The principle of comparative costs explains a paradox in international trade. In Ricardian illustration, Portugal can produce wine and cloth at cheaper costs, yet she will import cloth from England and will not produce it at home.
This is because she can use her labour (and other resources more profitably in the production of wine, and the loss which she incurs by importing cloth from England is more than compensated by her profit from producing wine in which she has a comparative advantage.
Ricardo, therefore, held that international trade between two countries will produce mutual gain to both:
(i) if each country exports the commodity in which it has a comparative advantage, regardless of its absolute advantage, and
(ii) obviously, when each country can produce a unit of its exported commodity relatively cheaply than it can produce a unit of imported commodity at home.
It is to be noted that, Ricardo laid down these conditions (especially the latter one) of gain from trade in the light of the assumption that the terms of trade are 1 to 1. The second condition, of course, may be described as the special Ricardian rule of gain from trade when the terms are 1:1.
In Ricardo’s view, thus, international trade does not require offsetting absolute cost advantages but is possible where a comparative cost advantage exists. International trade occurs as a consequence of each country specialising in that branch of production in which it enjoys a comparative advantage, thereby obtaining a greater total product from its given resources.
It was on the basis of such consideration that Cairnes made the (oft-quoted) statement: “The one condition at once essential to, and also sufficient for, the existence of international trade, is a difference in the comparative, as contradistinguished from the absolute, cost of producing the commodities exchanged.”
It is obvious that the comparative costs doctrine is simply an extension of the principle of the division of labour. It advocates geographical specialisation through country-wise (territorial) division of labour, or localisation of industries. However, it constitutes a real improvement over Adam Smith’s law of absolute advantage as the basis of international trade.
It is more general and seeks to cover situations having no absolute advantages. It includes in it also Adam Smith’s formulation of a country having absolute and comparative advantages together as a special case of study. Further, the comparative costs principle also tried to give a more convincing and adequate proof of the gains of international trade.