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RICARDO'S Theory

(1) David Ricardo's theory of comparative cost advantage is the main reason for international trade according to classical economics. (2) The theory is based on the labor theory of value and assumes labor is the only factor of production and its costs determine the value and comparative costs of producing goods between countries. (3) According to the theory, countries will specialize in and export the goods they have a comparative lower labor cost to produce, and import goods that have a higher comparative labor cost, allowing both countries to benefit through increased production possibilities.

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92 views5 pages

RICARDO'S Theory

(1) David Ricardo's theory of comparative cost advantage is the main reason for international trade according to classical economics. (2) The theory is based on the labor theory of value and assumes labor is the only factor of production and its costs determine the value and comparative costs of producing goods between countries. (3) According to the theory, countries will specialize in and export the goods they have a comparative lower labor cost to produce, and import goods that have a higher comparative labor cost, allowing both countries to benefit through increased production possibilities.

Uploaded by

Dishi Parekh
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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oa ee

9¢ international Trad
™ oa 245
i pa OF COMPARATIVE COST

ording to Ricardo comparative costs advantage


is the main
feason for the emergence of international trade.
_ This theory is based on the labour theory of value. The labour
t cory of value states that the value of anything
depends upon the
amount of labour used for producing it. The comparative cost
advantage theory is based on the following assumptions:
( ) Labour is the only factor of production and it is assumed to
bea homogeneous factor.
0) The cost of production of all commodities are measured in
terms of labour cost.
(3) Production function in both the countries are assumed to be
linear and homogeneous.
(4) Labour is perfectly mobile within the country but immobile
between countries.
(5) The economy is a laissez-faire economy ie. there is no
government intervention.
(6) Production is subject to constant returns to scale.
(7) Free trade exists which implies absence of tariffs, quotas, etc.
(8) Perfect competition prevails in both countries.
(9) Transport costs are ignored.
(10) There is full employment in both the countries.
Ricardo explained the theory by using two country-two
Commodity and one factor of production model. Let us suppose
two countries Portugal and England and two commodities wine

Pa el
~
246 Vipul’s™ Business Economics
- |) (SF¢y
Lt ™, iw

3
0k
i
and cloth. The number of labour hours to pages i unit of
both the goods in both the countries can be given as follows;
Countries | No. of hours required to Comparative Domestic
produce one unit of Cost Ratio | Exchange Ray,
Wine Cloth
“| Portugal ' 80 90 0.66 < 0.9 1W=0.88¢
2 :] England PO) | gli, |e ld ele 1W=1.20C
From, the table it is quite clear that Portugal has absol
ute
advantage in producing both the goods and England has
disadvantage in producing both. Still Portugal has comp
aratively
§teater advantage in producing wine rather than cloth. Hence
it
will specialise in the production of wine whic
h requires only 80
labou r hours compared to 90 labour hours for cloth. Hence it
wil]
produce wine on a large quantity and export it in exch
ange of
cloth from England. England on the other
hand has less
comparative disadvantage in producing cloth
rather than wine,
Hence it will specialise in the production
of cloth and exchange it
with Portugal for wine.
The cost ratios of producing the
goods in both the countries
can be calculated to show the adv
antages of trade. The cost of
ratio of producing wine is 80/120,
which is better compared to
cost of ratio of producing cloth
which is 90/100. That is 0.66 <
in Portugal. In the case of Englan 0.9
d the cost ratio works out to be
better for cloth compared to cost rati
120/80 i.e. 1.1. < 1.5. Thus it
is benefici

for England then itnr is 1 unit of wine domestic exchange rate


= 1.9 units of cloth. In the case
of Portugal it is 1 unit of wine
= 0.88 units of cloth.
takes place between the two coun trade
a
unit of wine will range between tries the exchange ratio for one iiecapley
1 2 units of cloth to 0.88 unit
s of
y

hen countries specia


lise ik € this the production of both the
ds will be more. In
the absen ce of trade, Portugal will
ynit of wine and 1 un produce
it of clo th by using 170 labour hours (80 +
), England will use 220
laboour hours (120 + 100) to produce the
in this case is 2 units of wine and 2
1S Specialisation Portugal will use 170
pours to produce wine only. Therefore wine
production will be
170/80 = 2.1 units of wine. In the case of England 220 labour
hours will be used to produce cloth only. Hence production will
‘be 220/100 = 2.2 units of cloth. Thus specialisation leads to a
larger volume of output.
The following table shows the level of production before and
after trade and indicates the increase in production due to
specialisation.
Before Trade
No. of hours required to produce 1 unit and output produced
ig sree Wine Cloth
Hours Output Hours Output
Portugal 80 1W 90 iC
England 120 1W 100 1C
‘Total Output 2. 2C
After Trade ss:
Total no. of labour hours available, no. of hours required to
produce 1 unit and total output produced
Wine Cloth
Countries House Output Hours Output

Portugal 170
170
9 721 - “
248 Crm Vipul’s™ Business Economics - (SFC)

England z a 220 = =22

Total Output 2.1W 2.2C


Thus according to this theory, the differences in comparative
cost advantage leads to international trade.
Critical Evaluation:
The Ricardian theory of international trade is considered as a |
significant improvement over Adam Smith’s theory. Later )
theories have evolved on the basis of this theory. At the same
time, Ricardo’s theory has been criticised on the following
grounds:
(1) The theory is based on two-country, two commodity and one
factor model. It is restrictive in nature.
(2) It is based on the labour theory of value which is based on
many unrealistic assumptions. Hence it is also an unrealistic /
theory.
(3) Assumptions of full employment, perfect mobility of factors
within the country etc. are not tenable.
(4) Only one factor of production namely labour is considered. +
Other factors are ignored. Hence it is not comprehensive.
(5) It is a partial theory as it ignores the demand side giving too
much emphasis to supply side.
(6) It does not explain the actual determination of the exchange
rate.
(7) Many unrealistic assumptions like constant returns to scale
homogeneous production function etc. are not practical.
(8) The theory does not explain the differences for comparative
cost advantage. It gives only immediate reason but not the
ultimate reason for international trade.
(9) It is based on partial equilibrium analysis while the modern
theory is based on general equilibrium analysis.
(10) This theory is said to be a static theory as it is based on
unrealistic assumptions like constant returns to scale, same
technology, etc. The modern world is a dynamic world where
things change constantly due to technological changes.
of International Trade
wa" ta" 249

i
\
em is not Suitable for developing countries like India
assumptions like perfect competition, full employment
. not possible.
r Despite all the limitations, the Ricardian theory is widely
accepted as the basic theory of international trade. All other
developments are based on this theory.
— ame eee oe eam ATA TIONIAT

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