In this article we will discuss about Classical Theory of International Trade:- 1. Introduction to International Trade 2. Need for a Separate Theory of International Trade 3. Problems 4. Assumptions 5. Summary 6. Critical Evaluation 7. Modifications 8. Theory of Comparative Cost and Underdeveloped Countries.
Introduction to International Trade:
Internal or inter-regional trade means trade between different regions of the same country. It refers to the exchange of goods and services within the political boundaries of a nation. Internal trade, is also called home trade or domestic trade. International trade, on the other hand, refers to the exchange of goods and services between different countries or trade across the political boundaries. It is also known as foreign trade.
International trade takes place because of the following reasons:
(i) Human wants are varied and unlimited and no single country possesses the resources to satisfy all these wants. Hence there arises a need for interdependence between countries in the form of international trade.
(ii) International trade is the result of territorial division of labour and specialisation in the countries.
(iii) Factor endowments vary in different countries.
(iv) Labour and entrepreneurial skills vary in different countries.
(v) Factors of production are highly immobile between the countries.
Economists are divided on the question whether international trade should have a separate theory or not. The classical economists are of the view that international trade differs fundamentally from internal trade and therefore a separate theory to explain international trade is necessary.
The main differences between international trade and internal trade which lead to the need for a separate theory of international trade are as follows:
i. Difference in Factor Mobility:
The main difference between internal and international trade is that the factors of production like labour and capital are comparatively more mobile (though not perfectly mobile as the classical economists believed) within the country and comparatively less mobile (though not perfectly immobile as the classical economists believed) between the countries. Within the country, the factors of production tend to move out of those areas where their prices are low to those areas where prices are high.
Thus, factor mobility within the country results in the equalization of factor prices. At the international level, on the other hand, the mobility of factors of production is restricted due to the factors like- (a) high travelling expenses, immigration laws, citizenship qualifications, etc.; (b) differences in climate, living conditions, language, culture; (c) racial, religious discriminations. The relative factor immobility between the countries necessitates a separate theory of international trade.
ii. Different Currencies:
Another reason for a separate theory of international trade is the use of different currencies in different countries. Even if the names of the currencies of some countries may be the same, the internal purchasing power and the systems of issue are different. Moreover, different foreign exchange policies are adopted by different countries.
Rates of exchange i.e., the prices of acquiring various currencies differ as a result of these foreign exchange policies. In fact, it is the difference in the foreign exchange policies rather than the existence of different national money which distinguishes international from domestic trade.
iii. Different National Policies:
Difference in the national policies of different countries also leads to the necessity of a separate theory of international trade. Different countries follow different national policies relating to commerce, trade, taxation, industry, etc. These policies are more or less uniform within the country but vary between countries.
Therefore, they affect the domestic trade uniformly, but influence the international trade differently. Policies like tariffs, import quotas, subsidies, etc. interfere with the free and normal movement of goods between the countries.
iv. Different Exchange Control Policies:
Another reason for a separate theory of international trade is different exchange control policies adopted by different countries. There are built-in stabilisers in the inter-regional, and not the international, monetary flows. If certain region in a country suffers from depression, people there will not be able to pay taxes and will receive more investment and subsidies from the government.
But, no such automatic system of monetary adjustment exists at the international level. Different countries facing different degrees of inflationary and deflationary situations adopt different degrees of inflationary and deflationary situations adopt different exchange control policies, affecting the international trade differently.
v. Differences in Natural Resources:
Different countries have different geographical conditions and are endowed with different natural resources. Some countries have abundance of natural resources, while others have scarcity. Again, certain types of natural resources are more abundant in some countries than in other countries.
On account of these differences, the cost of producing the same good differs between countries. Different cost conditions make international trade possible and profitable which results in the emergence of a separate theory of international trade.
vi. Different Political Groups:
The existence of different political groups in different countries also results in a separate theory of international trade. Internal trade occurs within the same political unit, while the international trade occurs between different political units.
The government of each country attempts to maximise the welfare of its own people against that of others. Therefore each country adopts such an international trade policy that promotes its own interest at the cost of that of the other countries.
vii. Different Markets:
Separate theory of international trade is needed on account of the existence of different markets for different countries. Internal trade occurs in a homogeneous home market, while international trade occurs in heterogeneous world markets. Heterogeneity of international markets is due to differences in climate, customs, language, habits, weights, measures, etc.
As a result of these differences, goods which are traded within the country may not be traded in other countries. For instance, Indians use left-hand driven cars, while Americans use right-hand drive cars. Thus, the markets for automobiles are separated internationally.
The Modern economists, like Ohlin, Haberler, have regarded the internal and international trade as similar and are of the view that there is no need for a separate theory of international trade. According to Ohlin, “International trade is but a special case of inter-regional trade.”
In the words of Haberler, “Strictly speaking, it is neither possible nor essential to draw a sharp distinction between the problems of foreign and domestic trade. If we examine the alleged peculiarities of foreign trade, we find that we are dealing with difference in degree rather than with such basic differences of a qualitative nature as would warrant sharp theoretical divisions.”
The following are the similarities between internal and international trade which are generally used as arguments against a separate theory of international trade:
(i) The prices of domestically or internationally trade goods arc determined in the same way through the equilibrium between demand and supply forces.
(ii) Factor immobilizes give rise to both internal and international trade. The classical economists are wrong in their assumption that factors of production are perfectly mobile within the country and perfectly immobile between the countries. In fact, factors are also mobile between nations and immobile within a nation.
As Kindleberger points out, “Today it is thought that this distinction of the classical economists has been made too rigorously. There is some mobility of factors internationally – There is also some considerable degree of immobility within countries.”
(iii) Both types of trade occur due to division of labour and specialisation. Each region or country tends to specialise in the production of those goods for which it is most suited.
(iv) Participants in both internal and international trade aim at maximising their gain. Traders want to maximise their profits and buyers want to maximise their utilities.
In spite of the emphasis of the modern economists on the various similarities of internal and international trade, it is now a well-established fact that there do exist certain basic differences between internal and international trade and the dissimilarities between the two types of trade are more marked than their similarities. Hence, the need for a separate theory of international trade remains.
The classical theory of international trade deals with three problems:
(i) The condition for international trade, i.e., under what conditions the trade between two countries is possible?
(ii) The determination of the direction of trade, i.e., which commodity a country will export and which it will import? and
(iii) The determination of terms trade, i. e., at what rate the commodities will be exchanged in the international trade?
Adam Smith and Ricardo concentrated on the first and second question, while the third question is left to be taken up by J.S. Mill. Later on economists like Cairnes, Bastable, Taussig, Haberler, etc. introduced many modifications to theory.
The classical theory of international trade is the comparative cost theory which states that a country, in the long run, will tend to specialise in the production of and to export that commodity in whose production it experiences comparative cost advantage and import that commodity in whose production it experiences comparative cost disadvantage.
In order to know the comparative cost advantage, we have to compare cost ratios and not costs and it matters little whether we compare the cost ratios of two com modifies in one country or of one commodity in two countries. Specialisation and trade, according to the comparative cost principle, will not only make all the trading countries better off but also maximise the world production through international division of labour.
Assumptions of the Classical Theory:
The classical theory of international trade on the following assumptions:
(i) Labour is the only factor of production and the value of a commodity is proportional to the quantity of labour required in its production.
(ii) All labour units are homogeneous, i.e., all the labourers are equally efficient.
(iii) Since there is a single factor of production, commodities are produced at constant costs.
(iv) Under the constant cost conditions, prices are determined by supply and the changes in demand have no effect on them.
(v) Factors of production are perfectly mobile within the country but completely immobile among countries.
(vi) There is free trade and government does not interfere in trade.
(vii) There are no transportation costs.
(viii) There is perfect competition in both commodity and factor markets.
(ix) The theory is based on two countries-two commodity model.
(x) The two countries have common monetary standard and the quantity theory of money is considered valid.
In order to understand the classical theory of international trade more clearly, three types of cost differences are to be distinguished:
(A) Equal cost difference,
(B) Absolute cost difference, and
(C) Comparative cost difference.
If the two countries have equal differences in production costs, international trade is not possible. This can be shown with the help of an example illustrated in Table-1.
Table-1 shows that in India, the production of one unit of w heat requires 40 hours of labour and one unit of cloth requires 80 units of labour. The domestic barter rate in India is I Wheat = .5 Cloth. Similarly in England, one unit of wheat requires 60 hours of labour and one unit of cloth require 120 hours of labour. England’s domestic barter rate is- 1 Wheat = .5 Cloth. In this case, both India and England have the same cost ratio.
If we assume a1 and b1 the unit labour cost of producing wheat and cloth in India and a2 and b2 in England, then the nature of cost ratio is as follows:
Since the two countries have the same cost ratio, no incentive for trade exists. In spite of the fact that India is capable of producing both commodities more cheaply than England, it will export any commodity to England only if it can get more than 1 Wheat = .5 Cloth (i.e., India’s domestic barter rate).
But, on the other hand, England, will not import any commodity from India if it cannot get it at a price less than 1 Wheat = .5 Cloth (i.e., England’s domestic barter rate). Thus, at equal cost differences, no country will be motivated to enter into trade with the other.
The non-possibility of trade under equal cost difference condition is diagrammatically represented in Fig. 1. In Fig. 1A, lines II and EE are the production possibility curves for India and the England respectively.
The slopes of these curves represent the relative costs of production of wheat and cotton in India and England respectively. The production possibility curves are straight lines which show that the production is subject to the law of constant costs in both the countries.
The relative position of II and EE curve shows that India can produce both wheat and cloth at a cheaper rate than England. But both the production possibility curves are parallel to each other, i.e., the slope curves are the same which means that both India and England have the same cost ratio. This indicates that there is no scope for trade between the two countries and specialisation by any country in any product will not be advantageous.
Fig 1B illustrates the same idea with the help of offer curves. Line 1 = E is the offer curve of India and England which represents that the cost ratio (or the domestic barter rate) in the two countries is the same (i.e., 1 Wheat = .5 Cloth). The offer curve is a straight line which shows that it is drawn on the basis of the assumption of constant cost conditions.
In a situation of equal cost ratios, trade between the two countries is not possible because India wants more than .5 units of cloth for one unit of wheat, while England, on the other hand, wants to give less than .5 units of cloth for one unit of wheat imported. Thus, if there is equal cost difference, there is no possibility of international trade and no country will gain by specialisation.
According to Adam Smith, trade between two countries will occur only if each country has an absolute cost advantage over the other in one commodity.
Cost Ratio- a1/a2 b1/b2
Absolute Cost Difference- a1/a2 < 1 < b1/b2
Table 2 shows that India requires 40 hours of labour to produce one unit of wheat and 80 hours of labour to produce one unit of cloth. On the other hand, England requires 80 hours of labour to produce one unit of wheat and 40 hours of labour to produce one unit of cloth. Thus, the domestic barter rate in India is- 1 Wheat = .5 Cloth, and in England is- 1 Wheat = 2 Cloth.
In this case, India has an absolute cost advantage in wheat and England in cloth. India will specialise in wheat and export it to England because England is willing to pay a price greater than what it cost in India (i.e., more than .5 Cloth for 1 Wheat).
Similarly, England will specialise in cloth and export it to India because India can pay a higher price than England’s barter rate (i. e., more than 1 Wheat for 2 Cloth).
The cost ratios in this example are expressed as:
Which means that India has an absolute cost advantage over England in wheat and England has an absolute cost advantage over India in cloth. Possibility of trade under the condition of absolute cost difference is shown in Fig 2. Fig. 2A shows that the production possibility curves II and EE for India and England respectively have different slopes which mean that both the countries have difference cost ratios. India has an absolute cost advantage (80 – 40 = 40) in the production of wheat.
On the other hand, England has an absolute cost advantage (80 – 40 = 40) in the production of cloth. Since both the countries have absolute cost advantage in different products, both of them can benefit through mutual exchange of goods.
In Fig. 2B, the same argument can be understood with the help of offer curves. Line I is the offer-curve of India which has been drawn on the basis of India’s domestic barter rate (or cost ratio), i. e., 1 Wheat = .5 Cloth. On the other hand, England’s offer curve (line E) is drawn on the basis of its domestic barter rate (or cost ratio), i.e., 1 Wheat = 2 Cloth.
In this case, international trade is bound to take place because India wants more than .5 units of cloth for one unit of wheat exported. On the other hand, England is willing to give any price less than 2 units of cloth for one unit of wheat imported.
Thus, when there is absolute cost difference a country will specialise in the production of the commodity in which it has absolute cost advantage and will gain by exporting it.
Adam Smith, however, did not visualise a less favourable situation for international trade. Instead of being capable of producing one commodity absolutely cheaper than the other, a country may be able to produce both commodities absolutely cheaper than the other country. What will be the direction of trade in this case? Ricardo’s analysis of comparative cost difference gives the answer.
When a country has an absolute superiority over the other country in both the commodities, it will be beneficial for it to specialise in that commodity in which it enjoys comparative cost advantage.
Table 3 shows that in India, the production of one unit of wheat needs 40 hours of labour and the production of one unit of cloth 80 hours of labour. India’s domestic barter rate is- 1 Wheat = .5 Cloth. On the other hand, England requires 90 hours of labour to produce one unit of wheat and 100 hours of labour to produce one unit of cloth. England’s domestic barter rate is- 1 Wheat =.9 Cloth.
In this case, India has an absolute cost advantage over England in both wheat and cloth, but is has comparative cost advantage over England in wheat. India will gain by producing only wheat, exporting it to England at a price more than its domestic barter rate (i.e., 1 Wheat = .5 Cloth) and importing cloth from England.
Similarly, England will gain by producing only cloth, exporting it to India at a price more than its domestic rate (i.e., 1 Wheat = .9 Cloth) and importing wheat from India.
The nature of cost ratios in this case is as follows:
which means that India possesses absolute advantage over England in both wheat and cloth, but it has comparative advantage in wheat than in cloth.
In Fig. 3, the production possibility curves for India and England (i.e., lines II and EE respectively) show that India can produce one unit of wheat with 40 hours of labour whereas England requires 90 hours of labour to produce one unit of wheat; the absolute cost advantage in the production of wheat is 90 – 40 = 50.
Again, India needs 80 hours of labour for producing one unit of cloth, whereas England needs 100 hours of labour; India’s absolute cost advantage in the production of cloth is 100 – 80 = 20. Thus, India enjoys absolute cost advantage in both wheat and cloth, but it possesses a greater comparative advantage in the production of wheat.
Similarly, England has absolute cost disadvantage in both wheat and cloth, but it has smaller comparative disadvantage in the production of cloth. Thus, India will specialise in wheat and England in cloth.
The same idea is represented in Figure 3B through offer curves. India’s offer curve (Line I) is drawn on the basis of its domestic barter rate (or cost ratio), i.e., 1 Wheat = .5 Cloth. Similarly, England’s offer curve (line E) is drawn on the basis of its domestic barter rate (or cost ratio), i. e., 1 Wheat = .9 Cloth.
In this case international trade will take place and will be advantageous to both the countries because India wants more than .5 units of cloth for one unit of wheat exported and England is willing to give any price less than .9 units of cloth for one unit of wheat imported.
Thus, when there is comparative cost difference, a country will specialise in the production of the commodity in which it has greater comparative advantage (or lesser comparative disadvantage) and will gain by exporting it.
International trade based on comparative cost doctrine shows an overall reduction of production costs. Before trade, India requires 120 hours (40 + 80) of labour to produce one unit of wheat and cloth each. England requires 190 hours (90 + 100) of labour to produce one unit of wheat and cloth each.
After trade, India produces two units of wheat in 80 hours (40 + 40) of labour and England produces two units of cloth in 200 hours (100 + 100) of labour. Thus, before trade, 4 units of both the commodities in two countries require 310 labour hours, whereas after trade the same four units require 280 labour hours. There is an overall reduction of production cost by 30 labour hours through international trade.
Comparative cost theory does not tell what the actual terms of trade will be. It gives only the upper and lower limits of the range in which the trade between the two countries will be mutually beneficial.
The terms of trade refer to the rate of exchange and are determined by the cost ratios of production. If Indian wheat is exchanged for English cloth at a rate of 1 Wheat = .9 Cloth, then all gains of trade will go to India.
This is the upper limit. If Indian wheat is exchanged for English cloth at the rate of 1 Wheat = .5 Cloth, then all gains will go to England. This is the lower limit. The actual terms of trade will be determined between these two limits. If Indian wheat is exchanged for English cloth at the rate of 1 Wheat = .7 Cloth, then the gains from trade will be evenly distributed between India and England.
Fig. 4 graphically represents the terms of trade and the distribution of gains from trade. The terms of trade as reflected by the cost ratios of production are represented through the offer curve.
Line I represents the offer curve of India which is drawn on the basis of India’s barter rate (or cost ratio) 1 Wheat = .5 cloth. Line E is the offer curve of England which is drawn on the basis of England’s domestic barter rate (or cost ratio) 1 Wheat = .9 Cloth.
India’s offer curve (I line) shows that India wants more than .5 units of cloth for 1 unit of wheat exported. England’s offer curve (E line) shows that England is willing to offer less than .9 units of cloth for 1 unit wheat imported. Thus, 1 Wheat = .5 Cloth and 1 Wheat = .9 Cloth are the two limits of the range in which the actual rate of exchange (terms of trade) will be determined.
The actual rate of exchange will be determined on the basis of the relative bargaining strength of the two countries. If the actual rate of exchange is fixed at the upper limit, i.e., 1 Wheat = .9 Cloth (as indicated by the offer curve E), it means India is powerful and England is weak in bargaining. Or, in other words, England’s demand for India’s wheat is inelastic.
In such a situation, the whole gain from trade (i.e., AB or .9 – 5 = .4 cloth per unit of wheat) will go to India. On the other hand, if the actual rate of exchange is fixed at the lower limit, i.e., 1 Wheat = .5 Cloth (as indicated by the offer curve I), it means England is strong and India is weak in bargaining and the whole gain from trade (i. e., AB or .4 cloth per unit of wheat) will be received by England.
But, if both the countries are equally strong in bargaining the actual rate of exchange will be determined in the middle of the two limits, i.e., 1 Wheat = .7 Cloth (as indicated by the offer curve T). The total gain from trade (i.e., AB or .4 units of cloth per unit of wheat) will be equally distributed between India and England. India’s gain will be AC or .2 units of cloth per unit of wheat and England’s gain will be BC or .2 units of cloth per unit of wheat.
Summary of the Classical Theory:
(i) International trade will not take place if the cost ratios of production are the same in the two countries.
(ii) International trade is bound to take place if there is absolute cost difference between the two countries.
(iii) International trade will also occur and will be beneficial to both the countries even in less favourable condition of comparative cost difference. Each country will produce and export that commodity in which it enjoys comparative cost advantage.
(iv) Trade on the basis of comparative cost advantage leads to the overall reduction of production costs.
(v) The terms of trade reflect the cost ratios of production in the two countries. The comparative cost theory tells the upper and lower limits of rate of exchange on the basis of the cost ratios.
The comparative cost theory of international trade is one of the major contributions of the classical economists. Until the World War I, the theory remained un-attacked and was generally considered the most appropriate explanation of the basis of international trade. Even the modern modifications and developments in the theory of international trade are more of a complementary rather than destructive nature.
Prof. Samuelson has aptly remarked; “If theories, like girls, could win beauty contests, comparative advantage could certainly rate high in that it is an elegantly logical structure.” However, comparative cost theory has been extensively criticised by many economists like Ohlin and Graham mainly because of its unrealistic assumptions and hypothetical character.
Some of the defects of the theory are given below:
i. Assumption of Labour Cost:
The most important criticism of the theory of comparative cost is that it is stated in labour or real terms. It assumes that labour is the only factor of production and the cost of production consists of labour cost alone. The theory ignores the basic fact that labour is not the only factor of production and the production costs include non-labour costs too.
ii. Defects of Labour Theory of Value:
The labour theory of value on which the comparative cost theory is based has long been discarded because of the following defects:
(a) The labour theory is based on the unfounded assumption that labour is the only factor used in the production of commodities.
(b) The labour theory assumes homogeneous labour, while in reality labour differs in efficiency and skill,
(c) Labour theory of value assumes that if other factors are used along with labour, they are combined in fixed proportions. But, in reality, capital- labour ratio varies from industry to industry.
(d) The labour theory of value is also based on the unrealistic assumptions of- perfect competition and perfect mobility of labour.
(e) The labour theory of value was discarded by the neo-classical economists since it ignored the role of utility in the determination of value.
iii. Assumption of Constant Cost:
The theory of comparative cost assumes the existence of constant cost conditions. It maintains that the additional units of the same commodity can be produced at the constant average cost. The reality on the other hand, is that there are either increasing costs or decreasing costs because of the operation of the laws of diminishing returns or increasing returns respectively. Constant costs are the exception rather than the rule.
iv. Assumption of Factor Mobility:
The classical theory of international trade is based on another unrealistic assumption that factors of production are perfectly mobile within the country and perfectly immobile between the countries.
The reality is quite different:
(a) Within in a country, factors of production do not move freely from one industry to another and from one region to another. This is evident from the existence of different wage rates and interest rates in different industries and regions.
(b) Factors are not perfectly immobile internationally. There have been many cases of movement of labour and capital from factor-surplus to factor-scarce countries.
v. Assumption of Two Commodities and Two Countries:
Another unrealistic assumption of the theory of comparative cost is that its operation is restricted to two commodities and two countries. The theory breaks down when it is applied to the normal and more realistic situation of international trade among more than two countries and involving more than two countries.
vi. Neglect of Transport Costs:
The theory of comparative cost does not take into consideration the transport costs. Neglect of transport costs is highly unrealistic because in practice transport costs play an important role in influencing the pattern of world trade. In fact, international trade occurs only when the comparative cost advantage exceeds transport costs.
vii. Static Theory:
The unrealistic assumptions like the existence of full employment, fixed and constant supply of factors of production etc., make the theory of comparative cost a static theory and render it unfit for the changing and dynamic world.
viii. One-Sided Theory:
The comparative cost theory of international trade has been regarded as one-sided theory because it takes into account only the supply or cost side and ignores the demand side. The neglect of demand conditions is responsible for the theory’s inadequate explanation for the determination of terms of trade. In the words of Ohlin. The comparative cost reasoning alone explains very little about international trade. It is, indeed nothing more than an abbreviated account of the conditions of supply.
ix. Growing Emphasis on Self Sufficiency:
In modern times, because of defence and other strategic reasons, almost every country tries to achieve the objective of self-sufficiency and may decide to produce certain goods even though they can be cheaply imported from other countries. For instance, all countries prefer to produce military equipment at home even if it can be imported from abroad at cheaper rates. Thus the theory of comparative cost is unrealistic and has little relevance in the actual world.
x. Impossibility of Complete Specialisation:
Even if the various assumptions of the theory are accepted, the existence of comparative advantage may not lead to complete specialisation on the part of two countries which enter into international trade. As pointed out by Frank Grahm, this may happen when one trading country is big and the other is small.
The small country will be in a position to specialise fully as it can dispose of its surplus in the big country. But the big country cannot have complete specialisation because of the two reasons- (a) the small country will not be able to meet all the requirements of the big country. (b) The surplus of the big country will not be entirely absorbed by the small country.
Historical evidence since World War II has shown that the theory of comparative cost does not sufficiently explain the trend and pattern of actual international trade. If we divide the world into two blocks, i.e., (a) the developed countries and (b) the less developed countries; and the commodities into two groups, i.e., (a) the manufactured goods and (b) the primary goods, then on the basis of the comparative cost principle we expect that.
(i) The developed countries have a comparative advantage over the less developed countries in manufactured goods relative to primary goods;
(ii) The larger and growing part of the world trade is between developed and less developed countries; and
(iii) The developed countries produce and export manufactured goods in exchange for primary goods from less developed countries. But, the actual pattern of world is not in accordance with the theory of comparative cost.
The following features of world trade make this clear:
(i) The largest part of world trade is among the developed countries themselves, rather than between developed countries and the less developed countries.
(ii) Although, in accordance with the theory of comparative cost, the developed countries, on balance, export manufactured goods to the less developed countries in exchange for primary production, but the largest part of world trade is the intra-industry exchange of manufactures among the developed countries themselves.
(iii) As against the comparative cost principle, export of manufactures from less developed countries are the fast growing part of world trade, although their absolute share is still small.
(iv) Economics of scale, which arise from the division of labour and product differentiation, imply that trade between countries with modest comparative cost differences will be largely intra- industry, and that trade between countries with substantial comparative cost differences will be largely inter-industry.
A notable feature of trade among the developed countries is that it is a large and growing volume of intra-industry trade, both absolutely and relative to inter-industry trade.
Modifications of Comparative Cost Theory or Classical Theory:
The theory of comparative cost has been criticised mainly because of its unrealistic assumptions. Later economists were able to discard some of these assumptions without doing any harm to the basic argument. Important modifications in the theory of comparative cost were made by J.S. Mill. Taussig, Haberler and Ohlin.
i. Mill’s Law of Reciprocal Demand:
J.S. Mill made the theory of comparative cost determinate by stating the conditions for equilibrium terms of trade. Comparative cost difference between the countries sets the outer limits between which international trade can take place profitably. It does not tell us where, between these limits, international trade will actually take place.
Mill’s law of international values provides the answer to this question. “The produce of a country exchanges for the produce of the other countries, at such values as are required in order that the whole of her exports may exactly pay for the whole of her imports.” Or, in other words, the equilibrium terms of trade are determined by the equation of reciprocal demand.
ii. Labour Costs Measured in Terms of Money:
Ricardo’s comparative cost theory was explained in terms of labour costs. But, the modern economy is a money economy in which transactions are made through money. International trade is determined by absolute differences in money prices rather than by Comparative differences in labour cost.
Prof. Taussig has shown how the comparative differences in labour cost can be converted into absolute differences in money prices without affecting the real exchange relations.
This can be illustrated with the help of the following example:
In India- 1 day’s labour produces 40 units of wheat;
1 day’s labour produces 40 units of cloth.
In England: 1 day’s labour produces 20 units of wheat;
1 day’s labour produces 30 units of cloth.
In this example, India has an absolute superiority in producing both wheat and cloth. But, it has comparative advantage in wheat. Thus, India will specialise in wheat and England will specialise in cloth.
In order to convert the labour cost into money cost, let us assume daily wages as Rs. 10 in India and Rs. 8 in England.
It is clear from Table 4 that money cost or price of wheat is lower in India (25 paise per unit) as compared to that in England (40 paise per unit). Thus, in view of Ricardo’s comparative cost theory, India will specialise in the production of wheat and export it to England.
On the other hand, England has relatively less disadvantage in terms of money cost of producing cloth. Thus, England will specialise in the production of cloth and export it to India.
iii. Comparative Cost Theory in Terms of Opportunity Cost:
Haberler was the first to abandon the labour theory of value as a fundamental premise of the theory of international trade and to restate the theory in terms of opportunity cost. The value of a commodity is determined not by the physical cost of resources required to produce it, but by the opportunities of production of other commodities which have to be foregone in order to obtain this commodity.
The theory of comparative cost now states that the country will specialise in the production of those commodities which have comparatively low opportunity cost. Thus, the opportunity cost theory provides a broader and more realistic basis for international trade.
iv. Comparative Cost Theory under Increasing Cost Conditions:
The theory of comparative cost, stated in terms of opportunity cost, can be extended to cover more realistic conditions of increasing costs. Increasing cost conditions prevail when- (a) there are diminishing returns to scale and (b) all resources are not equally adaptable for the production of all the commodities, or in other words, certain factors are specific to certain commodities.
Increasing costs imply that the marginal costs of producing one commodity in terms of the other are increasing. Or, in other words, in order to obtain additional units of commodity A, we must sacrifice increasing amounts of commodity B.
Under the increasing cost conditions, a country will specialise in the production of that commodity in which it has comparative cost advantage but the specialisation will not be complete simply because of the fact that additional amount of the commodity can be obtained only at increasing costs.
v. Ohlin’s Modification:
True, the differences in the comparative costs provide the foundation on which the international trade is possible. But, the next question is: why do the costs differ? Ohlin’s answer to this question is that commodities require different inputs and the countries vary in factor endowments.
A country has comparative advantage in those commodities which use intensively the country’s relatively abundant factor and has comparative disadvantage in the products which use intensively the country’s relatively scarce factor. Ohlin thus takes a step further by basing the pattern of international trade on the economic structure of the trading countries.
Theory of Comparative Cost and Underdeveloped Countries:
So far we have been discussing the positive aspect of the comparative cost theory which showed that the theory has a scientific purpose of determining the direction of trade. The theory also has a welfare aspect, in which it serves as a proof for the advantages of free trade. Comparative cost difference between the nations not only directs them to trade freely with each other, but also ensures them gainful effects from such trade.
The question arises- does this conclusion hold good if the trading nations exhibit different stages of economic development? The classical economists are very optimistic in their reply. They are of the view that uninterrupted trade between a rich and a poor country on the basis of comparative cost difference will not only make the former better off, but also function as an engine of growth in the latter.
International trade, by widening the markets and by stimulating the division of labour, accelerates the process of economic development in the underdeveloped countries. But, the protectionists and growth economists have cast their doubts regarding the growth aspects of free trade in the less developed countries and have, therefore, recommended an alternative engine of growth, (i.e. domestic industrialisation) for these economies. They considered the classical theory of comparative cost inapplicable to the conditions and growth problems of these countries.
The main arguments against the comparative cost theory regarding its applicability in underdeveloped countries are as follows:
(i) The underdeveloped countries export primary products and the world demand for these products is highly unstable in the short period. This makes their export earnings uncertain.
(ii) The world demand for primary products is not only unstable, but also is likely to be stagnant or declining in the long ran. This is because of the low income elasticity of rich countries for primary goods. As income increases, people tend to spend smaller amount of their income on necessities.
(iii) Factor prices in the underdeveloped countries are not the true indicators of their comparative cost. This is because of the imperfections in their factor markets.
(iv) Temporary protection to manufacturing industry during its early stage not only safeguards its growth from foreign competition but also enables it to enjoy the advantages of experience.
As the labour and management gain more and more experience in actual production, their efficiency increases, as a result of which, the cost decreases and the industry becomes, in the later stages, capable of resisting the foreign competition even without protection.
(v) Development of manufacturing industry stimulates activity in other sectors of the economy through the linkage effects. It, on the one hand, increases the demand for inputs from other sectors (backward linkage effect) and, on the other hand, supplies its output to other sectors which use it as input (forward linkage effect).
(vi) The policy-makers in the underdeveloped countries have limited skill to anticipate correctly the changes in the trade conditions of the world market. This leads to the adoption of a policy favouring the diversification of economic structure of the country to enable it to meet the changing requirements of the world market.
(vii) From the experience of the colonial rate in these countries, it can be concluded that free trade between the developed and under- developed countries on the basis of comparative cost difference has not only failed to be the engine of economic growth in the latter, but also has been responsible for the typical problems of the present-day underdeveloped countries.
Outside forces, in the form of foreign trade and colonial rule, uprooted the workers from traditional cottage industries, created conditions of population explosion (by providing better health facilities which reduced the death rate) and thus led to the present problem of disguised and open unemployment in these countries.
In fact, the impact of trade on growth is indeterminate and therefore cannot be generalised.
Kindle Berger has constructed three models in this regard:
(i) There are countries like England, Sweden, Denmark, Switzerland, Canada, U.S.A., where trade has stimulated growth.
(ii) In the countries like Japan, trade acted as a balancing sector.
(iii) In many countries, generally the underdeveloped countries, trade has been considered as a lagging sector.
In the end, Kindle Berger concludes:
Trade can stimulate growth, when the demand is right abroad and supply is right at home. It can inhibit it when the demand is wrong abroad and supply is wrong at home.
Despite the arguments against the comparative cost theory in solving the growth problems of the underdeveloped countries, the theory still has relevance for these countries:
(i) For the underdeveloped countries which are small and which possess sufficient and suitable natural resources and for which stable demand conditions prevail in the world market, international trade, according to the comparative cost principle, provides an ideal path of economic development.
(ii) For the large, overpopulated countries with meager natural resources and with unfavourable world demand for exports, domestic demand is necessary. But, such nations too cannot afford to ignore the opportunities of economic growth provided by the expansion of export of those commodities in which it has comparative advantage.
(iii) The static nature of comparative cost should not render it inapplicable in the developing countries and restrict it from adopting a policy of protection. By definition, an underdeveloped country is that which has not been able to gain from its potential comparative cost advantage.
The policy of protection, by reallocating the domestic resources, enables the country to specialise in the long run in those fields of production where it has potential comparative cost advantage. Thus, the theory of protection, far from being contradictory to the theory of comparative cost, actually strengthens it by dynamiting its character.