Ricardian Comparative Cost Advantage Theory of International Trade

 Ricardian Comparative Cost Advantage Theory of International Trade

The Theory of Comparative Cost Advantage, also known as the Theory of Comparative Advantage in international trade, was developed by David Ricardo in his seminal work "Principles of Political Economy and Taxation" published in 1817.

This theory states that countries should specialize in producing goods and services with a comparative advantage – that is, they can make at a lower opportunity cost than other countries. The opportunity cost refers to the potential benefit sacrificed when one alternative is chosen over another.

Ricardo's Theory of Comparative Cost Advantage focuses on specialization and trade, where countries specialize in producing goods and services with a comparative advantage, and trade with others for goods with a relative disadvantage. This leads to efficient global resource allocation. The theory also emphasizes opportunity cost, where countries produce and export goods with lower opportunity costs than their competitors. Comparative advantage allows for mutually beneficial trade, even if one country is more efficient in producing all goods. The theory also emphasizes relative productivity differences, where countries can still benefit from specializing in goods with comparative advantages.

Assumptions

1.       Barter System: Trade between two countries and two products takes place based on the barter system. Money does not exist and prices are determined by labor cost.

2.       Free Trade: There is free trade between two countries without any restrictions and trade barriers i.e. tariff or non-tariff barriers by the government.

3.       Homogeneous Labor: Labor is the only factor of production and its productivity remains the same and the cost of production is measured in terms of labor units.

4.       Mobility of Labor: According to this theory, Labor is perfectly mobile within a country but perfectly immobile between the countries

5.       Constant Return: Production is subject to the constant returns to scale i.e. increase in input is just equal to an increase in output.

6.       Full Employment: There is full employment of all factors in both countries.

7.       Cost of Production: Only labor hours used in producing goods are considered as the production cost.

8.       No Transportation Cost: There is no transport and transfer cost

9.       No Change in Technology: There is no technological innovation and no technological spillover.

10.    Perfect Competition Market: The underlying market structure driving production is based on perfect and free competition.

David Ricardo famously showed how England and Portugal both benefit by specializing and trading according to their comparative advantages. In this case, Portugal was able to make wine at a low cost, while England was able to cheaply manufacture cloth. Ricardo predicted that each country would eventually recognize these facts and stop attempting to make a product that was more costly to generate.

Indeed, as time went on, England stopped producing wine, and Portugal stopped manufacturing cloth. Both countries saw that it was to their advantage to stop their efforts at producing these items at home and, instead, trade with each other to acquire them.

The data shows the labor hours required for producing wine and cloth in Portugal and England. Portugal has a comparative advantage in wine production due to its lower labor hours (80 LHs) compared to England (120 LHs). In cloth production, Portugal has a disadvantage due to its higher labor hours (80 LHs vs. 90 LHs). England has a comparative advantage in cloth production due to its lower labor hours (100 LHs vs. 120 LHs). Therefore, Portugal should specialize in wine production, while England should specialize in cloth production. This allows for trade between the two countries, maximizing their overall production and consumption possibilities.

The above table shows that Portugal has a lower opportunity cost for producing wine compared to cloth (1 unit of wine = 0.89 units of cloth). Thus, Portugal has a comparative advantage in producing wine. On the other hand, England has a higher opportunity cost for producing wine compared to cloth (1 unit of wine = 1.2 units of cloth). Thus, England has a comparative advantage in producing cloth.

The benefit level for both countries and in total can be calculated with the help of below table information as follows:

The provided table illustrates the output, cost, and total cost for Portugal and England under different trade scenarios: without trade, with trade and specialization, and with trade but without specialization.

Without trade, if Portugal produces 1 unit of wine (W) and 1 unit of cloth (C), requiring a total cost of 170 labor hours. Similarly, England produces 1 unit of wine and 1 unit of cloth, requiring a total cost of 220 labor hours. In total, both countries produce 2 units of wine and 2 units of cloth, with a total cost of 390 labor hours. Each country produces both goods domestically, resulting in higher total costs compared to trade scenarios.

But with Trade & Specialization, Portugal specializes in producing wine, producing 2 units of wine with a total cost of 160 labor hours. Similarly, England specializes in producing cloth, producing 2 units of cloth with a total cost of 200 labor hours. In total, both countries produce 2 units of wine and 2 units of cloth, with a reduced total cost of 360 labor hours compared to the scenario without trade. Therefore, the cost advantage of free trade with specialization for Portugal is 10 labor hours, and for England, it is 20 labor hours and for both countries, it is 30 labor hours. So, if there is specialization in producing the good it has a comparative advantage, leading to lower total costs and increased efficiency.

On the other hand, if there is trade but without Specialization, Portugal and England do not specialize and produce according to their initial comparative advantage. Portugal produces 2 units of cloth with a total cost of 180 labor hours. England produces 2 units of wine with a total cost of 240 labor hours. In total, both countries produce 2 units of wine and 2 units of cloth, with a total cost of 420 labor hours, which is higher than the scenario with trade and specialization. Both countries trade but do not specialize, resulting in higher total costs compared to the scenario with specialization. This is because they are not fully utilizing their comparative advantages.

Overall, the table demonstrates the benefits of trade and specialization in increasing efficiency and reducing total production costs for both countries.

Comparative Advantage and its Benefits in Free Trade

First, let’s assume that the maximum amount of labor hours is 3600 hours available for both countries. In Portugal, if all labor hours went into wine, 45 units of wine could be produced and if all labor hours went into cloth, 40 units of cloth could be produced. Similarly, in England, if all labor hours went into wine, 30 units of wine could be produced and if all labor hours went into cloth, 36 units of cloth could be produced.

Following Ricardo’s theory of comparative advantage in free trade, if each country specializes in what they enjoy a comparative advantage in and imports the other good, they will be better off. Recall that: Portugal enjoys a comparative advantage in wine and England enjoys a comparative advantage in cloth. This can be explained with the help of the following table and diagram.

The provided table and diagram illustrate the output, cost, and total cost for Portugal and England under different trade scenarios: without trade and with trade & specialization.

Without Trade, Portugal produces 22.5 units of wine (W) and 20 units of cloth (C), requiring a total cost of 3600 labor hours. England produces 15 units of wine and 18 units of cloth, also requiring a total cost of 3600 labor hours. In total, both countries produce 37.5 units of wine and 38 units of cloth, with a combined total cost of 7200 labor hours.

With Trade & Specialization, Portugal specializes in producing wine, producing 45 units of wine with a total cost of 3600 labor hours. England specializes in producing cloth, producing 40 units of cloth with a total cost of 3600 labor hours. In total, both countries produce 45 units of wine and 40 units of cloth, with a total cost of 7200 labor hours.

Thus, if each country produces both goods domestically, resulting in lower output compared to trade scenarios. If they make the trade with Specialization, then each country specializes in producing the good in which it has a comparative advantage, leading to higher output and increased efficiency. For this, Portugal specializes in producing wine, while England specializes in producing cloth, resulting in a more efficient allocation of resources.

Limitations or Criticism of Comparative Advantage Theory

1.       Barter System: The theory operates under the assumption of a barter system, where trade occurs directly between goods without the use of money. However, in reality, modern economies operate with the use of currency, and the absence of money in the model oversimplifies the complexities of real-world trade.

2.       Free Trade: The theory assumes free trade without any restrictions or trade barriers between countries. In practice, many countries impose tariffs, quotas, and other trade barriers, which can distort comparative advantage and hinder the benefits of trade.

3.       Homogeneous Labor and Constant Returns to Scale: The theory assumes homogeneous labor and constant returns to scale, which may not accurately reflect the diverse and dynamic nature of labor and production processes in the real world.

4.       Immobility of Labor: The theory assumes perfect immobility of labor between countries, which is not realistic as labor migration is a common phenomenon influenced by various factors such as economic conditions, policies, and social factors.

5.       Full Employment: The assumption of full employment of all factors of production in both countries may not hold in reality, as economies often experience unemployment and underutilization of resources.

6.       No Transportation Cost Assumption: The absence of transportation costs in the model overlooks the significant role of transportation and logistics in international trade, which can affect the competitiveness of goods in global markets.

7.       No Technological Change: The theory does not account for technological innovation and advancements, which play a crucial role in shaping comparative advantage and influencing production efficiencies over time.

8.       Perfect Competition Market Assumption: The theory assumes perfect and free competition in markets, but in reality, markets are often imperfect, with monopolies, oligopolies, and other market structures that can distort trade patterns.

9.       Neglect of Trade in Services and Technologies: The theory focuses primarily on trade in goods and overlooks the growing importance of trade in services, ideas, and technologies in the modern global economy.

10.    Rent-Seeking Behavior: The theory fails to address rent-seeking behavior, where certain groups lobby for protectionist measures to preserve their interests at the expense of overall welfare and efficiency. This can lead to distortions in trade patterns and undermine the benefits of comparative advantage.

11.    Negative Externalities and Exploitation: Overemphasis on comparative advantage can lead to negative externalities such as environmental degradation and exploitation of labor in less developed countries, as industries may prioritize profits over social and environmental concerns.

12.    Dependency on Global Markets: Over-specialization in a particular export, such as cash crops in agriculture, can lead to dependency on global markets. Countries that focus solely on cash crops may become overly reliant on international demand and prices, leaving them vulnerable to fluctuations in global commodity markets. This dependence exposes them to risks such as price volatility, shifts in consumer preferences, and changes in market conditions.

In summary, while the theory of comparative advantage provides valuable insights into the benefits of international trade, it is not without its limitations and criticisms. These criticisms highlight the need for a more nuanced understanding of trade dynamics and the consideration of broader economic, social, and environmental factors in trade policy and practice.