Brief notes on the Modifications of Comparative Cost Theory

The theory of comparative cost has been criticized mainly because of its unrealistic assumptions. Later economists were able to discard some of these assumptions without doing any harm to the basic argument. Important modifications in the theory of comparative cost were made by J.S. Mill, Tausig, Haberler and Ohlin.

1. Mill’s Law of Reciprocal Demand:

J.S. Mill made the theory of comparative cost determinate by stating the conditions for equilibrium terms of trade. Comparative cost difference between the countries sets the outer limits between which international trade can take place profitably.

It does not tell us where, between these limits, international trade will actually take place. Mill’s law of international values provides the answer to this question.

“The produce of a country exchanges for the produce of the other countries, at such values as are required in order that the whole of her exports may exactly pay for the whole of her imports.” Or, in other words, the equilibrium terms of trade are determined by the equation of reciprocal demand.

2. Labour Costs Measured in Terms of Money:

Ricardo’s comparative cost theory was explained in terms of labour costs. But, the modern economy is a money economy in which transactions are made through money. International trade is determined by absolute differences in money prices rather than by comparative differences in labour cost.

Prof. Taussig has shown how the comparative differences in labour cost can be converted into a absolute differences in money prices without affecting the real exchange relations. This can be illustrated with the help of the following example.

In India:

1 day’s labour produces 40 units of wheat;

1 day’s labour produces 40 units of cloth.

In England:

1 day’s labour produces 20 units of wheat;

1 day’s iabour produces 30 units of cloth.

In this example, India has an absolute superiority in producing both wheat and cloth. But, it has compara­tive advantage in wheat. Thus, India will specialise in wheat and England will specialise in cloth.

3. Comparative Cost Theory in Terms of Opportunity Cost:

Haberler was the first to abandon the labour theory of value as a fundamental premise of the theory of international trade and to restate the theory in terms of opportunity cost.

The value of a commodity is determined not by the physical cost of resources required to produce it, but by the opportunities of production of other commodities which have to be foregone in order to obtain this commodity.

The theory of comparative cost now states that the country will specialise in the production of those commodities which have comparatively low opportunity cost. Thus, the opportunity cost theory provides a broader and more realistic basis for international trade.

4. Comparative Cost Theory under Increasing Cost Conditions:

The theory of comparative cost, stated in terms of opportunity cost, can be extended to cover more realistic conditions of increasing costs. Increasing cost conditions prevail when (a) there are diminishing returns to scale and (b) all resources are not equally adaptable for the production of all the commodities, or in other words, certain factors are specific to certain commodities.

Increasing costs imply that the marginal costs of producing one commodity in terms of the other are increasing. Or, in other words, in order to obtain additional units of commodity.

We must sacrifice increasing amounts of commodity B. Under the increasing cost conditions, a country will specialise in the production of that commodity in which it has comparative cost advantage but the specialisation will not be complete simply because of the fact that additional amount of the commodity can be obtained only at increasing costs.

5. Ohlin’s Modification:

True, the differences in the comparative costs provide the foundation on which the international trade is possible. But, the next question is: why do the costs differ? Ohlin’s answer to this question is that commodities require different inputs and the countries vary in factor endowments.

A country has comparative advantage in those commodities which use intensively the country’s relatively abundant factor and has comparative disadvantage in the products which use intensively the country’s relatively scarce factor.

Ohlin thus takes a step further by basing the pattern of international trade on the economic structure of the trading countries.