Comparative cost advanatge theory
- 3. COMPARATIVE COSTADVANTAGE THEORY: ORIGIN • The economist David Ricardo in his book “Principles of political economy and taxation” systemically represented the theory of comparative cost advantage theory. • According to comparative cost advantage theory of international trade, each country exports the commodity in which it has cost advantage and imports the commodity in which it has cost disadvantage
- 4. COMPARATIVE COST ADVANTAGE THEORY : ASSUMPTIONS • There are only two countries and two commodities • There is no governmental intervention in export and import • Only labour is factor of production. Quantity of labour used gives cost of production • There is perfect mobility of labour within the country but not between the countries • There is no cost of transportation between the countries • The law of constant returns to scale operates in production. • The units of labour are homogeneous • The units of each commodity in both countries are homogeneous
- 6. Countries Goods (Units) Exchange rate Wine Cloth England 100 50 2 : 1 2 wine = 1 Cloth Portugal 40 40 1 : 1 1 wine = 1 Cloth Total 140 90 230 Countries Goods (Units) Exchange rate Wine Cloth England 200 -- 4 : 1 4 wine = 1 Cloth Portugal -- 80 1 : 2 1 wine = 2 Cloth Total 200 80 280
- 7. COMPARATIVE COST ADVANTAGE OF COUNTRIES • Cost Ratio of Wine = In England 100 units of Wine In Portugal 40 units of Wine = 100 40 = 2.5 • Cost Ratio of Cloth = In England 50 units of Cloth In Portugal 40 units of Cloth = 50 40 = 1.5 Countries Goods (Units) Exchange rate Wine Cloth England 100 50 2 : 1 2 wine = 1 Cloth Portugal 40 40 1 : 1 1 wine = 1 Cloth Total 140 90 230
- 8. COMPARATIVE COST ADVANTAGE OF COUNTRIES • Cost Ratio of Wine = In Portugal 40 units of Wine In England 100 units of Wine = 40 100 = 0.4 • Cost Ratio of Cloth = In Portugal 40 units of Cloth In England 50 units of Cloth = 40 50 = 0.8 Countries Goods (Units) Exchange rate Wine Cloth England 100 50 2 : 1 2 wine = 1 Cloth Portugal 40 40 1 : 1 1 wine = 1 Cloth Total 140 90 230
- 9. COMPARATIVE COST ADVANTAGE THEORY : LIMITATIONS • Factor mobility is untenable • Existence of transport cost • Complete specialization is not possible • Problem of inadequate production • The theory is one sided • The theory is static • Unrealistic assumption of labour value • This theory is not applicable on the basic goods • Unrealistic assumption of free trade