Comparative Costs Theory (Evaluation) | International Trade | Economics

In this article we will discuss about the critical and empirical evaluation of comparative costs theory.

The complexities and peculiarities of international trade necessitated the separate treatment of international trade from the domestic or inter­regional trade. The classical theorists tried to create a theoretical structure to deal with such fundamental issues as why different countries engage themselves in trade; which goods and services will be exchanged by them; what will be the terms of trade; and what gains will accrue to them from international trade.

The classical theory of international trade was originally developed by Hume, Adam Smith and David Ricardo. Subsequently, it was modified by the writers like J.S. Mill, Bastable, Marshall and Cairnes. The modern exponents of this theory include such prominent economists as Taussig, Haberler and Ohin.

Critical Evaluation of Comparative Costs Theory:

The classical comparative costs theory remained as the most explicit and widely acclaimed explanation of international trade right upto the First World War. Even in the subsequent periods, the developments that have occurred in this field are of mainly supplemental character. The Ricardo- Mill theoretical structure, slightly modified and elaborated, remains essentially unblemished.

In this context, Samuelson has commented that- “if theories, like girls could win beauty contests, comparative advantage would certainly rate high in that it is an elegantly logical structure. The theory of comparative advantage may have to pay a heavy price in terms of living standard and potential rate of growth.”

Although the theory has a sound and logical structure, yet some of its glaring defects cannot be overlooked. The theory has been severely criticised by many an economist including Frank Graham and Bertil Ohlin.

The main objections against this theory are as follows:

(i) Validity of Labour Theory of Value:

The weakest spot in the Ricardian theory is its supposition that the exchange of goods is determined on the basis of comparative labour costs. The theory explicitly and implicitly relies upon such unwarranted assumptions as, labour is the only factor of production; homogeneity of labour or different categories of labour can be converted into a common denominator and; capital and labour are employed in the same proportion in the production of all commodities.

Not only the labour theory of value is a discarded principle, the assumptions underlying it are unrealistic and invalid. In fact, product is not the result of labour services alone. Other factors of production also do make a significant contribution in production. Hence the total cost should be calculated by including both labour and non-labour costs. The international exchange of goods should be determined, therefore, on the basis of money costs rather than labour costs.

(ii) Perfect Competition:

The Ricardian-Mill theory of comparative advantage assumes perfect competition in both goods and factor markets. In view of the existence of non-competing groups and imperfect factor mobility, however, the imperfections in goods and labour markets have to be recognised. Taussig has defended the classical theory by stating that the mere existence of non- competing groups cannot vitiate the classical theory and competitive conditions, provided relative scales of wages are the same in different countries. This can be true only if there is the same stratification of labour and level of technological advance in various countries. Such conditions, however, do not exist in real life and the classical theory of international trade stands exploded.

(iii) Static Nature of the Theory:

The theory of comparative costs is basically of a static character. It is based on such static assumptions as a given production function, given consumer tastes, fixed factor endowments, no change in the structure of industry and so on. In actual and dynamic realities, however, there are changes in tastes, technologies, factor proportions, and development of natural resources and structure of industries. In these circumstances, the Ricardian theory breaks down. Ellsworth suggested that “either a new type of analysis, more suited to its field must be evolved to supplement the older approach, or a very considerable amount of supplementary investigation must be undertaken.”

(iv) Constant Returns to Scale:

The entire structure of classical trade theory rests on the law of constant returns or constant costs so that additional production can be possible at an unchanged labour cost per unit of output. In reality, production may be governed by the law of diminishing returns or increasing costs. It may ultimately result in the cost ratio becoming equal in two countries, wiping out any gain from trade. The law of increasing cost may thus put a barrier upon the international trade. Some writers, however, argue that the increasing costs can at the most affect the degree of specialisation and cannot create much serious hurdle in international trade.

(v) Too Much Emphasis on Supply Conditions:

This theory cannot provide a complete explanation of international trade as it lays too much emphasis on supply conditions and overlooks the impact of demand conditions on prices of goods and their imports and exports. Under the constant cost situation, it was believed that commodity price cannot be affected by demand factors.

But under varying cost conditions, the relative magnitudes of domestic and foreign demand and the shape of domestic and foreign cost curves vitally determine size of output, prices, specialisation and gain from trade. Repudiating the traditional theory on this ground, Ohlin remarks, “The comparative cost reasoning alone explains very little about international trade. It is indeed nothing more than an abbreviated account of conditions of supply.” The omission of demand factor was, however, sought to be rectified later by J.S. Mill and Alfred Marshall.

(vi) Lack of Complete Specialisation:

Graham has pointed out that the comparative advantage may fail to lead to complete specialisation and this theory may break down. This may happen when a large country is engaged in trade with a smaller country. The complete specialisation can be possible in case of the latter. But so far as the large country is concerned, there may not be complete specialisation for two reasons.

Firstly, it cannot meet all its requirements of a specific commodity from that small country. Secondly, the large surplus produced by it, in the case of complete specialisation, cannot be absorbed by the smaller country. The incomplete specialisation is bound to have complex effects on terms of trade and smooth flow of trade may get seriously impeded. The incomplete specialisation may again result if the two traded commodities are not of comparable values. Suppose one commodity has high value while the other has a low value.

The country producing high value commodity may specialise completely while the other cannot do it. This signifies highly restricted scope of the theory of comparative costs. In the words of F.D. Graham, “The classical conclusion of complete specialisation between two countries can hold ground only when the dice is loaded by assuming trade in two commodities of approximately equal total consumption value and between two countries of approximately equal economic importance.” Since these conditions are very rare in actual life, the whole theory becomes generally irrelevant.

(vii) Absence of Transport Costs:

A very serious defect in the classical doctrine of comparative advantage is its assumption concerning the absence of transport costs. The increasing transport costs may completely nullify any comparative advantage that one country may have over the other. Some writers have, however, incorporated transport costs into production costs to demonstrate that the basic content of the theory can still remain undamaged.

(viii) Mobility of Labour:

The assumption that labour has perfect mobility internally and immobility on the international plane, places a serious limitation on its applicability. The factor immobility as the basis of international trade has been criticised by Ohlin. The factor mobility is very limited even within the different regions of the same country. Therefore, it is not at all a special feature for international trade and it is inappropriate to relate the terms of trade to factor immobility.

(ix) Full Employment:

Like all other doctrines propounded by the classical writers, the comparative costs theory too rests upon the assumption of the state of full employment within a country. Keynes has convincingly refuted the classical myth of full employment. Hence the Ricardian theory of comparative advantage does not rest on solid theoretical foundations.

(x) Two-Commodity Two-Country Model:

The comparative cost theory has a severe operational limitation that it is concerned only with the two- commodity two-country situation. In complex multilateral trade realities, this theory is rather too simplistic.

(xi) Neglect of Product Varieties:

This theory is sometimes criticised on the ground that no attention has been paid to different varieties of commodities. It is possible that a country exports one variety of a product, while at the same time imports some other variety of it. This objection is, however, ruled out on the ground that comparative costs theory treats different varieties of a product as separate commodities rather than the same product.

(xii) Normative Approach:

The Ricardian theory lacks a positive approach in explaining the terms of trade. It has essentially a normative approach as it concerns itself with optimum allocation of resources and maximisation of welfare. Jagdish Bhagwati holds that the Ricardian theory is basically a welfare model, the purpose of which is to build up a case for free trade rather than a positive model for analysing the realistic facts of foreign trade.

(xiii) Necessity of Self-Sufficiency:

In practical life, there are many political, strategic or development considerations that make the countries deviate from the principle of free trade. The tariff barriers are raised and import-substitution policies are pursued with a great vigour.

For instance, India decided to produce raw jute in her various states even at higher costs rather than import it from erstwhile East Pakistan (now Bangladesh) because of a prolonged trade deadlock with that country. So political or strategic considerations may dominate and the countries may frequently depart from the principle of comparative advantage.

(xiv) Not Relevant in Less Developed Countries:

The Ricardian theory of international trade is simply a justification of free trade. It is an extension of the classical laissez faire doctrine in the field of international trade. It emphasises that the international specialisation based on comparative costs can ensure maximum current output. But the basic problem in less developed countries is to maximise the rate of growth. The Ricardian theory does not involve any mechanism through which the rate of economic growth can be maximised.

On the contrary, free trade creates conditions of cut­throat competition which is most detrimental for the poor countries. It greatly restricts the scope of industrialization in those countries because of their comparative disadvantage due to low efficiency of labour and lesser technical advance. The economic interests of the poor countries require protectionist measure at least in the transitional period.

The writers like Prebisch, Singer, Myrdal and Myint have pointed out that tariff restraints are unavoidable for the less developed countries. In the conditions of chronic balance of payments deficits and foreign exchange crisis, the restraints on trade are bound to be imposed. In any case, the comparative costs principle is irrelevant to the conditions of developing countries.

(xv) Economic Rigidities:

The Ricardian comparative costs principle can apply if the market structure is elastic and does not involve rigidities. Moreover, there must also be stability in prices. However, if economic rigidities are present and prices are unstable, this theory breaks down.

(xvi) Dangerous and Clumsy:

Bertil Ohlin has made highly caustic comments about this theory. He considers this theory as clumsy, cumbersome, unreal and dangerous. It is an over-simplification to relate international trade to labour productively, while ignoring all other elements of cost. Further, it is highly dangerous to extend the conclusions derived from a two-commodity and two-country model to very complex multi-commodity and multi- country situation.

It is obvious that the Ricardian comparative costs doctrine has both structural and practical deficiencies and it failed to determine precisely the actual ratio of international exchange and distribution of gains from trade among the trading countries. It, however, cannot be denied that all trade, including international trade, is governed by comparative cost advantage. Paul Samuelson remarked, “Yet for all its over-simplification, the theory of comparative advantage has in it a most important glimpse of truth. Political economy has found few more pregnant principles.”

Empirical Evaluation of Comparative Costs Theory:

Although there are a series of theoretical and practical objections against the Ricardian theory, yet the empirical evidence has lent some support to it. The writers like Mac Dougall (1951), Robert Stern (1962) and Beta Belassa (1963) have attempted studies about the exports of the U.S.A. and U.K. to a third country on the assumption that the trade barriers affect the exporters of both the countries in an equal way so that the comparative costs will govern the flow of traded goods.

All these studies employed data concerning these two countries for 1937 to 1959 period. MacDougall denoted the ratio of U.S. exports to U.K. exports of a series of products as Y and the ratio of their respective labour productivities regarding these products as X.

He obtained the following regression equation:

Y = 2.19 + 1.89 X, r = + 0.61

Stern’s study gave the following regression equation:

Y = -0.68 + 1.27 X, r = + 0.44

A high degree of positive correlation between X and Y tends to support the Ricardian doctrine. Another important study was attempted by I.B. Kravis in 1956 on the basic of the U.S. and Japanese data. All these studies show that differences in labour productivity have an important influence upon the pattern of international trade.

A study conducted in 1990 indicated that average productivity of labour in Japanese manufacturing was 20 percent lower than labour productivity in the United States. But the Japanese productivity was 16 to 24 percent higher than the productivity in the United States. That is perhaps the reason that Japan has the ability to export millions of automobiles to the United States.

This has made R.E. Caves to remark that- “the classical theory of international trade may earn its place today because of its empirical relevance.”

The study made by Jagdish Bhagwati in 1964, however, has contradicted the above studies. He has found that linear regression of export price ratios (United States/United Kingdom) on labour productivity ratios yield no significant regression co-efficient. Similarly the regression of unit labour costs on export price ratios for the same two countries yielded no significant result. Therefore, no hasty conclusion about the empirical validity of the classical comparative advantage principle should be given until more conclusive evidence becomes available.