Let us make an in-depth study of the comparative costs:- 1. Theory of comparative costs 2. Criticism of comparative costs.
Theory of Comparative Costs:
Eminent economists have said that the comparative cost theory is the basis of international business.
It explains that—”it pays countries to specialise in the production of those goods in which they possess greater comparative advantage or the least comparative dis-advantage.”
In the words of Cairnes—”The difference in the comparative cost of producing the commodities exchanged is essential to, and sufficient for, the existence of international business”. This is the fundamental basis of international business.”
When this theory is applied to international business, the theory states that a country tends to specialise in the production of those articles in which it enjoys greater comparative advantage. What is more important is not the cost of commodity in country A and its cost in country B but the ratio between the costs of the commodities in the two countries.
A Paradox Indeed:
One will surprise to find a country importing a particular commodity from another country even when she can herself produce it at a lower cost. Why so? This can be explained by giving suitable and proper example—we find that Great Britain can produce both dairy products and machinery chapter than Denmark, yet she imports dairy products from Denmark and export machinery. Why so? This paradox can be explained in this manner.
Take this point-a Professor can polish and black his own shoes better than his servant and can of course teach and lecture far better. But his time is more profitably used with his books than with brush and polish. Similarly, a doctor may be a better dispenser than his assistant, but it pays him to examine patients and leave dispensing to his compounder.
In the same way Great Britain imports cheese and butter because she gains more by producing machinery. This is not a matter of surprise because every nation uses its resources in such channels which will yield the best results. This is the main basis of all international business.
Criticism of the Comparative Cost Theory:
Important criticisms of the comparative cost theory are as follows:
1. This Theory is Based on Wrong Assumptions:
The comparative cost theory is based on some such assumptions which do not hold good in real life.
Some of these assumptions are:
(i) Static assumptions of fixed costs,
(ii) The unit costs remain the same,
(iii) It assumes that there are no transport costs,
(iv) Fixed supplies of the factors of production etc.,
(v) Further it assumes that there are no other costs except labour costs, and
(vi) It assumes perfect mobility of factors inside and perfect immobility outside the country. Economists do not believe over all these assumptions.
Therefore, this theory is not applicable to real life. Thus, the international business does not follow the law of comparative cost.
2. This Theory Implies Specialisation:
But in real life complete specialisation is not possible nor always desirable so far as countries are concerned.
3. International Business Arises Owing to Differences in Relative Factor Prices:
But international business also tends to narrow down these differences. Hence, business should come to end if we accept comparative cost theory.
4. This Theory has been Considered as One Sided:
As it ignores the demand and concentrates only on the supply side. This theory does not speak as to what prices the goods will be demanded.
5. It is not an Adequate Explanation:
The comparative cost theory does not furnish an adequate explanation of international business.