David Ricardo, in his Principles of Political Economy (1817), furnished a more precise formulation of the theory of international trade. At the centre of the Ricardian theory of international trade is the celebrated principle of comparative advantage of "doctrine of comparative costs."
In fact, the doctrine of comparative costs was developed by Ricardo out of his (classical) labour theory of value. According to this theory, the value of any commodity is determined by its labour costs.
It asserts that, goods are exchanged against one another according to the relative amounts of labour embodied in them. For the prices of goods within a country are proportional to the relative quantities of labour contained by them. Thus, the exchange ratios or prices are determined solely by relative labour costs, through their influence upon supply and demand.
If the goods of a particular industry have their prices higher than their labour costs, additional labour moves to this industry from other occupations. Hence, the supply of that industry's goods will expand until their prices equal their labour costs. The labour cost principle, therefore, implies that there is a tendency of wages toward equality within a country, so that, prices of goods will be equal to their labour which may equalise the return to labour in all productions and regions throughout the country.
The labour cost principle is, however, based on the following assumptions that:
1. Labour is the only productive factor,
2. All labour is of the same quality and characteristics,
3. Labour has perfect mobility,
4. There is perfect competition in the labour market.
Ricardo, thus, thought that the labour theory of value, which is completely valid for the domestic trade of a country, cannot be applied to international trade, since factors of production are immobile internationally.
Like other classical economists, he also believed that, labour is completely mobile within a country and therefore, distributes itself among the different branches of production in such a way that its marginal productivity is everywhere equal to its wages.
This rule does not apply to international trade, since labour is not mobile between countries. In short, the labour cost principle does not govern value in exchange transactions in international trade. The question, therefore, arises: what determines values in international exchange?
To explain this, Ricardo developed his Doctrine of Comparative Costs. In developing the theory of comparative costs, Ricardo sought to explain why different countries specialised in the production of different commodities, or what is the basis of international trade.
According to the theory of comparative costs, international trade takes place because different countries have different advantages (efficiency) in the production (specialisation) of different commodities.
A country will specialise in the production of that commodity in which it has a greater comparative advantage or its comparative disadvantage is the least. It follows thus that the country would export the commodity in which it has comparative advantage, and import the commodity in which its advantage is less or in which it has a comparative disadvantage.
Assuming a simple two-country, two-commodity, one-factor (labour) model, Ricardo seeks to elucidate the above-stated theory in terms of the labour cost principle by means of his celebrated arithmetical example as follows:
Suppose, in Portugal a unit of wine costs 80 hours and a unit of cloth 90 hours of labour; in England a unit of wine costs 120 hours and a unit of cloth 100 hours of labour. Now, if we compare the cost of production in both the countries, for international trade to take place, the position will be as shown in.
We observe that costs of producing both commodities (wine and cloth) are lower in Portugal As compared to England, she has an absolute advantage in producing both the goods. For, 1...
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