David Ricardo in 1917 wrote a book"principles of political economy"in which he presented the theory of comparative costs regarding international trade.according to Adam smith trade between the two countries.
David Ricardo in 1917 wrote a book"principles of political economy"in which he presented the theory of comparative costs regarding international trade.according to Adam smith trade between the two countries is possible if each country has an absolute advantage over the other in the production of one commodity.
but according to Ricardo, the gain from trade is possible in the case where one country has an absolute advantage in the production of both the commodities but its advantages are greater in one line of production than the other he writes;
"if a country has an absolute advantage in the production of both the commodities and the other has an absolute disadvantage in the production of both the goods, trade is beneficial for both the countries according to Ricardo one country should produce that good where the advantage are comparatively more.the other should produce that good where the disadvantage is comparatively less"
this concept can be explained with help of example:
this table shows that to produce 1 unit of wine in Portugal 80 labors are required while to produce the same unit of wine in u.k 120 labors are required.
again in Portugal 1 unit of cloth is produced with 90 labors,while in u.k 1 unit of cloth is produced with 100 labors.
all this shows that Portugal has an absolute advantage in the production of both wine and cloth, while u.k has an absolute disadvantage in the production of both wine and cloth. but comparatively the advantage of Portugal is greater in wine making. because Portugal requires only 80/120 x100=67% of u.k efforts to produce unit of wine while it takes 90/100(100)=90% of u.k efforts to produce 1 unit of cloth this means that Portugal is comparatively more efficient in wine making than cloth.
on the other hand u.k enjoys comparatively greater disadvantage in the production of both goods. As it takes 120/80(100)=150% of Portugal efforts for u.k to produce 1 unit of wine while it takes 100/90(100)=111% of the u.k efforts to produce 1 unit of cloth. this shows that comparatively disadvantage of u.k is less in cloth making.
Thus according to Ricardo, Portugal should produce and specialize in wine,while u.k should produce and specialize in the production of cloth.
Ricardo comparative costs and gains from trade:
if a country is in autorky position (a closed economy).
As we know to produce 1 unit wine in u.k 120 labors are required while for 1 unit of cloth 100 labors are required this shows that wine making in u.k is more expensive.As 1 unit of wine will cost 120/100=1.2 units of cloth.
contrary wine making is cheaper in Portugal as compare with making cloth i.e 80/90=0.89.i.e 1 unit of wine will cost 0.89 unit of cloth.
there for if international price of one unit wine is settled between 1.2 and 0.89 unit of cloth,both
countries will gain.it 1 unite of wine is exchanged for one unit of cloth, it is advantageous for u.k to export cloth and import wine thus trade ration will also benefit Portugal, because with in the country she could get 0.89 unit of cloth for 1 unit of wine. thus Portugal would specialize, while u.k would specialize in cloth having less comparative disadvantages.
As a result of such specialize in each line of production each country can consume more by trading than in isolation with given resources.
To explain this concept we have a diagram:
In this figure MD is production possibility curve(ppc) which shows production of wine and cloth which u.k can produce given its resources.
the straight line ppc shows that all the factors are alike in both the production of wine and cloth.the ppc also shows the price ratio between W and C which is 1=1.2 before trade.
After trade u.k specializes in the production of cloth at the newly settled international price which 1=1 shown by the curve MF . at this international price u.k produces at M while it consumes OH of cloth (c! because of ! ed ss).
therefore it consumes OH of cloth and HT of wine. accordingly it experts HM of cloth and import HT of wine.
In other words the exports of cloth are TZ while imports of wine are MZ.
In a figure ER is ppc (production possibility curve which shows different combinations of W and C (wine and cloth ) which Portugal can produce given its resources the straight line ppc shows that all the factors are equally efficient in both the production of W and C the ppc further shows that the price ratio between W and C which is 1= 0.89 in Portugal before trade.
After trade Portugal specializes in the production of wine ay the newly settled international price which is 1:1 shown by curve EK.
At the international at E, while it consume at G, therefore it consumes ZG of cloth and OZ of wine.
Accordingly it exports EZ of wine and imports ZG of cloth .In other words the export of wine JG while imports of cloth are EJ.
Two Goods And Two Countries Model=2X2Model:
It is assumed that it is 2x2 model. but practically it is wrong because so many countries trade in so many goods.
Laborer Mobility With In The Country :
IT is assumed that labors are mobile with in the country,but internationally it is not so but in real life even in so many professions labor is not mobile with in the country e.g In profession like water drainage, hair cutting, clay parts etc.
So in such profession we can not find labor has ! ed internationally where there is shortage of labor like middle East, Canada etc.
Trade is not free:
It is assumed that there is no restriction many restrictions like exchange control,custom duties and quota systems. moreover such countries of the world are integrating themselves into Eco-block like Ecm ,ASIAN , SAARC where they are laboring trade restriction against non-members.
After trade every country is facing heavy transportation costs which increase the price of import goods.
Constant Return to scale:
Constant return to scale is assumed but due to advanced technology we have low of increasing return to scale.
Labor Theory Of Value:
All labors are not alike, while assumed alike.
In practical life there is no perfect competition in goods and labor markets and full employment is like a dream.