International Trade - The Principle and Significance of Comparative (Cost) Advantages

The theory or principle of comparative cost advantage states that countries derive mutual benefit from trade when they specialize in the production of those commodities in which they have greatest comparative cost advantage over others and exchange them for other commodities which have comparative cost disadvantage. This principle was propounded by David Ricardo in the 19th century and can help a nation to utilize its resources and as well channel more effort in the production of the actual goods bringing income to it through export.

A country should produce for export those commodities it can produce more cheaply and import those which it can only produce at higher costs. A country has a comparative advantage over others in the production of a commodity (take not that it is comparative and not absolute) in which it has the lowest opportunity cost than others. Therefore, it is the real cost of producing a commodity (in terms of other commodities foregone) that is taken into consideration. Take note that this principle of comparative cost advantage is based on the following assumptions:

Mass Mutual

1. There are only two countries
2. Only two items are produced with the available resources
3. There is free flow and mobility of factors of production
4. There is no transport cost
5. Constant costs prevail
6. Technology is constant
7. Labor is the only factor of production.

International Trade - The Principle and Significance of Comparative (Cost) Advantages

In relation to the above assumptions, Brazil and United States of America (USA) for example, are producing and consuming rice and wheat. The pre-specialization production position is shown below.

Brazil- Rice (100 bags); Wheat (50 bags)
USA- Rice (50 bags); Wheat (100 bags)
TOtal- Rice (150 bags); Wheat (150 bags).

Now, lets evaluate an estimated opportunity cost of producing the two commodities by the two nations.

Brazil, (Rice) 50/100= 1/2. i.e, 1 bag of Rice =1/2 bad of wheat. (Wheat) 100/50=2. i.e, 1 bag of wheat=2 bags of rice.
USA, (Rice) 100/50=2. i.e, 1 bag of rice=2 bags of wheat. (Wheat) 50/100=1/2, 1 bag of wheat =1/2 bag of rice.

By law of comparative cost advantage, Brazil should specialize in the production of rice while USA should specialize in the production of wheat. So total world output after specialization, i.e, Brazil=Rice, USA=Wheat, using all available resources when increase in output of both rice and wheat is 50 bags each would be:

Brazil rice (200), Wheat (0)
USA, rice (0); wheat (200)
Total Rice (200); wheat (200), which is more than the first analysis of Rice (150); Wheat (150).

The plus of this principle is that: there is an increase in total world production; there is better and effective utilization of resources, there is increased consumption of commodities e.g, rice and wheat, there are innovations, resourcefulness and improved technology; there is increase in interdependence between nations of the world and there is reduction in the prices of goods due to mass production.

Finally, the comparative cost advantage has limitations, which are: there are more than two commodities int eh world and the presence of many commodities makes the principle impracticable; there are also more than two countries in the world, all countries of the world do not have equal efficiency of labor, let alone other factors of production; there is no free transport between the countries of the world; there are other factors of production other than labor e.g, capital, land and entrepreneur; all countries of the world can never have equal availability of labor; the cost of production of the world can never be constant and the trade imbalance between countries of the world also makes the principle unworkable. So practically speaking, this principle is simply an abstract one.

International Trade - The Principle and Significance of Comparative (Cost) Advantages