(a) State and explain the law of comparative cost advantage. [12 marks] (b) Give two limitations of the law as a theory of international trade. [8 marks]

Answer Details

(a) The law of comparative cost (comparative advantage), associated with David Ricardo, states that a country should specialise in producing and exporting those goods in which it has the greatest comparative advantage (lowest opportunity cost) and import those goods in which it has a comparative disadvantage, even where it holds an absolute advantage in producing both goods. Trade will still benefit both countries because each concentrates where its opportunity cost is lowest.

The key idea is opportunity cost. Suppose two countries can each produce cloth and wine. Even if one country is more efficient at both, its advantage will be relatively greater in one good than the other. By specialising where its advantage is comparatively greatest and trading for the other good, total world output of both goods rises, and each country obtains more of both than it could by producing both itself. Thus specialisation according to comparative cost leads to mutual gains from trade.

(b) Two limitations of the law as a theory of international trade

• It ignores transport costs. The theory assumes goods move freely between countries; in reality high transport and handling costs can wipe out the comparative-cost gain.
• It assumes free trade with no barriers. In practice tariffs, quotas and other trade restrictions prevent countries from specialising and trading fully along comparative-cost lines. (Other valid limitations: it assumes constant costs and full employment, perfect factor mobility within a country but immobility between countries, and only two countries and two commodities.)