Differences in costs of production in two countries make exchange of goods profitable.
Exchange will not be beneficial if goods are produced at the same cost. A lower cost of production gives an advantage to one country over the other, and vice versa.
Now this advantage can be of one of the following three types:
(a) Absolute Differences in Costs:
Suppose a country has a monopoly in the production of a commodity. If other countries need this commodity, the country producing it will have an absolute advantage over them. Thus, India has almost a monopoly of manufactured jute (with the exception of Bangla Desh) and all other countries that need jute goods must buy them from India. Such absolute advantages are usually the result of differences in climate or other natural gifts.
(b) Equal Differences in Costs:
The differences in costs will be called equal, when a unit of productive power produces in country A, 20 tooth-brushes 01 20. kg. of sugar, and in country B, 10 tooth-brushes or 10 kg of sugar. In this case, both tooth-brushes and sugar will tend to be exported from country A to country B.
In payment for these, gold and silver will have to be contently sent to A by B. This cannot go on forever. Import of specie into A will raise prices there and export of goods to B will make things cheaper in B. Thus, the difference between the price levels of the two countries tends to be equalized. As a result, the trade between them will cease.
In country B, 20 tooth-brushes can be exchanged for no more than 20 kg. of sugar. Trade in such circumstances will, therefore, either not start, or if it does, will come to a stop very soon. In both countries 10 kg of sugar can be exchanged for 10 tooth-brushes. None of them gains by selling any of the two commodities.
(c) Comparative Differences in Costs:
It looks strange, but it is nevertheless true, that it may be more profitable for a country to import some goods for., another country even though she can produce them cheaper herself. This she will do when she finds that her labour and capital can be more profitably employed when used in producing some other goods in which she enjoys a greater comparative advantage in production.
Suppose Britain can produce both dairy products and steel cheaper than Holland, but she enjoys relatively greater advantage in producing steel. In that case, she gains more by concentrating on steel goods and exporting them to Holland and importing dairy products from Holland. Such a difference is called comparative difference and forms the basis of permanent international trade. In these circumstances, the trade between the two countries will not only start but will also continue.