Question

Define and explain the theory of comparative advantage. What are the major limitations of the theory in explaining international trade?

Answer 1

The law or principle of comparative advantage holds that under free trade, an agent will produce more of and consume less of a good for which they have a comparative advantage. Comparative advantage is the economic reality describing the work gains from trade for individuals, firms, or nations, which arise from differences in their factor endowments or technological progress. In an economic model, agents have a comparative advantage over others in producing a particular good if they can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior to trade. One shouldn't compare the monetary costs of production or even the resource costs (labor needed per unit of output) of production. Instead, one must compare the opportunity costs of producing goods across countries.

David Ricardo developed the classical theory of comparative advantage in 1817 to explain why countries engage in international trade even when one country's workers are more efficient at producing every single good than workers in other countries. He demonstrated that if two countries capable of producing two commodities engage in the free market, then each country will increase its overall consumption by exporting the good for which it has a comparative advantage while importing the other good, provided that there exist differences in labor productivity between both countries. Widely regarded as one of the most powerfulyet counter-intuitive insights in economics, Ricardo's theory implies that comparative advantage rather than absolute advantage is responsible for much of international trade.

For considerable period the theory of comparative costs formulated by David Ricardo was the most acceptable explanation of the international trade. However, Ricardo's theory was subjected to number of criticisms.

Following are the important limitations of Ricardian Comparative Cost Theory.

1. Restrictive Model

Ricardo's Theory is based on only two countries and only two commodities. But international trade is among many countries with many commodities.

2. Labour Theory of Value

Value of goods is expressed in terms of labour content. Labour Theory of value developed by classical economists has too many limitations and thus is not applicable to the reality.

Value of goods and services in the real world is expressed in money i.e. the prices are the values expressed in units of money.

3. Full employment

The assumption of full employment helps the theory to explain trade on the basis of comparative advantage. The reality is far from full employment. Cost of production, even in terms of labour, may change as the countries, at different levels of employment move towards full employment.

4. Ignore transport cost

Another serious defect is that the transport costs are not consider in determining comparative cost differences.

5. Demand is ignored

The Ricardian theory concentrates on the supply of goods. Each country specialises in the production of the commodity based on its comparative advantage. The theory explains international trade in terms of supply and takes demand for granted.

6. Mobility of factor of production

As against the assumptions of perfect immobility between the countries, we witness difficulties in the mobility of labour and capital within a country itself. At the same time their mobility between nations was never totally absent.

7. No Free Trade

Ricardian theory assumes free trade i.e. no restriction on the movement of goods between the countries. Though it is unrealistic to assume not to have any restriction. what the real world witnesses is a lot tariff and non-tariff barriers on international trade. Poor countries find it difficult to enjoy the comparative advantage in the production of labour intensive commodities due to the protectionist policies followed by developed countries.

8. Complete specialisation

The comparative advantage theory comes to conclusion of complete specialisation. In the Ricardian example, England is specialising fully on cloth and Portugal on wine. Such complete specialisation is unrealistic even in two countries and two commodities model. It is possible if two countries happens to be almost identical in size and demand. Again, a complete specialisation in the production of less important commodity is not possible due to insufficient demand for it.

9. Static Theory

The modern economy is dynamic and the comparative cost theory is based on the assumptions of static theory. It assumes fixed quantity of resources. It does not consider the effect of growth.

10. Not applicable to developing countries

Ricardian theory is not applicable to developing countries as these countries are nowhere near to full employment. They are in the process of change in quality of their labour force, quality of capital, technology, tapping of new resources etc. In other words developing countries exhibit all the characteristics of dynamic economy.

11. Constant Returns to Scale

Another drawback of the Ricardian principle of comparative costs is that assumes constant Returns to scale and thus constant cost of production in both the countries. The doctrine holds that if England specialises in cloth; there is no reason why it should produce wine. Similarly if Portugal has a comparative advantage in producing wine, it will not produce cloth; but import all cloth from England. If we examine the pattern of international trade in practice, we find it is not so. A time will come when it will not be reasonable for Portugal to import cloth from England because of increasing cost of production. Moreover, in actual practice a country produces a particular commodity and also imports a part of it. This phenomenon has not been explained by the theory of comparative costs.