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comparative theory of international trade
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It will be seen from Table 23.3 that U.S.A. is more efficient (or has absolute advantage) in the production of both wheat and cloth. Comparative advantage not only affects the production decisions of trading nations, but it also affects the prices of the goods involved. But the pattern of international trade shows that this is far from reality. It is indeed nothing more than an abbreviated account of the condition of supply”. But that’s only a temporary fix. Even though the U.S.A. is more efficient in the production of both wheat and cloth, she will still gain by having specialisation and trading with India. Not because of any particular intrinsic benefit but new firms start to get the network benefits of being around other IT setups.’ 2. In this way the productive resources of the country and of the whole world will be optimally utilised. In order to simplify our analysis, we make the following assumptions: 1. Theory of Comparative Costs or Comparative Advantage: The fundamental cause of international specialisation and hence international trade is the difference in costs of production. Welcome to EconomicsDiscussion.net! It will be much better if after comparing the costs of the various articles that it can produce, it selects those in which the comparative costs are lower or in which it enjoys relative advantage. Comparative cost theory of international trade This theory is developed by a classical economist David Ricardo. Now, if foreign trade possibilities are such that price of cloth is relatively more in foreign market than at home, it would be advantageous for the country to enter into trade and increase the production of cloth and reduce that of wheat. It has been pointed out that labour is not the only factor needed for the production of commodities, other factors such as capital, raw materials, land also contribute to production. 23.3 that U.S.A. would gain from specialisation and trade as point R lies at a higher level than point E. At point R, U.S.A. would be consuming more of both wheat and cloth than at point E which is the position before trade. For example, the world price of a bicycle will be between 5/3 shirt and 2 shirts, thereby decreasing the price the Italians pay for a shirt while allowing the Italians to profit. Introduction Both comparative and absolute advantage are theories of international trade. This advantage may come because of a country's infrastructure, labor force, technology or innovations, or natural resources. As a person specialises in the trade in which he has best advantages, a country also specialises in the … But it will not produce all of them since it will simply not be paying to do so. Likewise, 80 metres of cloth in U.S.A. has the opportunity cost of 60 kg. Every country has a fixed endowment of resources and all units of each particular resource are identical. The Ricardian theory of comparative costs, has also been criticized for its not going into the question what determines the terms of trade between the countries. The work of dispensing can be done by a low-paid person, while he can earn much more as a doctor. Internal trade is not exactly the same as the international trade. On the other hand, if India reduces production of one unit of wheat, 12 hours of labour will be released which on using for cloth production will result in gain of 1.33 units of cloth. International trade itself involves “two or more economic systems in an exchange of goods and services which transcend international boundaries” (Menipaz and Menipaz, 2011). There is free trade between the countries. It will be seen from the slopes of the production possibility curves of the two countries that while India can produce cloth at the lower comparative cost, the U.S.A. can pro­duce wheat at a comparatively cheaper cost. We shall explain what would be the basis of trade between these two countries and how the two would gain from specializing and trading with each other on the basis of comparative advantage or comparative cost. This raises per unit cost of cloth. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. Firms competing in the model of monopolistic competition and heavy branding. Political leaders are always under pressure from their local constituents to protect jobs from international competition by raising tariffs. Comparative advantage is a term associated with 19th Century English economist David Ricardo. Comparative theory states that the value of pr… The first one is that it allows us to consider both sources of com-parative advantage, technology and factor endowment—within a unifying yet highly tractable framework. These are only simplifying assumptions and do not invalidate its conclusions in a substantial way. The production equilibrium in the absence of trade will be reached at point R where the price line is tangent to the production possibility curve so that the marginal rate of transformation between the two goods is equal to the price ratio between them. Before publishing your Articles on this site, please read the following pages: 1. According to the international trade theory, even if a country has an absolute advantage over another, it can still benefit from specialization. According to him, prices of different goods and their quantities produced and consumed depend on both supply and demand conditions. Incomplete theory: It is an incomplete theory. 23.1 where on the X-axis wheat and on the Y-axis cloth have been measured, Now, line AB repre­sents the production possibility curve in India between wheat and cloth. In this way the productive resources of the country will be optimally utilised. Further India will export QR’ of cloth and import QC of wheat. Suppose, D’T’ is the terms of trade line showing the price ratio settled between the two countries. The following criticisms have been leveled against this theory: 1. The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to … The opposite will happen in the trading partner who will increase the production of wheat and reduce that of cloth by shifting resources out of the latter into the former. Share Your PDF File The answer to this is that whereas the U.S.A. has an absolute advantage in the production of both wheat and cloth, its margin of advantage is greater in case of wheat as compared to cloth. However, the consumption of two goods in a country depends on the tastes or demand pattern for the goods. Therefore, a noted economist Haberler has explained comparative cost doctrine in terms of opportunity costs. The challenge to the absolute advantage theory was that some countries may be better at producing both goods and, therefore, have an advantage in many areas. Similarly, a professor may be able to teach his own son who is reading in a lower class much better than any school teacher. Privacy Policy3. After trade the equilibrium of U.S. A. would lie at some point on the terms of the trade line D’T, depending upon its demand for goods. TOS4. Economists use the term comparative advantage when describing the opportunity cost of two producers. supply or cost conditions) and the demand for the goods. Opportu­nity cost version of comparative costs theory does consider the case of increasing costs. Content Guidelines 2. Content Guidelines 2. 3. In the explanation of comparative cost theory, the concept of opportunity cost is generally illustrated through production possibility curve. A comparative advantage in trade is the advantage that one country has over another in the production of a particular good or service. It will suffice to mention here that consumption of the two goods in India would take place at a certain point on the terms of trade line tt to the left of point R, say at point C. Of course, this consumption point C would be determined by the demand conditions in India. There are no transport costs between the two countries. In … It will be seen from Table 23.4 that total world output (i.e. He pointed out that immobility of factors between countries could not serve as a basis for international trade, since immobility of factors is not peculiar the relations between countries but is also present between different regions of the same country. In case of increasing opportunity costs, the production possibility curve instead of being a straight line is concave to the origin, as shown in Figure 23.4. This theory holds that there are benefits to be gained from importing as well as exporting. Some resources may be equally suitable for the production of both wheat and cloth but all resources are not of this kind. Suppose, with given resources, India can produce 20 kgs. The proliferation of brand clothing labels. The fundamental cause of international specialisation and hence international trade is the difference in costs of production. It is alleged that comparative cost theory is static in character as it is based on fixed supplies of factors of production, the given technology, and the fixed and identical production functions in the trading countries. It is thus evident that the U.S.A. is more efficient in the production of both the commodities as it produces them at a lower labour cost than India. In the equilib­rium situation, the two goods would be produced in such quantities where: MRTCW stands for marginal rate of transformation between the two goods. It only pinpoints the need for reformulating and refining it so as to make it applicable to the dynamic conditions of the developing countries. Heckscher-Ohlin Theory. Under conditions of increasing opportunity costs, the production possibility curve is not identi­cal with a price curve as in case of constant opportunity costs. In the first place, Ricardian version of comparative cost theory has been attacked on the ground that being based on labour theory of value, it considers only labour cost to measure the comparative costs of various goods. Similarly, in Fig. of wheat has opportunity cost of 80/60 or 1.33 metres of cloth. This is important not only for generalizing results This theory has been a victim of undue criticisms such as that it assumes the absence of transport costs, the existence of perfect competition and full employment, and further that it consid­ers two commodities, two countries model. In a two-commodity world when one country can produce both of them at a lower cost than another, it will pay to it to specialise in the production of a commodity which it can produce at comparatively lower cost and import the other commodity for which it has a comparatively higher costs. The factors of production are perfect… Most of the criticisms that have been leveled against this doctrine relate to the Ricardian version of comparative cost theory based on labour-theory of value. Since U.S.A. has a comparative advantage in the production of wheat it will specialise in wheat and would produce OB or 60 units of wheat, whereas India has comparative advantage in the production of cloth and will specialise in cloth production. Each country benefits by specializing in those occupations in which it is relatively efficient; each should export part of that production and take, in exchange, those goods in whose production it is, for whatever reason, at a comparative disadvantage. 3. In view of this he asserted that other factors could be validly ignored and for purpose of comparative costs relative efficiency of labour alone of different countries could be considered. However, as stated earlier, Haberler rescued the comparative cost theory from labour theory of value and reformulated it in terms of opportunity cost which covers all factors. Furthermore, although Ricardian theory of comparative costs may show the limits within which the equilibrium must be, it does not show how to determine the terms of trade, and hence the price of the goods. Let us make in-depth study of the critical appraisal and factors for the variation of comparative cost theory of international trade. However, this does not represent the real situation, where all resources do not produce equally well both of the two commodities. On the other hand, as more factors of production are drawn from wheat for allocating them to the production of cloth, per unit cost of wheat falls. The theory of comparative costs is simply an application of the principle of division of labour to different countries. The various trading partners are not at the same stage of technological development and therefore the factor proportions used for the production of commodities in different countries are vastly dif­ferent. at a lower relative marginal cost prior to trade. An individual can do a number of jobs but he cannot do them all alike. A country tends to specialise in the production of those goods for which it has got relative or comparative advantage. Comparative cost theory explained above is based upon labour theory of value. A country can produce numerous goods. Both the countries will be better off if the U.S.A. specialises in the production of wheat and exports it to India for import of cloth and India specialises in the production of cloth and exports it to the U.S.A. and import wheat from it. It will be seen from Table 23.3 and 23.4 that if U.S. A. reduces the production of cloth by one unit 6 man-hours of labour will be released and if these are used for the production of wheat it will gain 2 units of wheat production. Further, in the real world it is found that countries do not have complete specialisation. His contribu­tion lies in his inquiring into the question why comparative costs of commodities in different coun­tries differ and offering a satisfactory explanation of it in terms of different factor-proportions required for the production of various goods. These merits of the theory have led Professor Samuelson to remark, “If theories, like girls, could win beauty contents, comparative advantage would certainly rate high in that it is an elegantly logical structure.” He further writes, “the theory of comparative advantage has in it a most important glimpse of truth…. This has been shown in Figure 23.3 the product possibility. Thus Heckscher and Ohlin supplemented the comparative costs theory by providing valid reasons for differences in comparative costs in various countries. The comparative cost theory explained that different countries would specialise in the pro­duction of goods on the basis of comparative costs and that they would gain from trade if they export those goods in which they have comparative advantage and import those goods from abroad in respect of which other countries enjoyed comparative advantage. Note that this criticism about the static character of the comparative cost theory does not invali­date it. Share Your PPT File, Equalization of Factor Prices in International Trade. But if the hour that he devotes to the teaching of his son is devoted to coaching of a student for the degree examination, he will get much more payment than he has to pay a tutor whom he may employ for coaching his son. Now, the question is what will be the source of gain from specialisation in the present case. Globalisation has led to increased variety for consumers. This can be shown by superimpos­ing the opportunity cost curve CD of India over the opportunity cost of U.S.A., in such a way that point D is joined with point B of U.S.A. The fundamental cause as to why international specialisation occurs is the differences in costs, which result from the differ­ences in the availability of the amount and the quality of resources, the prices of these resources or factors and the method of their use. It may be mentioned here that Ohlin’s criticisms do not invalidate comparative cost theory. Let us illustrate the theory of comparative cost (or comparative advantage) with a numerical example. He writes, “The comparative cost reasoning alone explains very little about international trade. Thus, it would be to the advantage of U.S.A. to specialise in the production of wheat and of India in the production of cloth. (i) According to the classical economists, there was need for a separate theory of international trade because international trade was fundamently different from internal trade. Thus, specialisation, according to the comparative advantage, would lead to the increase in production of both wheat and cloth and the two countries would gain from trading with each other by exporting the goods in which they specialize. Share Your Word File As a matter of fact, a stage comes when it is no longer advantageous for India to import wheat from U.S.A. (because of increasing costs in producing wheat). In fact, it was this question which was raised by David Ricardo, a classical economist, who put forward the theory of comparative costs (advantage) as an explanation of the potential gain from international trade. This is because of the occurrence of dimin­ishing returns or increasing costs as the production of one commodity is stepped up at the expense of the other commodity. 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