestic
services. Since, under India conditions, due to lack of popularity of personal accounting
practices, it is difficult to ascertain the personal income of individuals, the use of income method
is not practicable.
The Bowley-Robertson Committee had suggested the adoption of Census of Products Method for
major sectors of India, and the Census of Income Method for some minor sectors, while the
National Income Committee relied mainly upon the Census of Income Method. However, none
of above methods alone is perfect. Therefore, a combination of this method will give a more
correct perspective of the estimate. Hence, the CSO use combined process of the two methods to
a better result.

The expenditure or Outlay Method

National income on the expenditure side is equal to the value of consumption plus investment. In
this method we have to : (i) estimate private and public expenditure on consumer good and
services, (ii) add the value of investment in fixed capital and stocks, with due consideration for
net positive or negative inventories, and (iii) add the value of exports and deduct the value of
imports.

To express it is symbolic terms,

Y=  (C+I +G) + [(X – M) + (R – P)],

where

C = Consumption expenditure, I = Investment expenditure, and

G= Government purchases.

THE THEORY OF COMPARATIVE ADVANTAGES

(The Classical Theory of International Trade)

The classical theory of international trade is popularly known as the Theory of Comparative
Costs or Advantage. It was formulated by david Ricardo in 1815.

The classical approach, in terms of comparative cost advantage, as presented by Ricardo

basically seeks to explain how and why countries gain by trading.

The idea of comparative costs advantage is drawn in view of deficiencies observed by Ricardo in
Adam Smith’s principles of absolute cost advantage in explaining territorial specialisation as a
basis for international trade.

Being dissatisfied with the application of classical labour theory of value in the case of foreign
trade, Ricardo developed a theory of comparative cost advantage to explain the basis of
international trade as under:

Ricardo’s Theorem
Ricardo stated a theorem that, other things being equal, a country tends to things being equal, a
country tends to specialize in and export those commodities in the production of which it has
maximum comparative disadvantage. Similarly, the country’s imports will be of goods having
relatively less comparative cost advantage or greater disadvantage.

The Ricardian Model

To explain his theory of comparative costs advantage, Ricardo constructed a two-country, two-
commodity, but one factor model with the following assumptions:

1. Labour is the only productive factor.

2. Costs of production are measured in terms of the labour units involved.

3. Labour is perfectly mobile within a country but immobile internationally.

4. Labour is homogeneous.

5. There is unrestricted or free trade.

6. There are constant return to scale.

7. There is full employment equilibrium.

8. There is perfect competition.

Under these assumptions, let us assume that there are two countries A and B and two goods X
and Y to be produced.

Now, to illustrate and elucidate comparative cost difference, let us take some hypothetical data
and examine them as follows.

Absolute Cost Difference

As Adam Smith pointed out, if there is an absolute cost difference, country will specialise in the
production of a commodity having an absolute advantage (see Table 1).
It follows country A has an absolute advantage over Bin the Production Of X while B has an
absolute advantage in producing Y. As such, when trade takes place, A specialiscs in X and
exports its surplus to B and B specialises in Y and exports its surplus to A.

Equal Cost Difference

Ricardo argues that if there is equal cost difference, it is not advantageous for trade and
specialises for any country in consideration (see table 2).
On account of equal cost difference, the comparative cost ratio is the same for both the countries,
so there no reason for undertaking specialisation. Hence, the trade between two countries will not
take place.

Comparative Cost Difference

Ricardo emphasizes that under all condition, it is the comparative cost advantage which lies at
the root of specialisation and trade (see Table 22.3).

It will be seen that country A has an absolute cost advantage in both the commodities X and Y.
However, possesses a comparative cost advantage in producing X. For, comparatively, country
A’s labour cost involved in producing 1 unlit of X is only 66 per cent of B’s labour cost
involved in producing X, as against that of 80 per cent the case of Y.

On the other hand, country B has least comparative disadvantage in production of Y, though she
has absolute cost disadvantage in both X and Y.

It should be noted that, to know the comparative advantage, we have to compare the ratio of the
costs of production of one commodity in both countries (i.e.,10/15 in the case of X in our
example) with the ratio of the cost of producing the other commodity in both countries(i.e., 20/25
in the case of Y in our example). To state in algebraic terms:

If in country A, the labour cost of commodity X is Xa and that of is Ya, and in B, it is Xb and Yb
respectively, then absolute differences in cost can be expressed as:

Xa/Xb < 1 Ya/Yb

(which means that country A has an absolute advantage over country B in commodity X and
country B has over A in commodity Y). And, comparative differences in costs are expressed as:

Xa/Xb < Ya/Yb <1

(which implies that country A possesses an advantage over B in both X and Y, but it has more
comparative advantage in X than in y). If, however, there is an equal cost difference, i.e., Xa/Xb
= Ya/Yb, there will be no international trade between the two countries.
In our illustration, since country A has comparative cost advantage in commodity X, as per
Ricardo’s theorem, this country should tend to specialise in x and export its surplus to country B
in exchange for Y(i.e., import of Y from B). Correspondingly, since country B has least cost
Disadvantage in producing Y, she should specialise in yand export its surplus to A and import X.

Gain Attributes of International Trade

It further follows that when countries A and B enter into trade, both will gain. In the absence of
trade, domestically in country A,1X = 0.5Y. Now, if after trade, assuming the terms of trade to
be 1X = 1Y, country Against 0.5 unit more. Similarly, in country B, 41X = 0.6 Y domestically,
after trade, its gain is 0.4Y.

In short, “each country can consume more by trading than in isolation with given amount of
resources,” Indeed, the relative gains of the two countries will be conditioned by the terms of
trade and one is likely to gain proportionately more than the other but it is definite that both will
gain .

In fact, the principle of comparative costs shows that it is possible for both the countries to gain
from trade, even if one of them is more efficient than the other in all lines of production. T5he
theory implies that comparative costs are different in different countries because the abundance
of factors which may be necessary for the production of each commodity does not bear the same
relation to the demand for each commodity in different countries. Thus, specialisation based on
comparative cost advantage clearly represents a gain to the trading countries in so far as it
enables more of each variety of goods to be produced cheaply by utilising the abundant factors
fully in the country concerned and to obtain relatively cheaper goods through mutual
international exchange.

Ricardo’s theory pleads the case for free trade. He stresses that free-trade is the pre-requisite of
gains and improvement of world’s welfare, free trade “by increasing the general mass of
production diffuses general benefit and binds together by one common tie of interest and
intercourse, the universal society of nations throughout the civilized world.”

To sum up, what goods will be exchanged in international trade is the main question solved by
Ricardo’s theory of comparative costs. The theory is lucidly summarized by Kindleberger as
follows:

“the basis for trade, so far as supply is concerned, is found in differences in comparative costs.
One country may be more efficient than another, as measured by factor inputs per unit of output,
in the production of every possible commodity, but so long as it is not equally more efficient in
every commodity a basis for trade exists. It will pay the country to produce more on the
assumption of full employment equilibrium condition for each of the trading countries. This is
far from being a reality in any reality in any country of the present world. Moreover, a poor
country is characterized by chromic unemployment, under-employment and “disguised”
unemployment.
4. In a planned developing Economy there is a regulation on Market Mechanism and Free
competition: The principle of comparative costs assumes perfect competition. This is of course,
an unrealistic phenomenon throughout the world. In a developing economy, where planning is
adopted, a further blow is struck at the freely working price mechanism as assumed the doctrine.

5. A poor Country Y has not Perfect Mobility of Labour due to Market Imperfections: Further,
the Ricardian theory assumes that labour is perfectly mobile within a region. This is not true for
any region whether it is developed or underdeveloped. However, due to market imperfections,
transport bottle necks, ignorance, personal attachment and such other factors, labour is relatively
less mobile in an under developed country than in a developed country. As such, the theory has
least applicability to poor countries.

6. Poor Countries have to be more and more Self-sufficient: Many poor countries also face
foreign exchange crises and adverse balance of payments; hence regulation of foreign trade
(specially imports) becomes an economic necessity for them and as such they cannot acce0pt in
toto the doctrine of comparative costs. These countries have to be more and more self-sufficient,
self-reliant and resort to import substitution rather than specialising merely in the production of
primary products according to the comparative costs advantage principle.