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Opportunity cost theory of international trade

November 27, 2022

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This article was written by Mahesh P Sudhakaran from KLE Society’s Law College, Bangalore and covers all aspects of the opportunity cost theory of international trade.

It has been published by Rachit Garg.

Introduction

From a concept-based narrative economics begins with the fundamental issue of scarcity and scarcity creates roadblocks to the pathway of utility. With the existence of scarcity comes the need to make choices, but choices aren’t easy. Hence, is it paramount to derive parameters based on which these choices are made taking due note of all essential variables, and parameters which ensure optimum utilisation of resources and utility. Similarly, in the international sphere carrying out trade is complex and the problem of scarcity takes the centre stage as every country establishes different patterns of trade, due to diversity in resources, culture and other variables. Every country has their niche when it comes to production as each country is different in terms of what they are skilled in producing, For eg gulf countries are rich in oil resources and are equipped with the skill to capitalise upon these resources whereas India is capable of producing iron-ore. Countries are independent of one another for the exchange of skills and products to balance out their respective deficiencies and to provide stability to the demand-supply ratios, hence international specialisation refers to utilising one country’s resources in certain specialised areas of production wherein that particular country has an absolute or comparative cost advantage in the global spectrum. The principle of comparative advantage has been a basis of international trade since the culmination of World War 1, this was initially a Ricardian theory, which was further modified by economists like J.S Mill, Alfred Marshall and Taussig. This concept was further explained through Haberler’s opportunity cost theory which we’ll discuss in detail below.

Who introduced the opportunity cost theory of international trade

The opportunity cost theory was propounded by Gottfried Haberler in 1936. Haberler sought to explain the theory of comparative advantage in international law using the opportunity cost theory. Gottfried von Haberler was born on July 20, 1900, and passed away on May 6, 1995. He was an Austrian-born American economist, teacher, and author who specialised in international trade. He pursued a study in Economics at the University of Vienna and obtained his doctorate in 1925. After the completion of his studies, he started teaching economics and statistics at the University of Vienna and also lent consultation services to the League of Nations. He joined Harvard University as a professor up until 1971, wherein he joined the American Enterprise Institute. Haberler is most known for his written work in the field of international trade, his theory of international trade is deemed to have been his most significant work to date. His theory of international law was accepted as a more accurate take on comparative costs in terms of opportunity cost. He derived the production substitution curve which generated a mechanism to ascertain the effects of various variables in the process of production. Haberler is considered to be someone who was ahead of his time about the ideologies he possessed as he advocated for free trade system and abolishment of unnecessary trade barriers. He exerted his influence in reconsidering and reviving key doctrines like purchasing power doctrine which was concerned with considering relative price levels as important determinants that have a bearing upon equilibrium exchange rates.

What does the theory say

As per Haberler. “The marginal cost of a given quantity (x) of a commodity, say A must be regarded as the quantity of a commodity, say, B must be forgone so that X, instead of (X-1) units of A can be produced. The exchange ratio on the market between A and B must equal their costs in this sense of the terms.” In simpler terms, this theory states that the cost of a particular commodity is the quantity of the second commodity that has to be given up so there are adequate resources to produce additional units of the commodity that is fixed. This is an extension or recreation of the comparative advantage theory using the theory of opportunity cost. The Ricardian theory of opportunity cost stated that labour was the sole factor of production and that labour is homogeneous. Haberler’s theory departs from this view and recognizes pre-trade and post-trade situations concerning constant, increasing, and decreasing opportunity cost under different circumstances. As per this theory, the country which has a lower opportunity cost in producing a certain commodity has a comparative advantage with respect to that particular commodity but is at a comparative disadvantage when it comes to another commodity. Let’s examine both these doctrines in detail now.

Ricardo’s Theory of Comparative Advantages

As per David Ricardo, both absolute and comparative differences in costs have influence over the trade relations of two or more countries in the international sphere. Countries have specialisation when it comes to the production of certain products due to variables like differences in climate, natural resources, geographical situation, and the efficiency of labour. Due to these factors, certain countries can produce certain commodities at lower prices when compared to other countries; this is indeed what the concept of specialization stands for. Hence, when a country enters into trade with some other country, it will export those products or commodities which has comparatively lower production costs and will import those commodities which have relatively higher production costs when compared. The important conclusion drawn here is that countries carry out imports and exports based on their comparative advantage and that labour is the sole factor of production. Ricardo considered this to be the very basis of international trade. The Ricardian theory is based on certain key assumptions:

There are only two countries, For eg, India and China.
They produce the exact two commodities.
Tastes are identical in both countries.
The only factor of production is labour.
There is an unchanged labour supply.
Labour units are homogeneous.
Prices of both commodities are purely based on labour. cost, i.e, the number of labour units employed to produce each.
Commodities are produced as per the law of constant costs or returns.
The existence of unchanged technological knowledge.
Trade between these countries is carried out through the barter system.
Perfect mobility with respect to factors of production within each country, but are perfectly immobile between countries.
Free trade between countries and the absence of trade barriers.
Transport costs are absent during trade.
Fully employed factors of production in both countries.
The international trade market is perfect making the exchange ratio of both commodities the same.

Criticism of the Ricardian theory

Assumption of Labour costs

The primary and the most commonly opined criticism of Ricardian doctrine is that it exclusively considers labour cost as the factor of production and does not take into bearing non-labour costs involved in the production process. Furthermore, the assumption of labour being homogeneous is unrealistic as labour is heterogeneous at varying degrees.

Dissimilar taste

Dependance on the idea of similar taste is a flawed assumption as taste is subjective based on various factors. Taste is subject to change based on income levels, economic growth, personal biases, and many other variables.

Fixed proportions

This doctrine is based on the assumption that labour is used in fixed proportions to carry out the production of all commodities or products, whereas practically perceiving this scenario can be deemed as irrational and unrealistic. Labour is used as per the requirements of each product based on its purpose, nature, and other factors and cannot be rigidly said to be fixed.

Constant Cost assumption

The Ricardian theory is based on the assumption that an increase in output is owed to constant costs generated by international specialization, however, this is unrealistic as if an increase in output is owed to constant costs, the comparative advantage is reduced and can even disappear.

Transport cost factor

This theory completely ignores the transport cost factor while the comparative advantage is calculated. This assumption lacks merit as transport cost is a paramount factor to be considered when it comes to trade within the international spectrum.

Mobility

The Ricardian theory also assumes that factors stand perfectly mobile internally or domestically and are immobile externally or within the global sphere. This is not true as factors whether internal or external cannot move freely as the mobility is inversely proportional to the degree of specialisation.

Two commodity model

This theory is based on the two-country and two-commodity models, as in the real world trade can take place between multiple countries at the same time.

Free trade assumption

This theory assumes the existence of free trade between all countries within the global sphere, but this assumption is unrealistic as practical trade is not completely free as there are barriers and other forms of restrictions which vary from country to country.

Full employment assumption

The Ricardian theory bases itself on the assumption of full employment. The full employment assumption is unrealistic as employment levels vary and unemployment prevails based on the socio-economic conditions of each country. Keynes was against this assumption and hinted towards the existence of unemployment and underemployment within every economy.

Ignores self-interest

The Ricardian doctrine does not take into account the strategic standpoint of any nation against imports despite having a comparative disadvantage, this can be due to military or strategic reasons.

Role of technology

The role of technology here is disregarded by Ricardo and such an assumption is incorrect as technology is an indispensable factor, technology helps in the generation of supply within the international sphere and international trade has benefited greatly since the advent of technology.

Neglects the demand aspect

This theory is solely based on the supply aspect and in this process it completely disregards the demand side of it, this was falsified by Prof. Ohlim who criticised the theory for not accommodating the supply aspect of it.

Haberler’s opportunity cost theory

The opportunity cost of any commodity is the quotient of the second commodity that is compromised to produce additional units of the first commodity, Haberler departed from the essential labour-centric approach set forth by Ricardo. This very form is termed the law of comparative cost. A nation with a relatively lower opportunity cost is said to possess a comparative advantage when it comes to a particular commodity. Haberler reformulated the theory while rejecting the classical labour theory of value. The consequential fall in the quantity of the second commodity depicts the opportunity cost of the additional quantity of a particular commodity. For example, if India has to reduce the production of cotton by 2 lakh bales with a view to increasing the production of wheat by 1 lakh tons, in such a scenario, the opportunity cost of one unit of wheat is two units of cotton (1W = 2C). Using the opportunity cost curve, Haberler expressed the opportunity cost of one commodity in terms of a second. The opportunity cost curve is also called the ‘transformation curve’ or ‘production possibility curve’ by Paul Samuelson and A.P. Lerner also termed the ‘production frontier’ or ‘production indifference curve’.

Assumptions of the opportunity cost theory of international trade

Existence of full employment equilibrium within the economy.
Perfect competition.
The price of each commodity is equivalent to the marginal cost of producing the same.
The price of each factor is equivalent to its marginal productivity.
A fixed supply of factors.
State of technology is already given.
Two trading nations or countries.
Every country carries out the production of two commodities, For eg, X and Y.
Countries have two productive factors- capital and labour.
Existence of perfect factor mobility within each country.
Immobile factors of production between two countries.
No trade restrictions by either of the countries.

Derivation

After carefully considering the above restrictions the production possibility curve of any country can be drawn. The opportunity cost curve, also known as the production possibility curve can be a straight line, concave to the origin, or convex to the origin based on the increasing, decreasing, or constant returns to scale of a particular country. Haberler further asserted that the theory of comparative cost would be accurate provided the theory of labour is not considered. The opportunity cost curve reflects the different combinations of two products a country can produce as per its characteristics and availability of technology. The slope of the opportunity cost curve is derived by the ratio or quotient of units sacrificed of one particular commodity to have one extra unit of the other commodity, this ratio is termed the marginal rate of transformation, or MRT.

If a particular country A produces two products X and Y, and a compromise is made with regard to a certain quantity of labour, capital, or any other particular input of product Y for the increased production of product X. I.e., for the additional production of X, a certain quantity of Y is sacrificed and certain units of Y are given up and have been converted into a marginal unit of X. This very rate at which marginal unit of product X is being substituted for units of product Y is the marginal rate of transformation. Alternatively, the MRTxy can be calculated as a ratio of the marginal cost of producing X to the marginal cost of producing Y.

The derivation of the same is as shown:

Here δC is the change in total cost, whereas δC/δX and δC/δY are marginal costs of commodities X and Y, respectively. Taking note of the assumption that minute changes in X and Y, δC is zero.

*Credits-* *https://www.economicsdiscussion.net/haberlers-opportunity-cost-theory/haberlers-opportunity-cost-theory-with-assumptions-economics/30770*

As MRTxy is negative, the production possibility curve slopes down from left to right.

As per figure 6.1(a) the MRTxy remains equivalent, that is MRTxy = – δY/δX = PP1/OQ1 = P1P2/Q1Q2. This also specifies that the marginal costs of both these commodities are untouched or unchanged. This establishes that all factors of production are efficient in equal terms with regard to all lines of production, as this view would differ in real life the Production Possibility Curve may not fall in a straight line. (in detail below)

As per Fig. 6.1(b) the opportunity cost curve that is AB falls convex in the direction of its origin causing MRTxy to decrease.

(PP1/QQ1 > P1P2/Q1Q2)

This occurs when the production of commodities is based on increasing returns to scale. In simpler words, this happens when the cost of commodity X in terms of commodity Y goes on diminishing and lesser units of Y are sacrificed in order to produce more units of X.

As per Fig.6.1(c) the production possibility curve AB falls in a concave manner towards its very origin. In this instant scenario, MRTxy goes on increasing.

The production possibility curve takes this shift when production is based on diminishing returns to scale. Due to the increase in the production of X, the MC of the same increases while the MC of Y falls. In simpler terms, a greater availability of X commodity shows deterioration in the significance of Y.

Key terminologies

Production possibility Curve

The production possibility curve or the PPC depicted various combinations of producing two products by an optimum and complete utilisation of all factors of production. In simpler words, the production possibility curve represents the ceiling limit which the production process cannot be carried out with the available level of technology and other key resources. Figure 1.3 represents the production possibility of a particular country A. With the available quotient of productive resources, it can carry out the production of either 10 units of cloth (provided all resources of the cloth production are employed) or 20 units of wine (provided all resources are specifically used in wine production). On the contrary, it can have a combination of both cloth and wine if resources are allocated optimally for both. Let’s take an example, it may possess eight units of cloth and four units of wine, or six units of cloth and eight units of wine. If the output of cloth falls by one unit, the output of wine can be increased by two units as using the resources needed to carry out the production of one unit of cloth, the production of two units of wine can be completed.

*Credits-* *https://rgu.ac.in/wp-content/uploads/2021/02/Download_578.pdf*

To be precise any point on the production possibility curve represents the output of producing combinations of the two commodities which are cloth and wine when the resources are fully allocated between the two commodities.

Increasing, Decreasing and Constant Cost Conditions

The production possibility curve is also known as the transformation curve. The slope of the curve at each point of the graph depicts the ratio of the marginal opportunity costs of both commodities. In simpler words, what can be understood is that the marginal opportunity cost of extra units of one commodity causes deterioration in the output of the other commodity or product. The shape of the curve is according to the assumptions laid down pertaining to the opportunity cost. It is to be noted that the opportunity cost curve shifts as per constant, increasing, and diminishing costs.

Constant costs

Trade under constant costs means that the MRT remains constant. It is the outcome of each factor of production being effective equally with respect to producing both goods. MRT as discussed above, is the amount of a particular good that must be sacrificed to ensure the availability of more resources to produce more units of the second commodity or good. Let’s take an example here, let G denote the good or commodity that has to be given up and let D denote the good or commodity that is to be produced additionally, it’s important to note that in this scenario the MRT remains the same. The table below represents alternative outputs of G and D when all resources are utilised and the figure depicts the production possibility curve.

As per the table above, each extra unit of D has the same cost when compared with its cost in terms of G, so resources which have the potential to produce 8 units of G must be sacrificed to maximise the output of D by a unit, irrespective of the level of production of both these commodities. Constant cost signifies that the MRT remains constant or unchanged. It is the outcome of each factor of production being effective in an equal manner with regard to the production of both goods. The production possibilities curve represents all possible combinations of two commodities that a particular country in this instance W might produce. The choice of the combination is made as per the curve. Points within the curve like point (g) show outputs of less than full employment and are not taken into consideration. The point above the curve, such as point (h), requires more resources than that particular country has and is hence also outside the ambit of consideration. The full employment output must be taken on the curve. The slope of the production possibilities curve depicts the MRT. The slope represents the sacrifice required of one commodity to ensure an increase in the output of the other commodity. Since the MRT is constant in this scenario, the slope must also be constant and therefore, the production possibilities curve has to be in a straight line. It can be inferred here that the MRT of G for D is 8 to 1; then a fall in the output of D by a single unit will ensure the availability of resources to increase the output of G by 8 units. Country Z here has a comparative advantage in the production of product D. On the contrary, country W has a comparative advantage when it comes to the production of G. During constant returns to scale, trade can only occur if each nation has a distinct MRT. The benefits accrued from carrying out the trade by a particular nation are based on how much the international exchange rates differ from that given nation’s MRT. The higher this difference, the greater the benefits or profits a nation will get from trade. The profits that arise from trade depend further on the amount of trade or the volume of trade that takes place. In the constant costs scenario, the exchange ratio is ascertained exclusively based on costs, the demand influences only the allocation of available factors of production between the two branches of production, and therefore the quantities of both commodities which are produced and in this particular situation demand has no correlation with price.

Increasing and diminishing costs

It would be unrealistic to assume that all nations would only face the constant cost scenario. When the figures above are considered for each extra or additional unit of one particular product produced, ever-increasing quantities of the other product must be compromised. That is to produce an additional unit of one product the amount produced of the other product must be sacrificed. On the other hand, diminishing costs refer to the reduction in average costs as the output expands. As per Graham’s thesis pertaining to diminishing costs, there is a contrary or contradictory view to the classical stigma that the specialisation based on comparative cost specifically leads to an increase in the quotient of output among trading countries. His notion was that in a scenario wherein there are free trade conditions when a country is subject to specialisation on the basis of comparative cost industries and tends to forgo decreasing-cost industries, its aggregate real income will fall in a manner that it’s less than before trade.

Innovation

It refers to the creation, development or establishment of any new product, service or procedure in order to improve efficiency, effectiveness, competitiveness or productivity. Innovation is mainly carried out with the objective to improve the quality of life or standard of living as a whole.

Neutral innovation

Neutral innovation is an innovation that is capable of increasing productivity of all the factors that are present in the very same proportion.

Labour saving innovation

Labour-saving innovation is a form of innovation that is capable of increasing the productivity of labour.

Capital saving innovation

Capital saving innovation is the kind of innovation that is capable of increasing the capability of capital making it more productive and causing a shift in the product possibility curve.

Benefits of the opportunity cost theory of international trade

Haberler’s opportunity cost theory has the following benefits:

Haberler’s theory is a more exact and precise representation of international trade when compared with Ricardian theory.
It has wider applicability than the Ricardian approach.
Haberler’s theory explains the international trade scenarios in constant, increasing and decreasing returns to scale.
Haberler’s theory also attempted to elaborate on the theory of international trade at various costs, that is constant, decreasing and constant.
Factor substitution was taken into consideration while profits were generated out of international trade.

Criticism of the opportunity cost theory of international trade

The following are a few drawbacks of Haberler’s theory:

As per many economists like Jacob Viner, the opportunity cost theory is to be deemed comparatively more inaccurate than the real cost approach as it failed to take into account certain real aspects or factors like strain, pain, sacrifice, lack of utility etc.
This theory was also criticised on account of its disregard for change in factor supplies.
It was contended by various economists that the opportunity cost theory was unrealistic and invalid in many manners like the non-existence or absence of economies to scale, diseconomies and perfect competition. (this is applicable to both product markets and factor markets).
Another criticism laid down by Jacob Viner is that the opportunity cost theory does not take into consideration the preference for leisure.
It has also been criticised after being called notional costs as the earnings sacrificed by one can be earned by another and not investments.
The employment market at every position may not be in a steady position to absorb skilled labour.

References

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Opportunity cost theory of international trade

Introduction

Who introduced the opportunity cost theory of international trade

What does the theory say