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International Economics

Learning Objectives

Theory of Opportunity Cost

Critical Assessment

IT under constant, increasing &


decreasing costs
International Economics

4.1 Introduction

Ricardos 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. Haberlers opportunity cost


theory of international trade makes an
attempt to overcome this short coming
in Ricardos theory.
International Economics

4.2 Statement of Haberlers 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 Haberlers 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 Haberlers 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 Haberlers 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 Haberlers 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 Haberlers 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
communitys indifference curve IC2
International Economics

4.2 Statement of Haberlers Theory of Opportunity Cost

Y
R

B
B
R
E B1 F
A
D IC3

IC2

IC1
O C1 C L X
Cloth
Optimization by a community
International Economics

4.2 Statement of Haberlers Theory of Opportunity


Cost

In the last diagram


RL is the iso-cost line.
IC1, IC2 & IC3 = communitys
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 communitys
reach with available resources & technology.
International Economics

4.2 Statement of Haberlers Theory of Opportunity


Cost

Three cost conditions and international


trade.
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 Haberlers Theory of Opportunity


Cost

Production Possibility Under Conditions of


Constant Opportunity Costs

Input O U T P U T U N I T S
Units England Australia

Bread Cloth Bread Cloth

50 150 150 50 75
40 120 120 40 60
30 90 90 30 45
20 60 60 20 30
10 30 30 10 15
International Economics

4.2 Statement of Haberlers Theory of Opportunity


Cost
Y
O
U 150 ENGLAND
T
P 120
U
T 90
Of
60
B
R 30
E
A
D 0 30 60 90 120 150 X
Output of cloth
International Economics

4.2 Statement of Haberlers Theory of Opportunity


Cost
Y
O
U 50 Australia
T
P 40
U
T 30
Of
20
B
R 10
E
A
D 0 15 30 45 60 75 X
Output of cloth
International Economics

4.2 Statement of Haberlers Theory of Opportunity


Cost

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 Haberlers Theory of Opportunity Cost

Y
P
150 England
IC Community Indifference Curve
PP Production Possibility Curve
B
R E
E 75
A
D

IC

P
O 75 150 X
Cloth
Domestic Equilibrium of Production at Constant Costs
International Economics

4.2 Statement of Haberlers Theory of Opportunity Cost

Y
Australia
P IC Community Indifference Curve
50 PP Production Possibility Curve
B
R E
E
A 25
D

IC

P
O 37.5 75 X
Cloth
Domestic Equilibrium of Production at Constant Costs
International Economics

4.2 Statement of Haberlers Theory of Opportunity


Cost

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 Haberlers Theory of Opportunity


Cost

The actual rate for international trade


is decided depending upon reciprocal demand
[i.e. Englands elasticity of demand for
Australian cloth vis--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 Haberlers Theory of Opportunity


Cost

Before Trade After Trade


England
Production 75 B 75 C 150 B
Export 62.5 B for 75 C
Consume 75 B & 75C 87.5 B & 75 C

Australia
Production 50 B 75 C 150 C

Export 75 C for 62.5 B


Consume 50 B & 75 C 62.5 B & 75 C
International Economics

4.2 Statement of Haberlers Theory of Opportunity


Cost
If the country is producing under the
conditions of increasing costs, production
possibility curve will be concave to the origin.
Y P

B M
R B1
E
A B F
D

P1

O C1 C N X
Cloth
Production Possibility Curve under increasing costs
International Economics

4.2 Statement of Haberlers Theory of Opportunity


Cost
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 Haberlers Theory of Opportunity


Cost

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 Statement of Haberlers Theory of Opportunity


Cost

import of bread
. export of cloth
Y P P2

B
R C
E B2 A IC2
A IC1
D
B
B3 P1

P3

O C2 C1 C3
N X
Cloth
Production Possibility Curve under increasing costs
International Economics

4.2 Statement of Haberlers Theory of Opportunity


Cost

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 Haberlers 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 Haberlers 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 Haberlers Theory of Opportunity


Cost
Proportionate Cost Structures
Y

B England
R
E
A
D Australia

O X
c l o t h
International Economics

4.3 Critical Assessment of Haberlers


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