Comparative Cost Theory
Eminent economists have said that the comparative cost theory is the basis of international business.
It explains that: ”it pays countries to specialise in the production of those goods in which they possess greater comparative advantage or the least comparative dis-advantage.”
In the words of Cairnes—”The difference in the comparative cost of producing the commodities exchanged is essential to, and sufficient for, the existence of international business”. This is the fundamental basis of international business.”
When this theory is applied to international business, the theory states that a country tends to specialise in the production of those articles in which it enjoys greater comparative advantage. What is more important is not the cost of commodity in country A and its cost in country B but the ratio between the costs of the commodities in the two countries.
A Paradox Indeed:
One will surprise to find a country importing a particular commodity from another country even when she can herself produce it at a lower cost. Why so? This can be explained by giving suitable and proper example—we find that Great Britain can produce both dairy products and machinery chapter than Denmark, yet she imports dairy products from Denmark and export machinery. Why so? This paradox can be explained in this manner.
Take this point-a Professor can polish and black his own shoes better than his servant and can of course teach and lecture far better. But his time is more profitably used with his books than with brush and polish. Similarly, a doctor may be a better dispenser than his assistant, but it pays him to examine patients and leave dispensing to his compounder.
In the same way Great Britain imports cheese and butter because she gains more by producing machinery. This is not a matter of surprise because every nation uses its resources in such channels which will yield the best results. This is the main basis of all international business.
Criticism of the Comparative Cost Theory:
1. This Theory is Based on Wrong Assumptions:
The comparative cost theory is based on some such assumptions which do not hold good in real life.
Some of these assumptions are:
(i) Static assumptions of fixed costs,
(ii) The unit costs remain the same,
(iii) It assumes that there are no transport costs,
(iv) Fixed supplies of the factors of production etc.,
(v) Further it assumes that there are no other costs except labour costs, and
(vi) It assumes perfect mobility of factors inside and perfect immobility outside the country. Economists do not believe over all these assumptions.
Therefore, this theory is not applicable to real life. Thus, the international business does not follow the law of comparative cost.
2. This Theory Implies Specialisation:
But in real life complete specialisation is not possible nor always desirable so far as countries are concerned.
3. International Business Arises Owing to Differences in Relative Factor Prices:
But international business also tends to narrow down these differences. Hence, business should come to end if we accept comparative cost theory.
4. This Theory has been Considered as One Sided:
As it ignores the demand and concentrates only on the supply side. This theory does not speak as to what prices the goods will be demanded.
5. It is not an Adequate Explanation:
The comparative cost theory does not furnish an adequate explanation of international business.
Critical Appraisal of Comparative Cost Theory:
Theory of comparative cost which is the important doctrine of classical economics is still valid and widely acclaimed as the correct explanation of international trade.
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. Haberler and others broke away from this labour-cost version and reformulated the comparative cost theory in terms of opportunity costs which takes into consideration all factors.
The basic contention of the theory that a country will specialise in the production of a commodity and export it for which it has a lower comparative cost and import a commodity which can be produced at a lower comparative cost by others, is based on a sound logic. The theory correctly explains the gain from trade accruing to the participating countries if they specialise according to their comparative costs.
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…. A nation that neglects comparative advantage may have to pay a heavy price in terms of living standards and potential rates of growth.”
Despite the sound logical structure and vivid explanation of gains from trade, the comparative cost theory, especially the Ricardian version based on labour theory of value has been criticized.
The following criticisms have been leveled against this theory:
- 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.
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. Therefore, it is the total money costs incurred on labour as well as other factors that should be considered for assessing comparative costs of various commodities.
Taussig tried to defend Ricardo by pointing out that even if labour theory of value was defective and even if other factors made important contributions to the production of goods, comparative costs could still be based on labour cost alone, if it is assumed that the trading countries are at the same stage of technological development.
This is because, he argued that given the same technological development, the proportions in which other factors could be combined with labour would be the same. 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, Taussig’s defense of Ricardian version of comparative cost theory is poor and invalid. 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. Hence, it is quite unrealistic and improper to consider relative efficiency of labour alone.
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.
- 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.
But it could not provide a satisfactory explanation of why comparative costs of producing commodities in various countries differ. Ricardo thought comparative costs of producing commodities in various countries differed due to the differences in efficiency of labour. But this begs the question why labour efficiency is different in various countries.
Factors for Variation in Comparative Costs of Different Commodities:
The credit of providing an adequate and valid answer to this question goes to Heckscher and Ohlin who explained that comparative costs of different commodities in the two countries vary because of the following factors:
- The various countries differ in respect of factor endowments suited for the production of different commodities.
- The different commodities require different factor proportions for their production.
Thus Heckscher and Ohlin supplemented the comparative costs theory by providing valid reasons for differences in comparative costs in various countries.
- Against the Ricardian doctrine of comparative cost it has also been said that it is based on the constant cost of production in the two trading countries. This assumption of constant costs leads them to conclude that different countries would completely specialise in the production of a single product on the basis of their comparative costs.
Thus, of the two commodities cloth and wheat, if India has a comparative advantage in the production of cloth, it will produce all cloth and no wheat. On the other hand, if U.S.A. has a comparative advantage in the production of wheat, it will produce all wheat and no cloth. But the pattern of international trade shows that this is far from reality.
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). Further, in the real world it is found that countries do not have complete specialisation. Indeed, a country produces a certain commodity and also imports a part of it.
However, it may be noted that even if the phenomenon of increasing costs is taken into account, foreign trade can still be explained in terms of differences in comparative costs. Only in the situation of increasing costs, countries would not have complete specialisation. Opportunity cost version of comparative costs theory does consider the case of increasing costs.
- 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. Voicing this criticism Else-worth remarks, “the comparative costs theorem, the way in which Ricardo set up his illustration, tended to obscure the problem of the terms of trade.”
Ricardian theory of comparative costs explains what commodity a country will export and what commodity it will import but it does not investigate at what rate it will exchange its exports for imports (i.e. terms of trade). However, the fixation of terms of trade is a vital issue, for on it a country’s share of gains from trade depends.
It is worthwhile to note that J.S. Mill, another noted classical economist, removed this shortcoming of the comparative cost theory by supplementing it with Reciprocal Demand Theory which explains the determination of terms of trade.
- Ohlin attacked the comparative cost theory for its assumption that factors of production were perfectly mobile within a country but immobile between countries. 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.
He further expressed the view that comparative cost doctrine applied not only to international trade but also to inter-regional trade. Indeed, according to him, international trade is only a special case of inter-regional trade. He further criticized the classical theory of comparative cost for its emphasis on supply conditions as an explanation of international trade and its neglect of the importance of demand conditions in determining the pattern of international trade.
He writes, “The comparative cost reasoning alone explains very little about international trade. It is indeed nothing more than an abbreviated account of the condition of supply”. According to him, prices of different goods and their quantities produced and consumed depend on both supply and demand conditions. He therefore, propounded a new theory of international trade based on general equilibrium theory of value.
It may be mentioned here that Ohlin’s criticisms do not invalidate comparative cost theory. Indeed, he only refined and modified it. Even in his theory, popularly known as factor-proportions theory of international trade, comparative costs serve as a basis of international trade.
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.
He further improved the comparative cost theory by incorporating in his analysis the demand aspect as be based his international trade theory on the general equilibrium theory of value.
- 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. Its conclusions cannot therefore be applied in the context of a dynamic economy, especially in the present-day developing countries where resources are being developed, technology is being improved, production functions are undergoing a change.
Indeed, structural changes are being brought about in these economies. In view of the changes in factor supplies and technology in developing countries, comparative costs of producing different commodities are also changing. In this dynamic context, a developing economy may have a comparative disadvantage in producing a certain commodity but may attain a comparative advantage after a certain stage of its development.
Note that this criticism about the static character of the comparative cost theory does not invalidate it. It only pinpoints the need for reformulating and refining it so as to make it applicable to the dynamic conditions of the developing countries.
To sum up, bereft of the labour theory of value and expressed in terms of opportunity costs comparative cost theory is still a valid explanation of international trade. It highlights the need for removal of artificial restrictions in the form of tariffs and other means on foreign trade so that various countries specialise on the basis of their comparative costs and derive mutual benefits from trade.
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. These are only simplifying assumptions and do not invalidate its conclusions in a substantial way.
Indeed, every theory makes some such simplifying assumptions in order to bring out the economic forces that have an important bearing on the subject under investigation.