THEORY OF COMPARATIVE COSTS 1

Ø  CLASSICAL THEORY OF INTERNATIONAL TRADE 1

(THEORY OF COMPARATIVE COSTS)

SHASHI AGGARWAL ECONOMICS AND LAW CLASSES

Ø  THEORY OF COMPARATIVE COSTS 1

1. GIVEN BY DAVID RICARDO IN HIS BOOK,PRINCIPLES OF POLITICAL ECONOMY AND TAXATION (1817)
2. DAVID RICARDO BELIEVED THAT THE INTERNATIONAL TRADE IS GOVERNED BY THE COMPARATIVE COST ADVANTAGE RATHER THAN ABSOLUTE COST ADVANTAGE. A COUNTRY WILL SPECIALIZE IN THAT LINE OF PRODUCTION IN WHICH IT HAS A GREATER RELATIVE OR COMPARATIVE ADVANTAGE IN COSTS THAN OTHER COUNTRIES WILL DEPEND UPON IMPORT FROM ABROAD OF ALL SUCH COMMODITIES IN WHICH INDIA HAS RELATIVE COST ADVANTAGES.
3. ACCORDING TO THIS THEORY EVERY COUNTRY SHOULD SPECIALIZE IN PRODUCTION I.E SHE SHOULD EXPORT THOSE GOODS IN WHICH SHE HAS GREATER COMPARATIVE ADVANTAGE AND IMPORT THOSE GOODS IN THE PRODUCTION OF WHICH SHE HAS GREATER COMPARATIVE DISADVANTAGE

• DEFINITION
• SHONE,” A COUNTRY WILL EXPORT GOODS IN WHICH IT HAS COMPARATIVE ADVANTAGE AND IMPORT GOODS FOR WHICH IT HAS GREATEST DISADVANTAGE.
• ASSUMPTIONS

1. ONLY TWO COUNTRY AND THEY PRODUCE TWO GOODS
2. NO INTERVENTION BY THE GOVERNMENT IN THE ECONOMIC SYSTEM
3. PERFECT COMPETITION EXIST BOTH IN THE COMMODITY AND FACTOR MARKET
4. STATIC CONDITIONS IN THE ECONOMY. FACTOR SUPPLIES,TECHNIQUE OF PRODUCTION,TASTE AND PREFERENCE ARE GIVEN AND CONSTANT
5. LABOUR IS THE ONLY FACTOR OF PRODUCTION AND COST OF PRODUCTION IS MEASURED IN TERMS OF LABOUR UNITS
6. ALL UNITS OF THE LABOUR ARE HOMOGENEOUS
7. FULL EMPLOYMENT
8. NO COST OF TRANSPORTATION
9. FACTORS OF PRODUCTION ARE MOBILE WITH IN THE COUNTRY BUT IMMOBILE BETWEEN TWO COUNTRIES
10. PRODUCTION IS SUBJECT TO LAW OF CONSTANT RETURNS TO SCALE
11. TRADE BALANCE VALUE OF EXPORT IS EQUAL TO VALUE OF IMPORT

• BASIS OF INTERNATIONAL TRADE
• THE THEORY OF COMPARATIVE COST IS EXPLAINED BY TAKING THREE TYPES OF DIFFERENCE IN COST:_

1. ABSOLUTE DIFFERENCE IN COSTS
2. COMPARATIVE DIFFERENCE IN COSTS
3. EQUAL DIFFERENCE IN COSTS

• ABSOLUTE DIFFERENCE IN COSTS
• ACCORDING TO ADAM SMITH THE MAIN BASIS OF INTERNATIONAL TRADE IN ABSOLUTE COSTS. THE DIFFERENCE IN ABSOLUTE COSTS ARISES :-
• WHEN ONE COUNTRY A IS IN POSITION TO PRODUCE A COMMODITY AT VARY LOW COST AS COMPARED TO ANOTHER COUNTRY
• OTHER COUNTRY  B CAN PRODUCE SOME OTHER COMMODITY AT A VERY LOW COST AS COMPARED TO THE A COUNTRY
• IT IS POSSIBLE WHEN A COUNTRY IS GIFTED BY NATURE:-

1. SPECIAL KIND OF SOIL
2. CLIMATIC CONDITION
3. FACILITIES

4.     ONE COUNTRY SPECIALIZES IN PRODUCTION OF PARTICULAR COMMODITY AND EXPORT TO B COUNTRY AND IMPORT FROM B COUNTRY THE COMMODITY IN WHICH B IS SPECIALIZED

• EXPLANATION

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• EXPLANATION AFTER INTERNATIONAL TRADE
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• EXPLANATION

1.     IF THERE IS NO TRADE BETWEEN THE TWO COUNTRIES AND BOTH PRODUCE TWO DAYS LABOUR WILL PRODUCE 6 UNITS OF WHEAT AND 6 UNITS OF RICE

2.     BUT IF A SPECIALIZES IN WHEAT AND B COUNTRY IN RICE AND TRADE WITH EACH OTHER.

3.     TWO DAYS LABOUR WILL PRODUCE A TOTAL OF 8 UNITS OF WHEAT AND 8 UNITS OF RICE.TOTAL GOODS WILL BE TO BOTH THE COUNTRIES WILL BE (8 UNITS OF RICE + 8 UNITS OF WHEAT)-(6 UNITS OF RICE+6 UNITS OF WHEAT)=2 UNITS OF WHEAT + 2 UNITS OF RICE

4.     B COUNTRY IS GOING TO GAIN IF IT GIVE  MORE THAN 0.5 UNITS OF WHEAT BY GIVING ONE UNIT OF RICE TO A COUNTRY

5.     A COUNTRY WILL GAIN IF IT GETS ONE UNIT OF RICE BY GIVING LESS THAN 2 UNITS OF WHEAT

• GRAPHICALLY EXPALNATION
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• EXPLANATION OF THE GRAPH

1. A B IS THE PRODUCTION POSSIBILITY CURVE OF B COUNTRY
2. IN ORDER TO PRODUCE ONE MORE UNIT OF COMMODITY HOW MANY UNITS OF ANOTHER COMMODITY WILL HAVE TO BE SACRIFICED
3. SLOPE OF THES CURVE WILL INDICATE THE OPPORTUNITY COST OF TWO COMMODITIES
4. ASSUMPTION IS OF CONSTANT COST
5. IF  B COUNTRY HAS TO PRODUCE ONE MORE UNIT OF RICE IT WILL HAVE TO PRODUCE .5 UNITS OF WHEAT
6. BY GIVING ONE UNIT OF RICE IT WILL GET MORE THAN.5 UNITS OF WHEAT
7. A COUNTRY GETS ON ONE UNIT OF RICE BY SACRIFICING LESS THAN 2 UNITS OF WHEAT