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Comparative Cost Advantage Theory April 1, 2010

Posted by Chetan Chitre in International Business Management, International Trade Theory.
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According to Smith’s Theory trade would take place between countries only if the country enjoys an absolute cost advantage in production of a particular commodity over another.

However, it is seen in some cases that country A enjoys a produces all commodities at a cost lesser than country B. But, despite this country A ends up importing some commodities from country B. Ricardo explained this using his theory of Comparative Cost Advantage.

According to this theory, country A may still import those commodities from country B where ‘opportunity cost’ of producing a good is higher in country A than in country B.

Opportunity Cost – Cost in terms of opportunity sacrificed. 

Eg. A building can be used either for residential purpose or for commercial purpose. If one ends up using it for any one of the above purpose (say – residential) – then it cannot be used for the other purpose (i.e. commercial) Hence the commercial use of the building was an opportunity that one has sacrificed and should be counted as “opportunity cost”.

The concept is important to decide on minimum level of returns. Returns should be greater than costs. Here we say that the costs should also include the ‘opportunity costs’. So if the construction cost is Rs. 1000 per sq. ft. and if the sale price for residential purpose is Rs. 1200/- per sq. ft. – we have made a profit.

However here we have not included the opportunity cost. We could have sold the building for commercial use Rs. 2000/- per sq. ft. By selling to for residential use at Rs. 1200 per sq.ft., our returns are thus less than the opportunity costs. It was, therefore, a wrong decision.

The opportunity cost thus sets a benchmark price below which one should not sell the building.

The Comparative Cost Advantage theory can be explained by way of the following example –

Bread Cloth
India 120 100
England 80 90

In the above example –

# In India it takes 120 units of labor to produce 1 unit of bread while England requires only 80 units of labor to produce the same bread.

# Further, in India it takes 100 units of labor to produce 1 unit of cloth while the same cloth is produced using only 90 units of labor in England.

# Clearly England has advantage in production of both cloth as well as bread. Will England import anything from India in such a situation?

# To see that we need to compare the opportunity cost of producing each of the commodities in both the countries. i.e. amount of production of Cloth to be sacrificed for production of bread and vice-versa.

Opportunity cost of Bread Opportunity cost of Cloth
India 120/100 = 1.20 

120 units of labor can produce 1 unit of bread of alternatively be used to produce 1.20 units of cloth. Thus we sacrifice 1.20 units of cloth when we produce 1 unit of bread.

100/120 = 0.83
England 80/90 = 0.88 90/80 = 1.12

# Thus we see that the opportunity cost of producing bread in England is less than in India. N the other hand the opportunity cost of producing cloth is more in England than in India.

# England would thus specialize in production of bread and import cloth from India, while India would specialize in production of cloth and import bread from England.

This can also be explained as –

# India takes 120 hours to produce 1 unit of bread – during these 120 hours the worker could have produced 1.20 units of cloth – 1 units of bread would thus be equal to 1.20 units of cloth. The price of 1 unit of bread would thus be 1.20 units of cloth

# By the same logic the price of bread in England would be 0.88 units of cloth.

# A baker in England would therefore prefer to sell (export) his bread in India for 1.20 units of cloth rather than sell it in England for 0.88 units of cloth. He may even be happy to sell I unit of bread for 1 unit of cloth as this is still a better deal than 0.88 units of cloth that he gets in England.

# Indian consumer would be happy to buy Bread from the English baker at price of 1 unit of cloth as it is still less than 1.20 units of cloth he pays to the Indian baker.

# An opposite situation would prevail in terms of Cloth. Indian Cloth maker would find it profitable to sell (export) his cloth in England

# Thus we see that despite the fact that England enjoys absolute advantage in production of both bread and cloth, it would still end up importing cloth from India.

Assumptions of Comparative Cost Advantage Theory –

(a) 2 countries – 2 commodities model – 1 factor of production i.e. labor

(b) Tastes and preferences in both countries are similar and constant

(c) All labor units are homogenous

(d) Supply of labor is unchanged

(e) Full employment

(f) Production under constant returns to scale

(g) No currency – barter trade

(h) Factors of production (labor) perfectly mobile within country but no mobility between countries.

(i) Free Trade

(j) No transportation costs

(k) Perfect competition

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