International Business

Assumptions And Criticisms Of Comparative Cost Theory

A country will specialize in the production of the relatively most cost advantageous commodity which it will export and the lesser cost advantageous commodity will be imported from other countries. It is thus, the comparative cost advantage in the production of goods and services which gives rise to international trade, according to the comparative cost theory of international trade. The comparative cost theory is based upon the following assumptions:

Assumptions of the comparative cost theory:

(1) Only two countries and two commodities are to be considered at a time.

(2) Labor is the only factor of production. The cost of production is expressed only in terms of so many units of labor.

 (3) All units of labor are homogeneous.

(4) The law of constant cost of production or the law of constant returns applies in both the countries.

(5) The factors of production are perfectly mobile within the country but totally immovable between countries.

 (6) It is assumed that there is no cost of transportation to be charged and there are no restrictions on the movement of goods from one country to another country.

Criticisms of the comparative cost theory:

The comparative cost theory of International Trade has come in for scatting criticism at the hands of modern economists like Bertil Ohlin and Franic Graham. The main criticism leveled against the theory are:

1. Assumption of Labor cost is Unrealistic. The theory assumes the labor, the only factor of production and that labor cost constitutes the total cost of production. The classical economists sought to explain domestic exchange of goods in terms of labor cost. This became the basis of international exchange of goods in terms of comparative labor cost. Indirectly, it means that the prices of commodities are fixed on the basis of labor costs. The theory of labor cost was rejected even in the 19th century as an explanation of relative values on several grounds.

2. Assumption of Fixed Proportions. Based on the labor cost theory of value, this theory further assumes that the various factors of production are always combined in the same fixed proportion. If the total costs other than the labor cost are taken into the analysis of relative values, then they must be in the same fixed proportion to total costs, otherwise, labor costs would not have been taken into account in determining the value of the commodity: The value, then, was determined by -something other than labor costs. Now the assumption of fixed factorial proportion is totally wrong and unrealistic. In real world, the proportions widely differ.

3. Assumption of Constant Costs. The theory assumes that the law of constant cost or constant return applies in all the industries so that additional units of the same commodity can be produced at a constant labor cost per unit. But this assumption is also not realistic. In real life, the law of constant cost operates only momentarily. It is the law of increasing cost or the law of decreasing cost that operates in production. The assumption, therefore, cannot be acknowledged.

4. Assumption Regarding Mobility of Labor is not correct. The theory assumes that labor is perfectly mobile within the Country and it is perfectly immobile. This assumption is totally wrong, unrealistic, and contrary to facts. In fact, it is neither totally mobile within the country nor totally immobile between the countries. Climatic, linguistic, racial, social, economic, political and so many other factors restrict the free mobility of labor within the country. Similarly, it is perfectly mobile internationally if no artificial barrier is imposed on its mobility between the countries.

5. Absence of Transport Costs. One of the charges leveled against the theory is its ignoring the transport costs. There are a number of items entering into the foreign trade which bead a sizeable part of the total cost as the transport cost. In some cases, the transport costs are higher than the costs of production of the commodities. A particular commodity cannot enter into foreign trade unless the difference in the production costs between the two countries is higher than the cost of transporting it from one country to another. Transport cost are, thus, too important to be ignored.

6. Not Valid in Modern Times. According to the theory, two countries shall enter into foreign trade if both are at comparative advantage. But the theory is no valid in modern times because in this age of self-sufficiency, a country produces even those goods in which it does not possess any comparative advantage. Production of important commodities of military and strategic use, is undertaken the countries even if they are comparatively at a loss.

7. Complete Specialization Impossible. In some cases, complete division of labor and specialization is not possible even if we take into account all the assumptions of the theory. In case of a small country which cannot produce even as much as to satisfy the needs of its people, it may specialize in the production of one commodity in view of its limited natural resources. It cannot, therefore, export that commodity despite specialization. On the other hand, a big country will have to produce both the commodities and has to specialize in the production of both the commodities to meet not only the requirements of its own people but to make up the supply for the other country even if it has no comparative advantage in the production of one of the commodities.

8. Central Theory. The theory is unreal in its entirety.

  • First, the theory does not take the cost differences (except labor costs) on account of interest on capital, transportation charges and other items, into accounts. This is quite an unrealistic treatment of the subject.
  • Secondly, it considers only two countries and two commodities in the beginning but later on, it has been extended to several countries and several commodities that make the theory very confusing.
  • Thirdly, all assumptions are almost unreal in the modern World.

Thus, in the modern world, the theory cannot be considers to be a real theory because of its unreal assumptions.

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