Essay on the Ricardian Theory of Comparative Costs

The Ricardian doctrine of comparative costs of production was explained in terms of labour cost of production. However, the modern economy is a money economy, and in actual transactions money cost is the determining factor.

International trade is, therefore, determined by absolute differences in money prices rather than comparative differences in labour cost. But, as Prof. Taussig said, we can easily translate comparative differences in labour cost of commodities into absolute differences in prices without affecting the real exchange relations between commodities. For this, let us take the following illustration:

Suppose, in country A:

1. day’s labour produces 20 units of wine, and

2. day’s labour produces 20 units of cloth, while in country B:

3. day’s labour produces 10 units of wine, and

4. day’s labour produces 15 units of cloth.

Thus, country A has an absolute superiority in producing both the commodities but it has a comparative advantage in wine. Hence, country A will specialise in wine. Country B has comparative advantage in cloth, so it will specialise in cloth.

In order to convert labour costs into money costs let us take daily wages into account, which we may assume to be Rs. 100 in country A and Rs. 80 in country B. Thus: It is easy to see that, the money cost (or price) of producing wine is lower in country A as compared to that in B (in A it is Rs. 5 per unit, while in B it is Rs. 8 per unit).

In view of the Ricardian comparative costs theory, whether we compare money costs or labour costs, it may be implied, thus, that, country A will specialise in the production of wine and export it to B. On the other hand, B has a relatively less disadvantage in money cost of producing cloth. Hence, B will specialise in the production of cloth and export it to A.

It may be criticised that the above result is obtained because we have arbitrarily chosen the wage rates. But the objection holds no water as under our assumption, there will always be an upper and lower limit within which the ratio of money wages between the two countries must lie.

It is only! the choice of one or other of the ratios within these limits which is arbitrary. But these limits to the wage rate differences are not arbitrarily chosen. They are fixed by the comparative efficiency of labour in each country.

When we assume that, the daily wage in country B is Rs. 80, then the daily wage in A cannot exceed Rs. 160 {i.e., it cannot be more than double B’s wage). This upper limit is fixed by the cost advantage of A in wine (20 to 10). A’s superiority over B in producing wine is two times.

Therefore, if the wage rate in B is Rs. 80, A’s wage rate cannot be twice as high as in B, i.e., wage rate in4 cannot exceed Rs. 160 (= 25 Rs. 80). Hence, if A’s wage rate rises to Rs. 160, its price per unit of both wine and cloth would be Rs. 8.

Then, its export of wine will be unprofitable. However, it will continue to import cloth from B (for it is cheaper than the domestic price). As a result, A’s balance of payments for cloth will increase and cause outflow of gold.

This flow of gold will raise prices and wages in B and lower the same in A. Eventually, the direction of trade will be the same as before and Comparative costs advantage will reassert itself but with a narrow range of trade and gain from trade than before.

Similarly, we can find that, the daily wage in A cannot be lower than Rs. 60 {i.e., it cannot be less than 3/4 of B’s wage rate). For, this lower limit is fixed by the cost advantage of A in cloth (20 to 15). If wages fall to Rs. 60 in A, there will be again one-sided trade. Now A would be exporting wine without any reciprocal import of cloth. There will be an outflow of gold from B to A. Thus, prices and wages will rise in A and fall in B, till a new position of comparative advantage is reached.

We, however, cannot say from the cost data alone where exactly within these limits the ratio of wages in two countries and therefore, the international terms of trade for the two commodities will, settle.

At the most it may be stated that: wages must be higher in the country of superior efficiency (enjoying comparative advantage) by somewhat, more than the ratio of least cost advantage, but it should be somewhat, lower than the ratio of greatest cost advantage to avoid one-sided trade | phenomenon.

The Ricardian theory of comparative costs thus, left us halfway. Later on, it is J.S. Mill who made an important addition to this theory by introducing the principle of ‘the equation of I reciprocal demand’. He pointed out that the exact ratio of wages and terms of trade is determined by the conditions of demand, by the fact that the total value of each country’s exports must equal the total value of its imports.