Essay on the Theory Of Comparative Costs and It is Applied To More Than Two Goods?

The Ricardian model is a very simple one, as it was exposed taking into account only two goods of which a country will specialise and export that in which it has a comparative cost advantage as compared to other country and will import the goods having less comparative advantage (or a comparative disadvantage) in its production cost.

Haberler, however, suggests a generalised theory of comparative costs, applicable to man goods in consideration as follows:

Country I possesses a comparative cost advantage over country II in its exportables relatively to all its importables. So is in the case with country II.

Proof of the Theorem :

Let us assume that:

Country I has to incur labour cost of a1 b1 c1,.. .n1, to produce a unity of commodities A, B,C, …N.

The supply prices – money cost per unit of these commodities are Pa1, Pb1, Pc1 . . . Pn1 respectively.

Similarly, country II has to incur say, a2, b2, c2. . . n2 of labour costs to produce these very goods (A, B, C…N) and their supply prices in this country are thus: Pa2, Pb2, Pc2. . . Pn2.

Suppose, now, the average money wage in country I is W1 and in country II, it is W2

It, thus, follows that:

In country I:

Pa, = a1, w1; pb1 = b1w1 . . . Pn2 = n2w2 In country II:

Pa2 = a2w2, Pb2 = b2w2 . . . Pn2 = n2w2

Thus, it can be said that the relative prices in each country are fixed by the labour costs, as:

Pa- Pb1 . . . Pn1, = a1:b1. . . n1 and

Pa2: Pb2 . . . : Pn2 = a2: b2 . . . : n2

For determining the absolute level of the money price, the absolute rates of prevailing money wages have to be included in the data.

For this, let R stand for the rate of exchange – the amount of foreign currency (of country II) received in exchange for one unit of the home currency (of country I). Hence, it can be said that, the quotient a1, w1,R< a2. w2 is applicable to any commodity A which is exported by country I. Because, it (country I) can export a good only when its supply price (money cost) is lower than that of in the foreign country (country II).

Likewise, the quotient b1,. W1. R > b2. W2 is applicable to any commodity B imported by country I.

From these relations, it follows that:

That means, country I has a comparative advantage over country II in producing commodity A – which is its exportable. So is the case for all its export goods, relatively to all goods it imports.

From costs data alone, however, we cannot draw the dividing line between the category of goods produced by countries I and II. For determining the exact position of the dividing line, we must consider the comparative strength of international demand for the different goods. It has been stressed that a country’s export and import will depend on the demand pattern once cost conditions are specified. Further, the requirement of foreign exchange equilibrium as well as of balance of payments equilibrium would fix up the marginal commodity in the export list of each country.

Harberler, in this context, states that the relation W2/W1 .R is the determinant of the position of the dividing lines between exportables and importables of country I.

Thus, there are two important variables (i) relative wage-levels (W2/W1) and (ii) the rate of exchange (R) in this regard. We have to consider R in the context of multi-commodity trade of a country. Any change in W2/Wl or R will obviously alter the lines of production and the comparative; cost situation.

To illustrate the point, let us consider the following hypothetical cost-data of the commodities in the two countries:

In the above table, the cost-data represent that the units of quantity of the various goods are so chosen that the cost per unit of every good in country I is the same.

The exact position of the dividing line between exports and imports of country 1 is determined by the quotient W2/W2R. (Evidently, in case of country II, the quotient WJW2.R would be the determinant).

If, W2/W1 = 1, the money wages being the same in both countries, R = 1, therefore, W2/W1. R= 1, then the money cost of goods A to D – (which are produced at a smaller absolute real cost by country I), will be lower in country I than in country II. Thus, country I will export A to D and import F to H. The good E lies on the dividing line, so it will be produced in both countries. In the multi-commodity trade analysis, unlike the classical two-commodity analysis, thus, there is no perfect specialisation as there will beat least one commodity which is commonly produced in both countries.

If, however, the quotient W2/W1R is greater or less than unity, then the dividing line will not be on E, but will shift rightward or leftward from E.

Further, it goes without saying that in the present illustration, country II will export F to Hand import A to D. Obviously, country I will export A to D at a price of 100 per unit and country II will export Fat a price of 65 per unit, G at a price of 50 per unit and H at a price of 25 per unit. Whether this situation will maintain equilibrium in the balance of payments depends upon the reciprocal demand of the two countries.

Suppose, now that the balance of payments for country I is adverse (say, because of its high imports from country II). Assuming gold standard of the classical era, the gold will flow from country I to II; as a result of this, prices and wages will rise in country II and decline in I. That

Means, W1 becomes smaller and W2 greater, so that the quotient rises (becoming greater than 1). The dividing line will shift to the right. ? will now be included in the exports of country I.

Now, the balance of payments will tend to be in equilibrium, because

(i) E is now exported;

(ii) the other export commodities A to D of country have become cheaper, so that aggregate quantum of exports of I will rise;

(iii) the imports of F, G and H from country II will be dearer, so it will decline. The outflow of gold from country I to II will continue and the dividing line will go on shifting till a perfect equilibrium in the balance of payment is reached.

It is now easy to see that in Ricardian two-commodity model the demand condition has been dispensed with conveniently. In a multi-comparative costs doctrine, however, the reciprocal demand conditions have been given due consideration, as it is an important factor determining the quotient W2/W1 R, which demarcates between the exports and imports of a country. In this way, the multi- commodity model of Haberler represents an improvement over the Ricardian model explaining the same principle of comparative costs advantage.