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David Ricardo's Comparative Cost Trade Theory

Updated on March 2, 2016
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IRSHAD CV has been a student in Economics. Now he is doing Masters in Economics. He completed B.A. Economics from the University of Calicut.

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David Ricardo
David Ricardo | Source

Introduction

Economists have developed different theories on trade. In each period, the ideology of trade and its practice varied with different dimensions. Today, as an impact of globalization, the world as a whole considering trade as an important matter. During the period of classical economists, Adam Smith came with the ‘absolute advantage trade theory’. Later, David Ricardo, another great economists developed a new theory which eliminated the limits of Smith’s absolute advantage trade theory.

Assumptions of the Theory

Ricardian theory of comparative cost theory is based on certain assumptions. They are given below.

i) There are two countries in the trade

ii) There are two commodities in the trade

iii) There is no factor mobility in between countries.

iv) The production function is based on the constant return to scale function.

The Theory

The comparative cost theory of Ricardo is challenged Adam Smith’s absolute advantage trade theory. Her, Ricardo’s trade theory says that, international trade is possible even a country enjoys absolute advantages in the production of commodities.

In simple words, Ricardo says that, international trade is possible when a country focuses on the production of commodities, which are comparatively advantaged to them to produce. And the country will import commodities of which the cost of production is comparatively costlier. The advantages of the production of commodities is depends on the opportunity cost also.

The comparative cost trade theory of Ricardo can be explained with the example in the table given below.

Commodity
Cost of Labor per Unit Output (England)
Cost of Labor per Unit Output (Portugal)
Wine
120
80
Wheat
100
90

The above table shows an example of trade between England and Portugal. They are mutually trading two commodities, wine and wheat. The given figures are the cost of factors of production.

From the above table, England can produce wine and wheat at a labor cost of 120 and 100 respectively. On the other side, Portugal is able to produce the same commodities at lower cost. That is wine for 80 and wheat for 90. Here the cost of production is lower in Portugal. Therefore Portugal enjoys comparative costly cheaper production in both commodities. Here, the relevant question is that, is international trade is possible from the above circumstances?

Yes, Ricardo says that, there is scope for international trade through the concept of opportunity cost. In the case of England, opportunity cost for producing wheat (100/120) is lesser than the opportunity cost for producing one unit of wine (120/100). Therefore, it is better for England to specialize in the production of wheat and exports it in to Portugal. On the other side, it is better for Portugal to specialize in the production of wine and export it in to England. Because, in Portugal, the opportunity cost for producing wine (80/90) is lesser than the opportunity cost for producing wheat (90/80).

In short, the comparative cost trade theory of Ricardo says that, international trade or international economics between two countries occurs when a country focuses on the production and exporting of comparatively advantaged commodities. In this way international trade will be possible and beneficial to each country. But the point is that, even though the trade will be beneficial to both countries, there may be variations in the degree of gain or benefits for each country.

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