Comparative Cost Advantage Theory

  • According to this theory given by DAVID RICARDO a nation shall undertake and specialize in the production of those goods or services for which they have the highest relative cost advantage.
  • The propounded theory takes following assumptions:
  1. Labor is only cost of production
  2. Production is subjected to law of constant returns
  3. There are no trade barriers
  4. Trade is free from cost of transportation

  • The theory shall be understood by considering two countries India and USA.India – labor abundant

    USA – capital abundant

    Now let us take two products shoes and computers and understand the resources requirement of both the countries for manufacturing the given products and the cost associated with the same.

    The given table shows the resources used by both the countries for manufacturing the said products

      Shoe Computer
    India 1 unit 4 units
    USA 6 units 3 units
  • Now from the table we can clearly infer that India must specialize in manufacturing shoes because for one unit of labor, one unit of shoe is produced as against 1/4th unit of computer.
  • Similarly USA must specialize in manufacturing computer due to its relative cost advantage over shoes.
  • Now let us understand the basis of trade. Assume that there are 120 units of labor in both the countries India and USA.

Production before trade

  Shoe Computer Output
India 60 units 15 units 75 units
USA 10 units 20 units 30 units
    TOTAL 105 UNITS

 

 After trade

  Shoe Computer Output
India 120 units 0 unit 120 units
USA 0 unit 40 units 40 units
    TOTAL 160 UNITS

Productivity increases by 55 units.

Consumption after trade

  Shoe Computer
India 60 units 20 units
USA 60 units 20 units
TOTAL 120 units 40 units

 

  • Limitations
  1. Neglecting the transportation cost may not be viable as it can outweigh the comparative cost advantage.
  2. Generally there are trade restrictions to a given extent.
  3. Assumptions of perfectly competitive market without any diminishing returns is not feasible and far from reality.
  4. Labor is not the only factor.
  5. It can be employed from one product to another.
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