Comparative Cost Advantage Theory

Comparative Cost Advantage: Meaning, Assumptions, Example, and Criticisms

What is Comparative Cost Advantage?

Comparative cost advantage can be defined as the advantage a nation gets in the production of goods and services comparatively high whether the production of both products has an absolute advantage or absolute disadvantage.

In 1817, Prof. David Ricardo further pushed the absolute cost advantage theory of Adam Smith with his book “On the Principles of Political Economy and Taxation”. Adam Smith’s absolute advantage theory was unable to give an answer to the question “What happens when a country can produce both the goods at an absolute cost advantage?”.

This question remained unanswered for a long time. Adam Smith’s theory argued that in such a condition a country might not derive any benefits from international trade. But Ricardo showed in his book that is not the case.

Ricardo introduced the international trade theory of comparative cost advantage and looked at such conditions in another way. He introduced the concept of opportunity cost which is the sacrifice of an opportunity for a better opportunity.

He argued while producing goods and services the cost of both products should be compared and the cost with relatively low will be chosen. A less profitable opportunity should be given up to dig the more profitable opportunity. It helps in more production ultimately leading to more exports and wealth generation.

According to Prof. David Ricardo, trade takes place under the condition of comparative cost advantage, “as long as the less efficient nation is not equally less efficient in the production of both the products”. It means no trade takes place if the absolute advantages of a country are equal in both goods. Trade will take place when absolute advantages are different between two goods.

To put it another way, one of the two countries suffers from disadvantages in both products, but one product suffers from fewer disadvantages than the other. Ricardo advocated and stressed concentrating resources on things that a country can manufacture more efficiently.

Two principles were highlighted by him: comparative cost advantage and specialization. Each country should focus on the activity in which it excels in order to gain the largest (comparative) advantage over other nations.

Example

To make a clear understanding of the comparative advantage, Smith’s absolute cost advantage also plays a significant role.

Let’s first understand, the absolute cost advantage.

Fig. Absolute Cost Advantage

In the above table, Ghana has an absolute advantage in Cocoa production which requires only 10 resources to produce 1 ton of Cocoa. Similarly, South Korea has an absolute cost advantage in Rice production which requires only 10 resources for 1 ton of Rice.

Ghana should specialize in the production of Cocoa and South Korea in Rice. Hence, Ghana should sell Cocoa and South Korea sell Rice as such the international trade occurred.

Absolute cost advantage does not talk about what happens if Ghana has an absolute cost advantage in both products Cocoa and Rice or what happens if Ghana has an absolute cost disadvantage in both Cocoa and Rice or similar to South Korea.

Comparative cost advantage theory seeks to give an answer to such questions.

Comparative Cost Advantage
Fig. Comparative Cost Advantage

In the above table, suppose, Ghana and South Korea are two countries, both have equal 200 resources for production, and have options to produce Cocoa and Rice.

As such, Ghana has an absolute cost advantage in both products Cocoa and Rice over South Korea. It is clear that Ghana has an absolute advantage in both items but it is relatively more efficient in Cocoa (as Cocoa’s cost is 10 and Rice’s cost is 13.33). Hence, it implied that Ghana has a comparative cost advantage in Cocoa which means comparative disadvantages in Rice production.

Similarly, South Korea has absolute cost disadvantages in both Cocoa and Rice as compared to Ghana. Though South Korea has an absolute disadvantage in both commodities, it is more efficient in the production of Rice (as Rice production cost is 20 only and Cocoa’s is 40). Thus, South Korea has a comparatively less disadvantage in the production of Rice.

Thus according to this Ricardo’s comparative advantage theory, Ghana should specialize in its production of Cocoa and South Korea should specialize in its production of Rice although it faces some disadvantages. Hence Ghana trades Cocoa and South Korea trades Rice & international trade has occurred.

Assumptions of Comparative Cost Advantage

This theory suggests that trade is a positive-sum game in which all countries participate in economic gains. Ricardo’s theory remains a major intellectual weapon for those who argue for free trade.

Some significant assumptions or key points of comparative advantage theory can be pointed out below.

  • Money does not exist and prices are determined by labor costs. Only labor cost is considered important in calculating production costs.
  • There are only two commodities and two countries.
  • Products must be identical.
  • There exists full employment of all factors in both the countries.
  • Production technologies in both countries exhibit constant returns to scale (the law of constant returns).
  • There will be no technological innovation and no technological spill-over. (but technology is a dynamic factor that keeps on helping cost reduction and the invention of new products.)
  • Factors of production can be easily and costlessly moved from one sector to others as the countries specialize through trade.
  • The underlying market structure driving production is based on perfect and free competition.
  • The economy is based on free trade and a positive-sum game is assumed.

Critical Review

Hence, David Ricardo’s comparative cost advantage international trade theory is an improved version of Adam Smith’s absolute cost advantage. This helps to find the answer to the question which was not answered by the absolute cost advantage theory.

However, this theory is also criticized by many scholars and economists, and also criticized in many ways, among them is Prof. Eli Heckscher.

The criticisms may be pointed out as,

  • The theory ignores the possibility of world trade in services, ideas, and technology.
  • The use of currency as a means of exchange and currency values are subject to fluctuations.
  • Transport, insurance, and other transfer costs in the pricing.
  • Involvement of more than 2 commodities and more than 2 countries.
  • Scope of trade increased under the law of decreasing unit costs.

In addition,

In his book “Global Rift”, L.S. Stravrianos writes “theory of Ricardo follows that each country derived the maximum benefits from participating in the new worldwide trade. The theory is rational, but it fails to explain what has happened and continues to occur in the Third World. The global market economy, far from helping all parties involved, is growing the gap between rich and poor countries at an ever-increasing rate.”

Some economists believe that Mercantilism’s philosophy was founded on a zero-sum game (where only one country has an economic gain). The theories of Adam Smith and David Ricardo, on the other hand, were founded on the positive-sum game, in which both countries benefit from trade, even if one has more.

Both Smith’s and Ricardo’s theories, according to Donald A. Ball, ignored the potential of creating the same things with different combinations of factors, and no explanation was offered as to why production costs vary.

Not until 1993 did Prof. Bertil Ohlin, a Swedish economist building on work begun by the economist Prof. Eli Heckscher in 1919, develop the theory of factor endowment.

In simple words, Ricardo’s comparative cost advantage theory may be criticized in the following points.

  • The wrong assumption of two countries & two products.
  • Ignores the other factors of production.
  • No homogeneous or uniform labor force.
  • No full employment situation.
  • Neglects the transportation cost.
  • Less mobility of labor within the country.
  • Obstacles of free trade by government.
  • Ignorance about quality and selling price of the product for advantage to a nation.

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