International Business

Comparative Cost Theory Of International Trade

Internal trade is not exactly the same as the international trade. The two differ basically in many respects. It was on the basis of these differences, that the old classical economists propounded a separate theory of international trade, known as classical theory of comparative costs. The theory explains the emergence of international trade. The theory is propounded by and is associated with the name of David Ricardo, a renowned Swedish economist.

The theory of comparative costs explains that a country tends to specialize in the production of that commodity in which it has a comparative cost advantage by virtue of its climate, natural resources, skills of its people, and capital equipment. The term comparative advantage means the special ability of a country to provide a particular commodity or services relatively at a lower cost than other commodities or services.

According to the theory, a country will concentrate on the production of such goods and services in which it has comparative cost advantage and export-them in exchange for other commodities in which it has positive cost disadvantage. The commodity in which it has a positive cost advantage or the production of which is most suited to it, will be produced at a large scale. The production of other commodities in which it has little cost advantage will not be carried on any longer.

The 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.

Assumptions of the Comparative Cost Theory :

The comparative cost theory is based upon the following assumptions:

(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.

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