Lecture-1: Introduction to International

Trade and Absolute, Comparative &

Harberler Opportunity Cost,
Unit-5: International Economics
NTA-UGC-NET
Economics (Paper-2)
 International Trade Theories
Chronological Order of Traditional Trade Theories
• Absolute Advantage Theory [1776] (Adam Smith)
• Relative/Comparative Advantage Theory [1817] (David Ricardo)
• Heckscher Ohlin Samuelson Model [1919, 1933, 1949]
✓ Heckscher Ohlin Theory/ Factor Endowment Theory [1919,
1933]
✓ Stolper-Samuelson Theorem [1941]
✓ Factor Price Equalisation Theory [1948]
✓ Rybczynski Theorem [1955]
• Harberler Opportunity Cost [1936]
• Metzler Paradox–Lloyd A. Metzler [1949]
• Leontief Paradox- Factor Intensity Reversal [1953]
• Secular Deterioration Theorem- Prebisch & Singer [1950]
• I.B. Kravis [1956] Availability Doctrine [1956]
• Immiserizing Growth- Jagadish Bhagawati- 1958
 International Trade Theories
Chronological Order of Traditional Trade Theories Chronology of Alternative Trade Theories
• Absolute Advantage Theory [1776] (Adam Smith) • Technological Gap Theory [1961] (M.V.Posner)
• Relative/Comparative Advantage Theory [1817] (David Ricardo) • Product Cycle Theory [1966] (Raymond Vernon)
• Heckscher Ohlin Samuelson Model [1919, 1933, 1949] • Dynamic Comparative Advantage Theory [1973]
✓ Heckscher Ohlin Theory/ Factor Endowment Theory [1919, (Roger W Klien)
1933] • Linder’s Theory of Over-Lapping Demand [1961 ]
✓ Stolper-Samuelson Theorem [1941] (Staffan Linder)
✓ Factor Price Equalisation Theory [1948] • Gravity Model:- Social Physics School [1962] (Jan
✓ Rybczynski Theorem [1955] Timbergen)
• Harberler Opportunity Cost [1936] • Immiserizing Growth- Jagadish Bhagawati- 1958
• Metzler Paradox–Lloyd A. Metzler [1949] • Theory of Unequal Exchange- Arghiri Emmanuel:
• Leontief Paradox- Factor Intensity Reversal [1953] 1972 Unequal Exchange: A Study of the
• Secular Deterioration Theorem- Prebisch & Singer [1950] Imperialism of Trade
• I.B. Kravis [1956] Availability Doctrine [1956] • Economies of Scale [1979] (Paul Krugman)
• Immiserizing Growth- Jagadish Bhagawati- 1958 • Intra-Industry Trade
 Mercantilists [from 15th to 18th Century]
• The term "mercantile system" was used by Adam Smith, but Mirabeau (1715–1789) had used "mercantilism" earlier.

• In England, it is termed a Commerical System or Mercantile System or Restrictive System (since it imposed more
restrictions on trade and commerce).

• In France, it is termed Colbertism while in Germany and Australia it is termed Cameralism (aimed at strong
management of a centralized economy for mainly the state's benefit).

• This system is also termed bullionism as it stressed too much the accumulation of precious metals like gold and silver.

• Mercantilism promotes imperialism, tariffs and subsidies on traded goods to achieve that goal. These policies aim to
reduce a possible current account deficit or reach a current account surplus. Mercantilism includes measures aimed at
accumulating monetary reserves through a positive balance of trade, especially of finished goods. Historically, such
policies frequently led to war and also motivated colonial expansion. Mercantilist theory varies in sophistication from
one writer to another and has evolved over time.
 Mercantilists [from 15th to 18th Century]
Ideas and policy prescriptions can be summarised as follows :

i. It was believed that the volume of world trade is more or less fixed. Policies should be framed in such a manner that it
should get as large a share of this trade as possible,

ii. Precious metals. i.e. gold and silver were the most desired form of national wealth. If a nation did not possess natural
source of precious metal, then the major way to get them is through trade.

iii. In order to preserve and increase this balance, high tariffs should be imposed to reduce imports of manufactured
goods, lower tariffs to encourage the import of cheap raw materials and bounties on exports should be given.

iv. The state should take steps to promote exports, especially of manufactured goods by undertaking steps like
establishing state-run workshops and manufactories by granting monopolies and regulating the guilds.

v. Colonies should be promoted as it is useful both as a market for exports and as sources of supply of raw materials and
if possible precious metals. If necessary, nation should not hesitate in indulging into wars for colonization

vi. Primary duty of the state is to enhance and maintain both national wealth and national power: to defend the country
 Mercantilists [from 15th to 18th Century]
• National Wealth & National Power: National wealth consists solely or primarily in its supply of precious metals. The
national wealth (gold and silver) and national power have a symbiotic relationship. In other words, national wealth is
essential for gaining, maintaining national power On the other hand, national power is essential for securing,
maintaining, protecting and increasing national wealth: in terms of precious metals.

• Foreign trade is the primary source of national wealth, in gold & silver and thus of national power Any country lacking
gold and silver mines could acquire precious metals only through foreign trade: X > M → bullion influx

a) ‘bullionism’ : policies to ensure a steady influx of precious metals & to prevent their outflow
b) economic nationalism: in fierce competition with other national states

• See-Saw Theorem of global wealth: The world’s supply of precious metals is FIXED (in short-run), so global wealth
is a zero sum game, which implies that one can obtain power and hold wealth only at the expense of its neighbours, so
as per them trade is a zero-sum game beliefs.
 Mercantilists [from 15th to 18th Century]
• Mercantilist system of thought trade was the most important occupation. Industry and commerce were ranked second in
importance. Agriculture was the least important of all. The state had an important role to play in the Mercantilist
system.

• Mercantilists encouraged large population for making the nation militarily strong and for increasing its productive
capacity. They believed that cheap and abundant supply of labour would keep the cost of production low. This would
enable a country to sell its commodity at a lower price in the international market. They encouraged immigration
because they would bring wealth and enrich the country.

• They argued that each individual should pay taxation as per the benefit received principle.

• As per them, the theory of value depends on the cost of production; however by the end of mercantilism, it was proved
that value depends on scarcity (much propounded by David Ricardo).

• They identified three factors of production- land, labour and capital. They gave a huge significance to labour (as father)
and land (as mother) which can increase the food production and thus, reduce import dependency.
 Neo-Mercantilisms [Recent] Available only here
• It is a policy regime that encourages exports, discourages imports, controls capital movement, and
centralizes currency decisions in the hands of a central government. The objective of neo-mercantilist
policies is to increase the level of foreign reserves held by the government, allowing more effective
monetary policy and fiscal policy. Neo-Mercantilist strategies include promoting nationalism and
patriotism, stockpiling gold and foreign reserves and striving for favorable balance of payment via
exchange rate manipulation, tariff, export subsidies and other trade protections.

• China, Japan and Singapore are described as neo-mercantilist. It is called "neo-" because of the change in
emphasis from classical mercantilism on military development, to economic development, and its
acceptance of a greater level of market determination of prices internally than was true of classical
mercantilism.
 Neo-Mercantilisms [Recent] Available only here
• Its policy recommendations sometimes echo the mercantilism
of the early modern period. These are generally protectionist
measures in the form of high tariffs and other import
restrictions to protect domestic industries combined with
government intervention to promote industrial growth,
especially manufacturing. At its simplest level, it proposes
that economic independence and self-sufficiency are
legitimate objectives for a nation to pursue, and systems of
protection are justified to allow the nation to develop its
industrial and commercial infrastructure to the point where it
can compete on equal terms in international trade. In macro-
economic terms, it emphasizes a fixed currency and autonomy
over monetary policy over capital mobility.
 Neo-Mercantilisms [Recent] Available only here
• Its policy recommendations sometimes echo the mercantilism
of the early modern period. These are generally protectionist
measures in the form of high tariffs and other import
restrictions to protect domestic industries combined with
government intervention to promote industrial growth,
especially manufacturing. At its simplest level, it proposes
that economic independence and self-sufficiency are
legitimate objectives for a nation to pursue, and systems of
protection are justified to allow the nation to develop its
industrial and commercial infrastructure to the point where it
can compete on equal terms in international trade. In macro-
economic terms, it emphasizes a fixed currency and autonomy
over monetary policy over capital mobility.
 Absolute Advantage Theory [1776] Adam Smith
Smith started with the simple truth that for two nations to trade with each other voluntarily, both nations must gain. If one
nation gained nothing or lost, it would simply refuse to trade
Assumptions [2 Goods, 2 countries, and 1 factor]

1. Lack of Mobility for Factors of Production: Adam Smith assumes that factors of production cannot move between
countries. This assumption excludes the possibility of migration between countries, as well as presence of
multinational companies. It also imply that the PPF of each country will not change after the trade and there is no
reason to expect wages (measured in the same currency) be the same after trade.
2. No Trade Barriers:
3. Trade Balance (no transportation cost): Smith assumes that exports must be equal to imports. This assumption means
that we cannot have trade imbalances, trade deficits, or surpluses.
4. Constant Returns to Scale: Adam Smith assumes that we will get constant returns as production scales, meaning
there are no economies of scale. For example, if it takes 2 hours to make one loaf of bread in country A, then it should
take 4 hours to produce two loaves of bread. Consequently, it would take 8 hours to produce four loaves of bread.
However, if there were economies of scale, then it would become cheaper for countries to keep producing the same
good as it produced more of the same good.

4. Labor is the only relevant factor of production.

5. There is full employment equilibrium.
 Absolute Advantage Theory [1776] Adam Smith
What is Absolute Advantage?
• The capability to produce more of a given product using less of a given resource than a competing entity. A country is
said to enjoy absolute cost advantage over another county in the production of a good, if the former country uses fewer
resources to produce a given quantity of output compared to the latter country.
• It is determined by a simple comparison of labor productivities, it is possible for a party to have no absolute advantage
in anything; in that case, according to the theory of absolute advantage, no trade will occur with the other party.
• When one nation is more efficient than (or has an absolute advantage over) another in the production of one commodity
but is less efficient than (or has an absolute disadvantage with respect to) the other nation in producing a second
commodity, then both nations can gain by each specializing in the production of the commodity of its absolute
advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage.
• Absolute difference in the cost of production of different goods across different countries is the fundamental reason
or logic behind international trade between two countries.
arises when one country can produce a good at a lower cost compared to the another country.
arises because the country is endowed with special resources, which can be soil, climatic conditions,
related environment, etc. Using different endowment, each country specialises & exports a good
 Absolute Advantage Theory [1776] Adam Smith
Absolute Cost Differences in Two Countries Absolute Cost Differences in Two Countries
Output per worker Labour Units required to Produce 1 unit of Goods
Labour Units Rice Tea Rice Tea
Countries Countries
(Man-day) (Kg) (Kg) (Labour Units or Cost) (Labour Units or Cost)
Sri Lanka 1 2 4 Sri Lanka 10 12
India 1 4 2 India 14 8
 Absolute Advantage Theory [1776] Adam Smith
Absolute Cost Differences in Two Countries Absolute Cost Differences in Two Countries
Output per worker Labour Units required to Produce 1 unit of Goods
Labour Units Rice Tea Rice Tea
Countries Countries
(Man-day) (Kg) (Kg) (Labour Units or Cost) (Labour Units or Cost)
Sri Lanka 1 2 4 Sri Lanka 10 12
India 1 4 2 India 14 8

Ascertaining Absolute Advantage [when ouptut is given]

Rice Production in Sri Lanka Tea Production in Sri Lanka
1
Rice Production in India Tea Production in India
2 4
 1 
4 2
 
Sri Lanka Ab. Disadvantage Sri Lanka Ab Advantage
in Rice Production in Tea Production
Since LHS is lesser than 1, so it implies Sri Lanka is having absolute disadvantage in Rice
production and India is having absolute advantage in Rice production.
Whereas, RHS is greater than 1, which implies Sri Lanka is having absolute advantage in Tea
production and India is having absolute disadvantage in Tea production.
 Absolute Advantage Theory [1776] Adam Smith
Absolute Cost Differences in Two Countries Absolute Cost Differences in Two Countries
Output per worker Labour Units required to Produce 1 unit of Goods
Labour Units Rice Tea Rice Tea
Countries Countries
(Man-day) (Kg) (Kg) (Labour Units or Cost) (Labour Units or Cost)
Sri Lanka 1 2 4 Sri Lanka 10 12
India 1 4 2 India 14 8

Ascertaining Absolute Advantage [when ouptut is given] Ascertaining Absolute Advantage [when labour units or cost is given]
Rice Production in Sri Lanka Tea Production in Sri Lanka Labour cost for Rice in Sri Lanka Labour cost for Tea in Sri Lanka
1 1
Rice Production in India Tea Production in India Labour cost for Rice in India Labour cost for Tea in India
2 4 10 12
 1   1 
4 2 14 8
   
Sri Lanka Ab. Disadvantage Sri Lanka Ab Advantage Sri Lanka Ab. Advantage Sri Lanka Ab Disadvantage
in Rice Production in Tea Production in Rice Production in Tea Production
 Absolute Advantage Theory [1776] Adam Smith
Absolute Cost Differences in Two Countries Absolute Cost Differences in Two Countries
Output per worker Labour Units required to Produce 1 unit of Goods
Labour Units Rice Tea Rice Tea
Countries Countries
(Man-day) (Kg) (Kg) (Labour Units or Cost) (Labour Units or Cost)
Sri Lanka 1 2 4 Sri Lanka 10 12
India 1 4 2 India 14 8
Absolute Advantage Theory [1776] Adam Smith
 Absolute Advantage Theory [1776] Adam Smith

Suppose we are looking at 2 days of production in both countries. In these two days, Sri Lank can produce 2 units of
Rice + 4 units of Tea, while India can produce 4 units of Rice + 2 units of Tea. This is the case before the trade. Now,
after the trade, Sri Lanka can free up one day of production of Rice, as it focuses only on the production of Tea, so in
two days, it will produce 8 units of Tea and in a similar manner, India can produce 8 units of Rice. This implies that
before the trade World was producing 6 units of Rice and 6 units of Tea in two days, whereas, after the trade, the World
is now producing 8 units of Rice and 8 units of Tea in the same two days. Thus, the world’s production has gone up.
Hence, as per the absolute advantage theory countries should focus on the production of that good in which they are cost
efficient i.e. they enjoy absolute advantage.
 Absolute Advantage Theory [1776] Adam Smith
In the fig, it can be seen that green PPF is more inclined towards Rice axis, while red PPF is more inclined towards Tea
axis. This implies India has absolute advantage in Rice production and Sri Lanka has absolute advantage in Tea
production. The slope of PPF indicates the opportunity cost or exchange ratio between the two goods domestically.

Absolute Cost Differences in Two Countries

Output per worker
Labour Units Rice Tea
Countries
(Man-day) (Kg) (Kg)
Sri Lanka 1 2 4
India 1 4 2
 Absolute Advantage Theory [1776] Adam Smith
In the fig, it can be seen that green PPF is more inclined towards Rice axis, while red PPF is more inclined towards Tea
axis. This implies India has absolute advantage in Rice production and Sri Lanka has absolute advantage in Tea
production. The slope of PPF indicates the opportunity cost or exchange ratio between the two goods domestically.

Absolute Cost Differences in Two Countries

Output per worker
Labour Units Rice Tea
Countries
(Man-day) (Kg) (Kg)
Sri Lanka 1 2 4
India 1 4 2
 Absolute Advantage Theory [1776] Adam Smith
Gains of Trade Using Production Possibility Frontier
In order to ascertain gains from trade, we resort to Domestic Exchange Ratio.

Rice
(0,1)

Tea
(0.5, 0) (2, 0)
 Absolute Advantage Theory [1776] Adam Smith
Gains of Trade Using Production Possibility Frontier
For 1 unit of Rice that is produced, India needs to sacrifice 0.5 units of Tea. For the trade between India and Sri Lanka to
be mutually beneficial, it is important that India should get 1 unit of Rice in exchange of anything more than 0.5 units of
Tea and Sri Lanka should get 1 unit of Rice in exchange of anything less than 2 units of Tea.

What if India gets 1 unit of Rice for say 0.3 units of Tea. It will
not trade then, as it can have better deal domestically and can
exchange 1 unit of Rice for 0.5 units of Tea (domestically) and
in this case, it is not beneficial for India to trade.
Rice
(0,1)

Tea
(0.5, 0) (2, 0)
 Absolute Advantage Theory [1776] Adam Smith
Gains of Trade Using Production Possibility Frontier
For 1 unit of Rice that is produced, India needs to sacrifice 0.5 units of Tea. For the trade between India and Sri Lanka to
be mutually beneficial, it is important that India should get 1 unit of Rice in exchange of anything more than 0.5 units of
Tea and Sri Lanka should get 1 unit of Rice in exchange of anything less than 2 units of Tea.

What if India gets 1 unit of Rice for say 0.3 units of Tea. It will
not trade then, as it can have better deal domestically and can
exchange 1 unit of Rice for 0.5 units of Tea (domestically) and
in this case, it is not beneficial for India to trade.

What if Sri Lanka gets 1 unit of Rice for say 2.5 units of Tea?
Then it is not beneficial for Sri Lanka, as this is too high and at
much lesser opportunity cost [1 unit of Rice for 2 units of Tea]
can be availed by Sri Lanka domestically. So, it will not engage
in international trade

1 unit of Rice for 0.5 Tea   2 Tea indicates the Gains from trade
 Comparative Advantage Theory [1817] Ricardo

What is Comparative Advantage?

The doctrine of comparative costs maintains that if trade is free, each country in the long-run tends to specialize in the
production of and to export those commodities in whose production it enjoys a comparative advantage in terms of real
costs, and to obtain by importation those commodities which could be produced at home only at a comparative
disadvantage in terms of real costs.
According to the law of comparative advantage, even if one nation is less efficient than (has an absolute disadvantage
with respect to) the other nation in the production of both commodities, there is still a basis for mutually beneficial trade.
The first nation should specialize in the production and export of the commodity in which its absolute
disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in which
its absolute disadvantage is greater (this is the commodity of its comparative disadvantage).
 Comparative Advantage Theory [1817] Ricardo
Assumptions of the Theory: [2 factors, 2 goods and 1 factor-labour]
1. There are only two countries, say A and B.
2. They produce the same two commodities, X and Y
3. Tastes are similar in both countries.
4. Labour is the only factor of production.
5. Prices of the two commodities are determined by labour cost, i.e.. The number of labour-units employed to produce
each.
6. Commodities are produced under the law of constant costs or returns.
7. There is free trade between the two countries, there being no trade barriers or restrictions in the movement of goods.
8. No transport costs are involved in carrying trade between the two countries.
9. The international market is perfect so that the exchange ratio for the two commodities is the same.
10. Labour is homogenous
11. There is perfect competition and full employment equilibrium
12. Cost or price of a commodity inferred exclusively from its labour content- Labour theory of value
13. No technical change
14. Constant cost of production
15. There are similar tastes in both countries.
16. Trade between the two countries takes place on the basis of barter system.
17. Factors of production are perfectly mobile within each country, but are perfectly immobile between countries.
18. The international market is perfect so that the exchange ratio for the two commodities is the same.
 Comparative Advantage Theory [1817] Ricardo

Ricardo based his law of comparative advantage under the labour theory of value. According to the labour theory of
value, the value or price of a commodity depends exclusively on the amount of labour going into the production of the
commodity. Besides, labour is used in the same fixed proportion in the production of all commodities. Given these
assumptions, Ricardo shows that trade is possible between two countries even when one country has an absolute
advantage in the production of both commodities, but the country has a comparative advantage in the production of one
commodity than in the other.
According to Ricardo, the comparative difference in cost is the key to international specialization and international trade.
He advocates that a country may be in a position to produce both goods at an absolutely lower cost than the other country,
yet it has a greater comparative advantage in the production of one good than the other. Implying that the other country
produces both the goods at a higher cost, but has less comparative disadvantage in the production of one good than the
other.
 Comparative Advantage Theory [1817] Ricardo

Checking for Absolute Advantage ( when output is given ):

Wine Production in England Cloth Production in England
1
Wine Production in Portugal Cloth Production in Portugal
120 100
 1
80 90
Since for England, ratios in both the goods is greater than 1, this implies
England has Absolute Advantage in Wine and Cloth &
Portugal has Absolute Disadvantage in Wine and Cloth

It should be noted that in this case, England is having absolute advantage in the production of both the goods. This is
why the PPF of England is above Portugal’s PPF throughout and not intersecting (point mentioned in the gurumantra).
Comparative Advantage Theory [1817] Ricardo
As per absolute advantage theory, no trade is possible between
England and Portugal. This is where Ricardo’s theory score over
Smith’s theory. Ricardo uses the concept of opportunity cost and
advocated that in this case too, mutually beneficial trade is possible
[i.e. positive sum game, where both the countries will be benefitted
from trade]. Let’s see how comparative advantage theory solves this
case.
 Comparative Advantage Theory [1817] Ricardo

Thus, relative productivity for Wine in England

(1.5), which is greater than that of Cloth (1.11).
This implies that England has greater
productivity in wine production and more
We know that: comparative advantage in the wine production.
Wine Production in England Cloth Production in England
1
Wine Production in Portugal Cloth Production in Portugal
120 100
 1 1.5  1.11  1
80 90
In terms of comparative advantage, England has more Comparative Advantage
in the production of Wine, as 1.5 is quite far from 1.
Whereas, in terms of Cloth production, England has less Comparative Advantage,
as 1.11 is not very far from 1.
 Comparative Advantage Theory [1817] Ricardo

Thus, relative productivity for Cloth in

Portugal (0.9), which indicates that Portugal
has lesser comparative disadvantage in Cloth
production compared to Wine, in which it has
Checking for Portugal: 0.66 productivity compared to England.
Wine Production in Portugal Cloth Production in Portugal
1
Wine Production in England Cloth Production in England
80 90
 1 0.66  0.9  1
120 100
In terms of comparative disadvantage, Portugal has more Comparative disadvantage
in the production of Wine, as 0.66 is too less than 1.
Whereas, in terms of Cloth production, Portugal has less Comparative disadvantage,
as 0.9 is very close to 1.
Comparative Advantage Theory [1817] Ricardo
 Comparative Advantage Theory [1817] Ricardo

As state by Ricardo, a country should specialize in the

production of that good in which it has more comparative
advantage or lesser comparative disadvantage. It should export
that good and import the good in which a country has lesser
comparative advantage or more comparative disadvantage
Comparative Advantage Theory [1817] Ricardo
Gains of Trade Using Production Possibility Frontier
 Comparative Advantage Theory [1817] Ricardo
Gains of Trade Using Production Possibility Frontier

Clearly, if England wants to enter into trade, then it would gain if it

receives more than 0.83 units of Cloth for one unit of Wine.
Similarly, if Portugal wants to enter into trade, then it would gain if it
receives less than 1.125 units of Cloth for one unit of Wine.
In the figure, the yellow shaded region indicates Gains from
international Trade for England and Portugal. Now how much gain
will be gained by either country i.e. distribution of gains from trade,
it will depend upon the terms of trade. Terms of trade is governed by
reciprocal demand of the trading partners for each other’s products.

1 unit of Wine for 0.83 Cloth   1.125 Cloth indicates the Gains from trade
Comparative Advantage Theory [1817] Ricardo
 Vent for Surplus Approach [Adam Smith]

• The vent for the surplus approach was given by Adam Smith, as inspiration from Mercantilist economists. This
approach argues that in absence of international trade, an LDC has surplus productive capacity due to unemployment or
underemployment of resources. Although the LDC can absorb these resources by generating employment domestically,
this would result in a fall in price and income, which forces the economy to be in a stagnant state and poverty.
• On the contrary, international trade can absorb and make utilisation of these surplus resources without casting any
negative impact of stagnation and poverty. Due to international trade, there will be an increase in the effective demand
for LDC. Adam Smith further mentioned that whenever there is any surplus production in any sector of the LDC
economy, then this surplus will be exported and in return, imports can be made.
• In this manner, the international trade absorbs the surplus domestic production and prevents any recession and
stagnation in an LDC while it is enabling the LDC to explore wider markets abroad and consume capital good from the
foreign countries. Thus, the vent for surplus theory indicates that international trade cannot be an obstacle but an
opportunity for accelerating the process of growth. Further to Adam Smith, Hyla Myint, considered this approach to be
more appropriate for the less developed countries compared to the theory of comparative cost advantage as proposed by
Ricardo.
 Vent for Surplus Approach [Adam Smith]

• In this way, the vent for surplus doctrine emphasises that international trade cannot be an obstacle but an opportunity for
accelerating the process of growth. Myint, therefore, considered the vent for surplus doctrine of Adam Smith as more
appropriate for the less developed countries than the principle of comparative cost advantage.
• Further to Adam Smith, Hyla Myint, considered this approach to be more appropriate for the less developed countries
compared to the theory of comparative cost advantage as proposed by Ricardo.
(i) Existence of Surplus Productive Capacity: The comparative costs theory is not relevant to the LDC’s because it
assumes given techniques and full employment of resources. In the LDC’s, there exists unutilised resources exist,
hence, production can be increased through greater use of resources than by reallocation of resources as suggested
by theory of comparative costs.
(ii) Limited Size of Domestic Market: LDC’s are poverty-trodden due to small size of internal market. It has a
prohibitive effect on investment and production. The comparative costs doctrine stressed only upon cost
differences and overlooked this important aspect. The disposal of surplus produce in the foreign countries can
open up new markets for products and ensure more opportunities of investment, production and employment and
the LDC’s can expand their production frontiers.
 Harberler Opportunity Cost [1936]

Harberler Opportunity Cost [1936]

Opportunity cost of a commodity is defined as the amount of a second commodity that must be sacrificed to release
enough resources to produce one additional unit of the first. Haberler used this concept to explain the law of comparative
advantage. He stated that the nation with a lower opportunity cost is said to have a comparative advantage in the
production of that commodity and comparative disadvantage in the production of other commodity. The existence of
comparative advantage in costs of production is the principal cause of emergence of international trade.
 Harberler Opportunity Cost [1936]

Assumptions
(i) The economic system is in a state of full employment equilibrium.
(ii) There is perfect competition in commodity and factor markets.
(iii) Price of each commodity equals the marginal cost of producing it.
(iv) Price of each factor equals its marginal productivity.
(v) The supply of factors is fixed.
(vi) The state of technology is given.
(vii) There are two trading countries A and B.
(viii) Each country produces two commodities, say X and Y.
(ix) Each country has two productive factors- capital and labour.
(x) There is perfect factor mobility within each country.
(xi) The factors of production are perfectly immobile between the two countries.
(xii) Neither of the two countries imposes any restrictions upon international trade.
 Harberler Opportunity Cost [1936]

Haberler's opportunity cost theory overcomes the short comings of Ricardo's comparative cost theory and expounds the
doctrine of comparative costs in terms of what he calls The substitution curve or what Samuelson terms production
possibility curve or transformation curve, or what Lerner calls 'production indifference curve’, or 'productions frontier’.
The opportunity cost theory explains that if a country can produce either commodity X or Y, the opportunity cost of
commodity X is the amount of the other commodity Y that must be given up in order to get one additional unit of
commodity X. Thus, the exchange ratio between the two commodities is expressed in terms of their opportunity cost.
The concept of opportunity costs has been illustrated in international trade theory with production possibility curve.
The opportunity cost of anything is meant the sacrifice involved of some other thing which could have been produced
instead (in the next best alternative use of the given resources). Haberlaer, however, exposes the exchange rate in
between two commodities in terms of opportunity costs which may be expressed in the form of a production possibility
or transformation curve. He seeks to derive a country’s opportunity cost curve (or transformation curve) under the
assumptions:
• There is perfect competition in factor and commodity markets.
• Price = Marginal cost of production for every commodity.
• Factor price = Marginal product of the factor.
• There is condition of full employment equilibrium.
• Supply of factors is fixed.
• Given the technology, goods from the given resource are produced most efficiently.
 Harberler Opportunity Cost [1936]

Assuming the production possibilities of two

commodities from a given resource, under the
condition of constant returns and costs, the
opportunity cost curve, will be a straight line.
Along y-axis, units of wine is measured and
along x-axis, units of cloth is measured.
Graphically, the MRT is shown by the
(negative) slope of the transformation curve.
Thus: MRT of cloth for wine is =∆ wine / ∆
cloth i.e (- a1 a2/b1 b2)
Harberler Opportunity Cost [1936]

a) opportunity cost curve AB is a straight line, and its slope is constant. It thus
reflects a condition of constant costs. If the law of increasing cost is operating
in the production of both the commodities, the transformation curve (AB) will
be concave towards the origin

(b) The concavity of curve implies a positive slope indicating an increasing

marginal rate of substitution. As the production of cloth is substituted for wine,
the opportunity cost of cloth in terms of wine will go on increasing. As we
proceed from left to right along the curve AB, for each additional unit of wine
sacrificed, a smaller and smaller quantity of cloth is realized. And is to say, for
each extra unit of substitution the marginal rate of substitution is increasing.

(c). The convexity of curve implies a negative slope indicting a decreasing

marginal rate of substitution. Thus, under the decreasing cost condition, the
opportunity cost of cloth in terms of wine will be decreasing. So also the
opportunity cost of wine in terms of cloth is decreasing.
Harberler Opportunity Cost [1936]

The opportunity cost theory analyses pre-trade and post-trade situation under
constant, increasing and decreasing opportunity costs whereas the comparative
cost theory is based on the constant costs of production within a country and
comparative advantage and disadvantage between the two countries.

Thus, the opportunity cost theory is superior to the classical comparative cost
theory on analytical grounds.

According to Jacob Viner, the opportunity cost approach is inferior as tool of

welfare evaluation to the classical real cost approach.

Despite these criticisms, the opportunity cost approach has been regarded as a
simplified version of a general equilibrium model by Richard Caves.

As pointed out by Samuelson "the opportunity cost approach is more fertile

because it can be readily extended into a general equilibrium system.
 Questions

Question-1: Who among the following mentioned that maintaining a

laissez faire stance towards trade is to the best interests of a country?
a. Mercantilist
b. Adam smith Question-2: When a government limits imports via tariffs and quotas
c. Bourgeois and subsidises exports in order to maximise exports and minimise
d. Physiocrates imports, the country is following_____
a. Mercantilist philosoph y
b. Absolute Advantage Theory
c. Comparative Advantage Theory
d. H-O Theory

Question-3: Economists suggest that trade’s main advantages is

allowing the world to achieve____
a. Economic growth for all countries.
b. Greater equality between countries.
c. Specialisation and the resulting economies of scale
d. More self-sufficiency.
 Hometask
BHU Entrance Test Economics