International Economics
Learning Objectives
♥
Theory of Opportunity Cost
♥
Critical Assessment
♥
IT under constant, increasing &
decreasing costs
International Economics
4.1 Introduction
Ricardo’s theory of International Trade
was
based
on
many
unrealistic
assumptions.
Labour
as
the
only
factor
of
production was one of them. He further
assumed that units of labour were
homogenous,
and
that
value
of
a
commodity is determined by amount of
labour embodied in it.
International Economics
4.1 Introduction
Actually production needs additional
factors like capital, land etc. Labour
has many non-competing groups. Plus
labour and capital can be used in
different proportions to produce same
quantity of output.
Prof.
Haberler’s
opportunity
cost
theory of international trade makes an
attempt to overcome this short coming
in Ricardo’s theory.
International Economics
4.2
Statement of Haberler’s Theory of
Opportunity Cost
Theory : ‘If a given amount of factors
of production [say a given combination of
land, labour and capital] can produce either
one unit of commodity X or one unit of
commodity Y, then the opportunity cost of a
unit of X is the sacrifice of one unit of
Y.’
Thus the rate of exchange between
commodities
is
expressed
in
terms
of
opportunity foregone of producing, with the
same combination of factors, units of
another commodity.
International Economics
4.2
Statement of Haberler’s Theory of
Opportunity Cost
Different quantities of X & Y that can
be produced from same combination of factors
is indicated on the ‘Production Possibility
Curve’
Y
B
R
E
A
D
O
X
Cloth
Production Possibility Curve under constant costs
International Economics
4.2
Statement of Haberler’s Theory of
Opportunity Cost
If the country is producing under the
conditions of
increasing costs this curve
will be concave to the origin as under.
Y
B
R
E
A
D
O
X
Cloth
Production Possibility Curve under increasing costs
International Economics
4.2
Statement of Haberler’s Theory of
Opportunity Cost
If the country is producing under the
conditions of
decreasing costs this curve
will be convex to the origin as under.
Y
B
R
E
A
D
O
X
Cloth
Production Possibility Curve under decreasing costs
International Economics
4.2
Statement of Haberler’s Theory of
Opportunity Cost
If the country is not taking part in
international trade, it will produce cloth
and bread in such a proportion that total
welfare of the community is maximized. It is
known that consumer will do so by equalizing
ratio of marginal utility of two commodities
with ratio of their marginal prices.
Similarly, a producer
maximizes his
profits when the ratio of the prices of
products is equal to the ratio of their
marginal costs.
International Economics
4.2
Statement of Haberler’s Theory of
Opportunity Cost
To summarize we can say that total
welfare of community would be maximized by
equalizing marginal rate of substitution
[MRS] in consumption, the marginal rate of
product transformation in production [MRTP]
and prices of products.
From the next diagram it can be seen
that the highest conceivable satisfaction is
attained by the country at point F on the
community’s indifference curve IC2
International Economics
4.2
Statement of Haberler’s Theory of
Opportunity Cost
Y
R
B
B
R
E
A
D
B1
F
IC3
IC2
O
IC1
C1
C
L
Cloth
Optimization by a community
X
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Opportunity
In the last diagram
RL is the iso-cost line.
IC1, IC2 & IC3 = community’s
indifference curves.
BC = Production Possibility Curve.
The country produces both cloth &
bread. It produces and consumes OC1 quantity
of cloth and OB1 of bread.
It
should
be
noted
that
higher
indifference curve IC3 is beyond community’s
reach with available resources & technology.
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Three cost
trade.
conditions
and
Opportunity
international
It would be instructive to analyze the
three cost situations and the theory of
international trade with two commodities
produced under.
i] constant opportunity costs.
ii] increasing opportunity costs and
iii] decreasing opportunity cost { this
is being excluded in view of its logical
inconsistency}.
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Opportunity
Production Possibility Under Conditions of
Constant Opportunity Costs
Input
Units
50
40
30
20
10
O U T P U T
England
U N I T S
Australia
Bread
Cloth
Bread
150
120
90
60
30
50
40
30
20
10
150
120
90
60
30
Cloth
75
60
45
30
15
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Opportunity
Y
O
U 150
T
P 120
U
T 90
ENGLAND
Of
60
B
R
E
A
D
30
0
30
60
90
120
Output of cloth
150
X
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Opportunity
Y
O
U 50
T
P 40
U
T 30
Australia
Of
20
B
R
E
A
D
10
0
15
30
45
Output of cloth
60
75
X
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Opportunity
Constant Opportunity costs or proportionate returns
conditions.
In case of a condition of constant costs or
proportionate returns, there will be optimum
production
possibility
curves
for
both
commodities and both countries.
These optimum production possibility
curves demonstrate the possible combinations
of bread & cloth which England & Australia
can
produce
under
full
employment
of
available inputs. See the next diagram.
International Economics
4.2
Statement of Haberler’s Theory of
Opportunity Cost
Y
P
England
150
IC
PP
B
R
E
A
D
Community Indifference Curve
Production Possibility Curve
E
75
IC
P
O
75
150
Cloth
Domestic Equilibrium of Production at Constant Costs
X
International Economics
4.2
Statement of Haberler’s Theory of
Opportunity Cost
Y
Australia
IC
PP
P
50
B
R
E
A
D
Community Indifference Curve
Production Possibility Curve
E
25
IC
P
O
37.5
75
Cloth
Domestic Equilibrium of Production at Constant Costs
X
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Opportunity
Nature
of
International
Trade
under
condition
of
Constant
Costs
[
or
proportionate returns or equal returns to
scale]:
From earlier diagrams it is noted that
domestically,
one
unit
of
bread
can
be
exchanged for one unit of cloth in England and
for one & half units in Australia.
International trade is beneficial to both
if the rate of exchange for bread is between
one & one & half.
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Opportunity
The actual rate for international trade
is decided depending upon reciprocal demand
[i.e. England’s elasticity of demand for
Australian
cloth
vis-à-vis
Australian
elasticity of demand for English bread].
If the rate is decided at say 1.2 and
England specializes in bread & Australian in
cloth.
The situation before and after trade is
provided next
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Before Trade
Opportunity
After Trade
England
Production 75 B 75 C
Export
Consume 75 B & 75C
Australia
Production
50 B
75 C
Export
Consume 50 B & 75 C
150 B
62.5 B for 75 C
87.5 B & 75 C
150
C
75 C for 62.5 B
62.5 B & 75 C
International Economics
4.2
Cost
Statement of Haberler’s Theory of Opportunity
If
the
country
is
producing
under
the
conditions
of
increasing
costs,
production
possibility curve will be concave to the origin.
Y
B
R
E
A
D
P
M
B1
B
F
P1
O
C1
C
N
Cloth
Production Possibility Curve under increasing costs
X
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Opportunity
It shows that if all the resources are
employed to produce bread OM units of bread can
be produced and if employed to produce cloth ON
units of cloth can be produced.
Limiting points of production M & N cannot
be joined by a straight line due to conditions
of increasing costs.
At the initial equilibrium point F, OB of
bread and OC of cloth is produced. If the quantity
of bread is to be increased to OB1 , output of cloth
has to be reduced to OC1. It can be seen that
increase in the quantity of bread namely BB1 is less
than decrease in output of cloth namely CC1.
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Opportunity
If there is not going to be any trade
with other country, and country wishes to
produce both B & C, then actual output of B
& C is decided by the tangency of price line
PP1 to production possibility curve MN [i.e.
point F].
When countries decide to trade, they
will specialize in production of B or C
where they have comparative cost advantage.
The domestic price line PP1 will now change
to new line P2P3 as decided by the terms of
international trade.
International Economics
4.2
Cost
Statement of Haberler’s Theory of Opportunity
import of bread
export of cloth
.
Y
B
R
E
A
D
P
P2
C
B2
A
IC1
IC2
B
B3
P1
P3
O
C2
C1
C3
N
Cloth
Production Possibility Curve under increasing costs
X
International Economics
4.2
Statement of Haberler’s Theory of
Cost
Opportunity
From this diagram it is clear that at
the original equilibrium point A, the
country was getting the optimum combination
of B & C, i.e. OC2 of cloth OB2 of bread as
it was maximizing satisfaction it its
indifference curve IC1 .
With
specialization
in
production,
Australia now produces OC3 units of cloth
and OB3 units of bread and optimizes its
resources at point B where the new price
line cuts the production possibility curve.
International Economics
4.2
Statement of Haberler’s Theory of Opportunity
Cost
However, the domestic demand for bread
continues to be OB2 . To meet shortfall it
would export cloth of quantity C1C3 and
import bread of quantity B2B3.
Thus the international trade leaves
Australia better off and the country is at
higher indifference curve IC2.
In case of conditions of constant costs
full specialization is possible, but under
increasing costs only partial specialization
is there. [in this case OB3 is produced and B3B2 is
imported.]
International Economics
4.2
Statement of Haberler’s Theory of Opportunity
Cost
Proportionate Cost Structures
If
two
counties
are
having
proportionate cost structures, then there is
no comparative cost advantage. e.g. after
employing full resources following outputs
are obtained.
England
200 units of bread or 100 of cloth.
Australia 100 units of bread or 50 of cloth.
In such case the distance between production
possibility curves of two countries is constant.
International Economics
4.2
Statement of Haberler’s Theory of Opportunity
Cost
Proportionate Cost Structures
Y
B
R
E
A
D
England
Australia
O
X
c l o t h
International Economics
4.3
Critical Assessment of Haberler’s
Opportunity Cost Theory
Since
Haberler
makes
all
the
assumptions that were made by Ricardo for
his comparative cost theory, all criticisms
levied against his theory are applicable
here.
Only plus point for Haberler is that
along with labour, he has considered all
other factors of production.
Further Haberler does not restrict
himself
to
constant
returns
and
does
consider increasing and decreasing costs.
The End