Thursday, 9 May 2013

COMPARATIVE COST ADVANTAGE THEORY AND FISHER'S EQUATION




Explain the comparative cost advantage theory od international trade. How will a country gain from such a trade?. Give criticisms also.
               

Ricardo's Theory of Comparative Advantage ↓


David Ricardo stated a theory that other things being equal a country tends to specialise in and exports those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage. Similarly the country's imports will be of goods having relatively less comparative cost advantage or greater disadvantage.

1. Ricardo's Assumptions :-


Ricardo explains his theory with the help of following assumptions :-
  1. There are two countries and two commodities.
  2. There is a perfect competition both in commodity and factor market.
  3. Cost of production is expressed in terms of labour i.e. value of a commodity is measured in terms of labour hours/days required to produce it. Commodities are also exchanged on the basis of labour content of each good.
  4. Labour is the only factor of production other than natural resources.
  5. Labour is homogeneous i.e. identical in efficiency, in a particular country.
  6. Labour is perfectly mobile within a country but perfectly immobile between countries.
  7. There is free trade i.e. the movement of goods between countries is not hindered by any restrictions.
  8. Production is subject to constant returns to scale.
  9. There is no technological change.
  10. Trade between two countries takes place on barter system.
  11. Full employment exists in both countries.
  12. There is no transport cost.

2. Ricardo's Example :-


On the basis of above assumptions, Ricardo explained his comparative cost difference theory, by taking an example of England and Portugal as two countries & Wine and Cloth as two commodities.
As pointed out in the assumptions, the cost is measured in terms of labour hour. The principle of comparative advantage expressed in labour hours by the following table.
England Portugal Wine Cloth Principle Comparative Advantage
Portugal requires less hours of labour for both wine and cloth. One unit of wine in Portugal is produced with the help of 80 labour hours as above 120 labour hours required in England. In the case of cloth too, Portugal requires less labour hours than England. From this it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo however tried to prove that Portugal stands to gain by specialising in the commodity in which it has a greater comparative advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.

• Cost ratios of producing Wine and Cloth ↓

Cost ratios of producing wine and cloth
Portugal has advantage of lower cost of production both in wine and cloth. However the difference in cost, that is the comparative advantage is greater in the production of wine (1.5 — 0.66 = 0.84) than in cloth (1.11 — 0.9 = 0.21).
Even in the terms of absolute number of days of labour Portugal has a large comparative advantage in wine, that is, 40 labourers less than England as compared to cloth where the difference is only 10, (40 > 10). Accordingly Portugal specialises in the production of wine where its comparative advantage is larger. England specialises in the production of cloth where its comparative disadvantage is lesser than in wine.

• Comparative Cost Benefits Both Participants ↓

Let us explain Ricardian contention that comparative cost benefits both the participants, though one of them had clear cost advantage in both commodities. To prove it, let us work out the internal exchange ratio.
Comparative Cost Benefits Both Participants
Let us assume these 2 countries enter into trade at an international exchange rate (Terms of Trade) 1 : 1.
At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine. At home it is required to give 1.2 units of cloth for one unit of wine. England thus gains 0.2 of cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth.
Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of cloth at home thus gaining extra cloth of 0.11. Here both England and Portugal gain from the trade i.e. England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit of wine.
In this example, Portugal specialises in wine where it has greater comparative advantage leaving cloth for England in which it has less comparative disadvantage.
Thus comparative cost theory states that each country produces & exports those goods in which they enjoy cost advantage & imports those goods suffering cost disadvantage.
Following are the important limitations of Ricardian Comparative Cost Theory.

1. Restrictive Model


Ricardo's Theory is based on only two countries and only two commodities. But international trade is among many countries with many commodities.

2. Labour Theory of Value


Value of goods is expressed in terms of labour content. Labour Theory of value developed by classical economists has too many limitations and thus is not applicable to the reality.
Value of goods and services in the real world is expressed in money i.e. the prices are the values expressed in units of money.

3. Full employment


The assumption of full employment helps the theory to explain trade on the basis of comparative advantage. The reality is far from full employment. Cost of production, even in terms of labour, may change as the countries, at different levels of employment move towards full employment.

4. Ignore transport cost


Another serious defect is that the transport costs are not consider in determining comparative cost differences.

5. Demand is ignored


The Ricardian theory concentrates on the supply of goods. Each country specialises in the production of the commodity based on its comparative advantage. The theory explains international trade in terms of supply and takes demand for granted.

6. Mobility of factor of production


As against the assumptions of perfect immobility between the countries, we witness difficulties in the mobility of labour and capital within a country itself. At the same time their mobility between nations was never totally absent.

7. No Free Trade


Ricardian theory assumes free trade i.e. no restriction on the movement of goods between the countries. Though it is unrealistic to assume not to have any restriction. what the real world witnesses is a lot tariff and non-tariff barriers on international trade. Poor countries find it difficult to enjoy the comparative advantage in the production of labour intensive commodities due to the protectionist policies followed by developed countries.

8. Complete specialisation


The comparative advantage theory comes to conclusion of complete specialisation. In the Ricardian example, England is specialising fully on cloth and Portugal on wine. Such complete specialisation is unrealistic even in two countries and two commodities model. It is possible if two countries happens to be almost identical in size and demand. Again, a complete specialisation in the production of less important commodity is not possible due to insufficient demand for it.

9. Static Theory


The modern economy is dynamic and the comparative cost theory is based on the assumptions of static theory. It assumes fixed quantity of resources. It does not consider the effect of growth.

10. Not applicable to developing countries


Ricardian theory is not applicable to developing countries as these countries are nowhere near to full employment. They are in the process of change in quality of their labour force, quality of capital, technology, tapping of new resources etc. In other words developing countries exhibit all the characteristics of dynamic economy.

11. Constant Returns to Scale


Another drawback of the Ricardian principle of comparative costs is that assumes constant Returns to scale and thus constant cost of production in both the countries. The doctrine holds that if England specialises in cloth; there is no reason why it should produce wine. Similarly if Portugal has a comparative advantage in producing wine, it will not produce cloth; but import all cloth from England. If we examine the pattern of international trade in practice, we find it is not so. A time will come when it will not be reasonable for Portugal to import cloth from England because of increasing cost of production. Moreover, in actual practice a country produces a particular commodity and also imports a part of it. This phenomenon has not been explained by the theory of comparative costs

 what do you mean by Quantity theory of money? Explain the fisher’s quantity theory of money. Give criticism also.
                        - Fisher’s Equation

The Quantity Theory of Money is the oldest theory. This theory is in existence from the time of classical economists to present day. There is a controversy as to the man who was responsible for the origin of it. But this theory was for the first time clearly explained by Locke, Hume and Cantallian.

In the 17th century it was found that there is a connection between the quantity of money and the general level of prices. This led to the formulation of quantity theory of money. The gist of this theory is that the value of money depends on quantity of money and the change in quantity of money causes change in the value of money.

After being long discarded this theory was revived during 1920s by Prof. Irving Fisher. According to Fisher there is an inverse relationship between the value of money and the quantity of money. Fisher observed “other things remaining same, the purchasing power of money changes to the opposite direction of the quantity of money in circulation“.
 Fisher, thus, introduced the velocity of circulation of money. Money circulates from hand to hand. For example, Britney, the beautician spends Rs 25 at Blackburn retail shop; Blackburn uses that Rs 25 to purchase a pair of shoe in Alpha’s shop; Alpha then spends that Rs 25 for hairdressing in Britney’s beauty parlor. In this way, Rs 25 has returned to where it was before the first circulation. The same Rs 25 was used for four separate transactions. Rs 25 did the work of Rs 100. Each money unit is used many times in a year “If one unit of money is made to serve four transactions this is equivalent to four units of money each being used in only one transaction”. This is the meaning of Velocity of circulation.
 The Quantity Theory of Money was thus modified by Fisher, which is called ‘Equation of Exchange’. Fisher’s equation of exchange is: M V = P T Q
Alternatively, it may also be expressed as. P = \dfrac{MV}{T}
In the equation M represents the total amount of money in existence. V represents the velocity of circulation. MV therefore represents the amount of money used in a period.
Similarly, P represents the general price level and T represents the total of all transaction that have taken place for money during the period.
Flsher’s equation can be illustrated by the help of an example,
 Suppose quantity of money, M = Rs 100
 Velocity of circulation, V = 1
 Total transaction, T = 100

Hence  p = \dfrac{Mv}{T}

 P = Rs \dfrac{100 \times 1}{100} = Rs 2 per unit

Now suppose that the quantity of money has increased to Rs 200. There is no change in velocity of circulation and total transaction.

Hence, P= Rs \dfrac{200 \times 1}{100} = Rs 2 per unit

This shows that when quantity of money increases, price level also increases on account of which value of money falls and vice versa.In this equation Fisher had included only cash and coins. Since even deposit money is included in money in present time. Fisher latter presented the new equation, which is as follows:  M V = M_1 V_1 = P T, which can be expressed also as,
P = \dfrac{MV + M_1 V_1}{T}
Here M, stands for the quantity of credit money; V_1stands for velocity of credit money.In this equation, it is shown that the price level (P) has direct relationship with M, V, M_1, and V_1 and indirect relationship with T.
 The equation of exchange shows that the price level and therefore the value of money is influenced not only by the quantity of money but also by [i] the rate at which money circulates, and (ii) the output of goods and services. Hence, the price might rise without any change in the quantity of money if there is a rise in the velocity of circulation. On the other hand, price might remain stable in spite of increase in quantity of money if there is a corresponding increase in the output of goods and services.

Assumptions
 Fisher’s equation of exchange is based on following assumptions.

i. The price level P is a passive variable. It is determined and controlled by other variables of the equation.
ii.In the short run the total transaction, T and velocity of circulation. V is constant and T depends on the quantity of production.
 iii.The total amount of money, M and velocity of circulation, V and total transaction, T. and price level P, are independent variables. They do not affect each other.
 iv. There is definite relationship between bank money, M, and quantity of money, M. The ratio of credit money to cash remains constant.
 v.There is full employment in the long run.

Criticisms

The Quantity Theory of Money has been criticized on the following grounds:

i. Not a Theory at All

It is not a theory at all. It is simply a convenient method of showing that there is a certain relationship between four variables –M, V, P and T.

It shows only that quantity of money, as determined by the actual amount of money in existence and the velocity of circulation is equal to the value of total trade transactions multiplied by their average price. As such it is obviously a truism, since the amount of spent on purchases is obviously equal to the amount received from sales. Not only must MV equal to PT, but MV is PT, since they are only two different ways of looking at the same thing.

ii. Independent Variables

The four variables, M, V, P and T are not independent of one another as this theory implies. The change in any one variable affects the other variable. For example, a change in M is likely to bring about a change in V or T or both.

iii. Symbol P

A serious defect is to use symbol P to represent the general price level. Price change does not all keep in step with one another. The equation was criticized because it implied that an increase in the quantity of money would automatically bring about proportionate increase in all prices. But in reality, the prices do not change in same percent. Clearly, then, there is no general price level.

iv. Price Level, P as passive

Unlike Fisher, the price level, P, is not a passive factor. It is an active factor and affects T also. The increase in price increases trade by encouraging production. Due to this the quantity of money and V both increase.

v. Determination of Value of Money

This theory attempts to explain changes in value of money. It does not show how the value of money is in the first place determined.

vi. Emphasis on Supply Side

This theory seems to be a general theory of demand and supply, but has given too much emphasis on supply side. It has completely ignored the influence of demand. It gives the impression that the supply of money is the only factor causing change in price.
DIFFICULTIES IN MEASURING NATIONAL INCOME>

There are many difficulties in measuring national income of a country accurately. The difficulties involved in national income accounting are both conceptual and statical in nature. Some of these difficulties involved in the measurement of national income are discussed below:

Non Monetary Transactions

The first problem in National Income accounting relates to the treatment of non-monetary transactions such as the services of housewives to the members of the families. For example, if a man employees a maid servant for household work, payment to her will appear as a positive item in the national income. But, if the man were to marry to the maid servant, she would performing the same job as before but without any extra payments. In this case, the national income will decrease as her services performed remains the same as before.

Problem of Double Counting

Only final goods and services should be included in the national income accounting. But, it is very difficult to distinguish between final goods and intermediate goods and services. An intermediate goods and service used for final consumption. The difference between final goods and services and intermediate goods and services depends on the use of those goods and services so there are possibilities of double counting.

The Underground Economy

The underground economy consists of illegal and uncleared transactions where the goods and services are themselves illegal such as drugs, gambling, smuggling, and prostitution. Since, these incomes are not included in the national income, the national income seems to be less than the actual amount as they are not included in the accounting.

Petty Production

There are large numbers of petty producers and it is difficult to include their production in national income because they do not maintain any account.

Public Services

Another problem is whether the public services like general administration, police, army services, should be included in national income or not. It is very difficult to evaluate such services.

Transfer Payments

Individual get pension, unemployment allowance and interest on public loans, but these payments creates difficulty in the measurement of national income. These earnings are a part of individual income and they are also a part of government expenditures.

Capital Gains or Loss

When the market prices of capital assets change the owners make capital gains or loss such gains or losses are not included in national income.

Price Changes

National income is the money value of goods and services. Money value depends on market price, which often changes. The problem of changing prices is one of the major problems of national income accounting. Due to price rises the value of national income for particular year appends to increase even when the production is decreasing.

Wages and Salaries paid in Kind

Additional payments made in kind may not be included in national income. But, the facilities given in kind are calculated as the supplements of wages and salaries on the income side.

Illiteracy and Ignorance

The main problem is whether to include the income generated within the country or even generated abroad in national income and which method should be used in the measurement of national income.

Besides these, the following points are also represents the difficulties in national income accounting:
  • Second hand transactions;
  • Environment damages;
  • Calculation of depreciation;
  • Inadequate and unreliable statistics; etc.

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