Reformulation of Theory of Comparative Costs in terms of Opportunity Costs

Haberler has reformulated the doctrine of comparative costs in terms of opportunity costs.

According to Haberler, the ratio of prices in each country in isolation is a reflection not only of the money costs of production but more fundamentally of social opportunity costs.

Opportunity cost refers to the cost of a commodity in terms of other commodity which must be foregone in order to obtain the first.

With the assumptions of:

(i) Perfect competition in product and factor markets,

(ii) Absence of external economies and diseconomies,

(iii) Given supply of factors of production,

(iv) Fully employed factors and

(v) Given technological knowledge, an increase in the output of any commodity is necessarily at the expense of a smaller production of one or more other commodities, since the increase in the production of the first commodity can be effected only by transferring productive factors out of their present employment in other lines. The other commodities not produced but could have been produced with the factors which have been used up in product is its social opportunity cost.

Let us see how opportunity costs can explain the basis of and gains from trade. Plow how this doctrine of opportunity cost is used to explain the comparative advantage in trade theory. For example, in country I, the price and cost of production of one unit of good X is Rs. 2 and that of Y is Re 1; this means that the opportunity cost of an extra unit of X is two units of Y. This is how money cost reflects the opportunity cost. Mow under competition, the price of each factor is equal to the value of its marginal product and is the same in all alternative occupations. The factors required to produce one unit of Y₁ therefore, could produce one rupee’s worth of X if transferred to that employment.

Therefore, in our example, one unit of X requires two rupees worth of productive services, so that two units of Y must be given upto acquire on extra unit of X.

Cost of production:

Country I

I unit of X = Rs. 2

1 unit of Y = Re. 1

1 unit of X = 2 units of Y.

Now in another country, for example, II, the opportunity cost of an extra unit of X is three of Y. If, as in the example given above, the price cost ratio and therefore the opportunity costs are different, trade will take place.

Cost of production:

Country II

1 unit of X = Rs. 3

1 unit of Y = Re. 1

1 unit of X = 3 units of Y.

The terms of trade must fall between the price cost ratios of the two countries in isolation, the exact point being determined by the reciprocal demand for each other products in conjunction with cost conditions. Suppose, the terms of trade is one unit of X=2.5 units of Y. Domestically, people of country I are able to obtain only 2 units of Y per one unit of X given up (not produced at home); with trade they obtain two and a half units of Y per unit of X given up (produced but exported). In country II, without trade each unit of X produced involve the sacrifice of three units of Y; with trade they obtain X at a rate of two and a half units of Y per X. Each country has a greater volume of goods available to it as a result of trade. Thus,

‘The opportunity cost doctrine can be made a basis to explain the comparative advantage and gains from trade.”

It is obvious that in this new approach there is no further need of the much controversial labour theory of value.

Its superiority lies in the fact that it directly admits the relevance of more than one factor and the different combinations of these factors to the problem of relative values. Haberler concludes that “it is now the general practice to apply either the concept of opportunity costs or the modern theory of general equilibrium to the problem of international trade. Basically there is no contradiction between these two methods.

The doctrine of opportunity costs when carried sufficiently beyond the initial simplifying assumptions and elaborated more fully merges into the theory of general equilibrium. The former theory can thus be looked upon as a somewhat simplified version of the later, designed for easy presentation and practical use.”

Joint credit for developing the modern simplified general equilibrium theory of trade had frequently been split between Heckscher-Ohlin on the one hand, and Haberler on the other. Haberler’s “opportunity costs” exposition essentially breaks into the general economic equilibrium at an intermediate point. Accepting certain assumptions about the system, we can conclude that the unit money costs of production of a commodity are equal to the value of commodities whose production is forgone in order to produce it.

Samuelson says, ‘when stated with full qualifications, the doctrine of opportunity costs inevitably degenerates into the conditions of general equilibrium.”

It has been commonly believed that the major source of difference between Haberler’s transformation curve geometry and Ohlin’s general equilibrium model is that the former is incapable of taking into account changes in the quantities of factors supplied. This limitation is implied in Viner’s extensive attack on the opportunity cost theory of value which underlies Haberler’s model. Viner’s attack is phrased in welfare terms, and really boils down to the claim that the opportunity cost interpretation is inferior as a tool of welfare evaluation to the real cost approach of the classical economists.