The Theory of Comparative Cost was put forward by David Ricardo in 1817. The main purpose behind developing this theory was to advocate for mutual trade.
According to Ricardo:
“Nations should not waste their scarce resources on producing the commodities which they can obtain from abroad at a lesser cost. A nation should divert its resources only to the production of commodities in which they have greatest relative efficiency and trade for those products which they cannot produce efficiently”.
David Ricardo, with the help of his comparative cost theory tried to illustrate that even if Portugal could produce wine and cloth more cheaply (in terms of labor hours) than England, it will be beneficial for Portugal to specialize in the production of wine, because she is comparatively more efficient in its production than cloth. So if Portugal concentrates in the production of wine and England specializes in the production of cloth, trade will be mutually profitable to them because they have now a larger supply of wine and cloth.
The principle of comparative cost can be made clear by taking a simple example from our every day life.
Let us suppose, there is a very successful barrister who at the very same time is a very good typist. Will it be advantageous for the barrister to type all his legal documents himself? The answer is no. The time which he spends in typing his papers can be more profitably utilized in the preparation and pleading of his cases in courts.
For example, if the types all his legal documents himself, he can save $2000 per month. If he engages a typist and spends that time in the preparation of cases, he can earn $4000 per month. It will thus be profitable for the barrister to devote his time in the preparation of cases and pleading them in court than doing any other work. In economic terminology, we can say, that though the barrister has an advantage in both pleading his eases and typing of documents, yet he can earn more if he devotes himself exclusively to the occupation in which he has the greater comparative advantage, i.e., in legal work.
We can take many other examples like this to clear the concept of comparative cost. For instance, it is advantageous for a doctor to employ a dispenser than to do the work of dispensary himself, though be himself is a better dispenser.
The principle of comparative cost which we have applied to individual cases is now applied to regions and countries. It pays each country to specialize in the production of those commodities in which it has the greater comparative advantage or in which it suffers the least comparative disadvantage.
In the words of Jacob Viner:
“The theory of comparative cost as applied to international trade is therefore, that each country tends to produce, not necessarily what it can produce more cheaply than an other country, but those articles which it can produce at the greatest relative advantage, i.e., at the lowest comparative cost. Each country will produce that article in the production of which its superiority is more marked or its inferiority least marked”.
It may be remembered here that when the products of one country exchange for that of another, it is not the cost of production which we compare but the ratio between the cost of the production of the commodities concerned.
Basic Principles of the Theory of Comparative Costs:
The basic principle of comparative costs is now illustrated by using a simplified trade model where:
(i) There are only two trading countries-country A and country B.
(ii) These two countries produce only two goods-cotton and sugar.
(iii) The commodities produced in each country are identical.
(iv) There are no barriers to trade and no transport costs.
(v) Labor is the sole productive resources in the country and it can move freely from one industry to another industry within the country.
Types of Cost Differences:
Within the limits set by the model, we take three possibilities and examine where trade is profitable:
(i) Countries with absolute difference in cost of producing goods.
(ii) Countries with equal difference in cost of producing goods.
(iii) Countries with comparative difference in cost of producing goods.
International trade is profitable only Under 1 and 3 countries but not under 2 as is explained below.
(1) Absolute Difference in Cost:
Let us assume there are two countries, Pakistan and India. Pakistan specializes in the production of sugar and India in wheat. Pakistan with X labor cost produces 30 quintals of wheat or 60 quintals of sugar. India with the same X labor cost produces 60 quintals of wheat or 30 quintals of sugar in a season, as is shown in the table below:
This table shows that in Pakistan 30 quintals of wheat is equal in its exchange value of 2 quintals of sugar. The substitution ratio or the opportunity cost relation between wheat and sugar is 1:2. In India, the substitution ratio between wheat and sugar in 1:1/2 (on quintal of wheat is equal to 1/2 quintal of sugar).
From this table it is clear that Pakistan has an absolute advantage in the production of sugar and India in the production of wheat, if Pakistan specializes in the production of sugar and India in wheat, there will be increase in total output and both the countries will gain from mutual trade.
Pakistan will gain so long as it can receive more than one quintal of wheat by giving two quintals of sugar. India will benefit from trade, if she gets more than 1/2 quintal of sugar in exchange for one quintal of wheat.
(2) Trade under Equal Difference in Cost Ratio:
If the opportunity cost ratio between two countries is equal, trade will not be advantageous to any of them. For example, if Pakistan with X labor cost produces 30 quintals of wheat or 60 quintals of sugar and India with the same given resources produces 26 quintals of wheat or 52 quintals of sugar, international trade will not take place between them.
Trade is not gainful in both the countries because of the fact that in both Pakistan and India, one quintal of wheat can be exchanged for 2 quintals of sugar. Pakistan can benefit only if it gets more than 2 quintals of sugar in exchange for one quintal of wheat- India wilt not agree to this bargain because she herself can exchange that much quantity in her own country.
(3) Comparative difference in Cost Ratio:
According to Ricardo, if one country is more efficient than the other in the production of both the commodities, international trade will be mutually profitable to them. This basic statement involves the Principal of Comparative Cost which is explained with the help of an example.
Let us suppose, Pakistan with X resources (labor) produces 10 quintals of wheat or 100 quintals of sugar and India with the same X resources (labor) produces 5 quintals of wheat or 75 quintals of sugar.
It is clear from the table, above that Pakistan has comparative cost advantage in the production of both commodities, i.e., wheat and sugar. But when we examine opportunity costs of producing both the commodities in two countries, the picture is then different. In Pakistan the cost of one quintal of wheat is equal to 10 quintals of sugar; whereas in India the cost of one quintal of wheat is equal to 15 quintals of sugar. Pakistan, thus, has a comparative advantage in the production of wheat and India in sugar. So if Pakistan specializes in the production of wheat and India in sugar, there will be greater output of both the commodities. Trade will be beneficial to the trading countries.
As regards the rate of exchange, it is determined by the relative elasticities of demand of two countries for the, goods of the other, if Pakistan’s demand for sugar is more intense than that of India for wheat, the terms of trade will be more favorable to India and vice versa.
The theory of comparative costs has been criticized on the following grounds:
(i) Unrealistic nature of the labor immobility assumption: The theory assumes that labor is mobile within the country but immobile between countries. This is not a realistic assumption. The migration of labor from one country to another has an important bearing on the traded goods.
(ii) Unrealistic assumptions of constant cost: The assumption of zero transport cost and constant cost is also not valid. It does not accord with facts.
(iii) Unrealistic assumption of perfect competition: The theory assumes perfect competition. But in the actual world, it is imperfect competition which prevails. The theory thus has no practical utility.
(iv) Labor differs in efficiency: The theory assumes that all labor is of the same quality. The fact, however, is that the efficiency of labor varies from person to person.
(v) Based on labor theory of value: The theory of comparative cost was based in terms of labor theory of value; while in reality labor is only one element of total cost.
(vi) Neglects the effects of elasticity of demand: The theory neglects the part played by demand in the determination of prices of trades goods. It takes only the supply conditions for explaining the prices cost differences of goods entering in international trade. The analysis of the cost theory is thus incomplete.
(vii) Based on the assumption of static conditions: Bertil Ohlin has severely criticized the assumptions of the principle of comparative cost theory. He has regarded it as a static theory which has no relevance to the complex situations of the dynamic world.
In spite of the drawbacks stated above, the comparative cost theory has still many supporters. It is used as a tool of analysis m relating to problems of international trade. Professor Samuelson is right when he says:
“If theories like girls could win beauty contests, the comparative advantage would certainly rate high in that it is an elegantly logical structure”.