Haberler’s Opportunity Cost Theory (With Assumptions)

The opportunity cost theory was put forward by Gottfried Haberler in 1936. With the help of this theory, Haberlertries to explain the theory of comparative advantage of international trade on the basis ofopportunity cost. In Haberler's words, "the marginal cost of a given quantity (x) of a commodity, say, A must be regarded as the quantity of commodity, say, B must be forgone in order 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." 

According to the opportunity cost theory, the cost of a commodity is the amount of a second commodity that must be given up to release just enough resources to produce one additional unit of the fixed commodity. This is basically a reformulation of the Comparative Advantage Theory of international trade in terms of opportunity cost. 

The opportunity cost theory analyses pre-trade and post trade situations under constant, increasing and decreasing opportunity cost. Unlike theRicardian theory, in this theory, Haberlerdidn't make assumption that labour is the only factor of production and labour is homogenous. In fact, it is not based on the labour theory of value. The theory is based on the proposition that the country with the lower opportunity cost in production of a commodity enjoys comparative advantage in that commodity and a comparative disadvantage in the second commodity. The theory rests upon the following assumptions: 

The economic system is in a state of full employment equilibrium.

•  There is perfect competition in commodity and factor markets.
•  Price of each factor equals its marginal product.
•  Price of each commodity equals the marginal cost of producing it.
•  The supply of factors is fixed.
• The state of technology is given.
• There are only two countries -A and B.
• Each country produces two commodities viz. commodity x and commodity y.
• There are two factors of production viz. labour and capital.
• Factors are perfectly mobile within the country but immobile between countries.
• There is free trade between the countries. 

Based on these assumptions, Haberler provides the exchange ratio between two commodities in terms of opportunity cost which can be expressed in terms of production possibility or transformation curve. The opportunity cost curve (or production possibility curve) may be a straight line, convex to the origin or concave to the origin depending on whether return to scale in a country is constant, increasing or decreasing respectively

Gottfried Haberler has attempted to restate the comparative costs in terms of opportunity cost. He demonstrates that the doctrine of comparative costs can hold valid even if the labour theory of value is discarded. The theory determines the cost of producing a commodity in terms of the alternative production that has to be foregone for producing the commodity in question.

Elaborating upon the opportunity cost, Haberler writes that “the marginal cost of a given quantity X of a commodity A must be regarded as that quantity of commodity B which must be foregone in order 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.”

Opportunity cost of a commodity is defined as the amount of a second commodity that must be given up to release just enough resources to produce one additional unit of the first. Haberler used this concept to explain the law of comparative advantage. In this form, this law is referred to as the law of comparative cost. Consequently, the nation with the 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. Ricardo has given an example of trade between England and Portugal shown in Table 1.5.

From the above table, it is clear that Portuguese labour is more efficient than English lobour in the production of wine as well as cloth. So Portugal has an absolute advantage in the production of wine and cloth. The trade between England and Portugal can also be demonstrated by introducing the concept of opportunity cost. Table 1.6 gives the opportunity costs for producing wine and cloth in the two nations calculated on the basis of information given in Table 1.5. 

This table shows that In England, 1 unit of cloth = 3/4 units of wine. (Domestic exchange ratio of England)

In Portugal, 1 unit of wine= 2/3 units of cloth. (Domestic Exchange Ratio of Portugal) 

Here, England has the lower opportunity cost of the two nations in producing cloth and Portugal has lower opportunity cost in producing wine. Thus, England has comparative advantage in producing cloth and Portugal has comparative advantage in producing wine. As long as the opportunity cost of production for a good differs in the two nations. One nation has a comparative advantage in the producing of one of the two goods, while the other nation has a comparative advantage in the production of the other good. 

England will gain from trade if it can get more than 3/4 units of wine by exporting 1 unit of cloth. Likewise, Portugal gains from trade if it gets more than 2/3 unit of cloth by exporting 1 unit of wine. England gains from export so long it exports 80 units of cloth for more than 60 unit of wine. While Portugal gain if it gets 80 units of cloth for less than 120 units of wine. 

Trade between two countries does not take place in case of equal cost differences. In this case, the opportunity cost of producing the two commodities is the same in both the countries. So, the production possibility curves will coincide with no possibility of gain from trade to either country. Here, the absolute advantage (or disadvantage) of each country with respect to the other is the same for both the commodities. Table 1.7 shows such situation. In this situation, the labour in county ‘A’ as well ‘B’ is twice as productive in commodity ‘X’ in comparison to production of commodity ‘Y’. As the internal cost and comparative cost are same in both the countries and there are no price differences, no mutually beneficial trade can take place. 

PRODUCTION POSSIBILITY CURVE

The production possibility curve (PPC) represents all the alternative combinations of two commodities that a nation can produce by fully utilizing all its factors of production. In other words, the production possibility curve shows the frontier beyond which production cannot be carried on with the available resources and technology. 

Figure 1.3 depicts the production frontier of country A. With a given amount of productive resources, it can produce either 10 units of cloth (if it employs all resources in cloth production) or 20 units of wine (if all resources are used in wine production). Alternatively, it can have a combination of cloth and wine if resources are allocated for both. For example, it may have eight units of cloth and four units of wine, or six units of cloth and eight units of wine. If it reduces the output of cloth by one unit, it can increase the output of wine by two units because with the resources required to produce one unit of cloth, two units of wine can be produced. 

In short, any point on the production possibility curve (PPA) shows the combination of cloth and wine output when the productive resources are fully employed and allocated between cloth and wine in a certain production. Any point above the PA line is beyond reach with the particular quantum of resources. For example, point N indicates a combination of eight units of cloth and ten units of wine which is impossible to obtain with the available resources. Again, when eight units of cloth are produced, the remaining resources are sufficient to produce only four units of wine. Any point below the production possibility curve represents a combination of cloth and wine when the available resources are not fully employed. For example, point R represents a combination of five units of cloth and seven units of wine. When only five units of cloth are produced, the remaining resources if they are fully employed, can give an output of ten units of wine.

The slope of the production possibility curve (PPA) represents the marginal rate of transformation (MRT) or the amount of the commodity that the nation must give up in order to get one more unit of the second commodity. If the nation faces constant costs or MRT, then its production possibility curve is a straight line as shown in Fig. 1.3 with slope equal to the constant opportunity costs or MRT and to the relative commodity prices in the nation. In many cases, production is subject to the law of increasing opportunity costs or MRT. Under such conditions, the production possibility curve is concave to the origin as shown in Fig. 1.4.

Starting with OA output of cloth and zero of wine, if AC unit

of cloth is given up, we can produce OW wine. But, if we give up further CC₁ output of cloth and reduce cloth production to C₁ level, the increase in wine output that can be achieved is WW₁, which is less than OW. The addition to the wine output that can be produced by giving up yet another equivalent amount of cloth is W₁W₂, which is still lower than WW₁ and so on. Thus, the amount of extra wine we can produce by decreasing production of cloth with a given amount of resources steadily decreases as we move downward along the PPC. This implies that opportunity cost of wine in terms of cloth is steadily increasing as we increase the production of wine and decrease the production of cloth. Conversely, for every additional unit of cloth, the amount of wine is to be given up. For the subsequent increases in the cloth output, the amount of wine to be given per unit of cloth increases from W₂W₃ to W₂W₁ and from W₁W to WO.

Under increasing costs, a nation will choose a combination of output at which the MRT will equal the equilibrium relative commodity price in the nation. The equilibrium relative commodity price in the nation is determined by the supply and demand conditions in the nation. This is presented in Fig. 1.5. If PP represents the price ratio in the country, production will be at point F, representing OC₁ cloth and OW₁ wine, because at F, PP, which represents the price ratio, is tangent to the PPC. When the price ratio is PP, if the country were to produce at some other point, for example A, the opportunity cost of producing more wine would be lower than its price which implies that producers could increase their profits by producing more wine. The profit will be maximum at point F at which the relative prices and opportunity costs are equal. 

If the price of cloth increases and P₁P₁ becomes the new price ratio, producers will reallocate resources to produce more cloth and move to A at which the price line is tangent to the production frontier. On the other hand, if the cloth price falls and price ratio changes to P₂P₂, production of wine will be increased by reducing the output of cloth and a new equilibrium will be established at point S.

Changes in factor supplies will cause a shift in the PPC of a nation, ceteris paribus. An increase in the factors of production will cause an outward shift and a decrease will cause an inward shift of the production frontier. In Fig. 1.6 given below, the X-axis represents labour intensive goods and the Y-axis represents capital intensive goods. In this figure, AA represents the original PPC. Supposing that all the factors of production increase in the same proportion, it will cause a shift of the PPC upward and the new PPC, A₁A₁ will be parallel to the old PPC, AA.

If only one of the factors of production increases or if the increase in the factors of production is disproportionate, the shape of the new PPC will be different from that of the old one. Assume that in Fig. 1.7, the X-axis represents labour intensive goods and the Y-axis represents capital intensive goods. If only the supply of labour increases, the PPC will shift from AA to A₂A₂ as shown below in Fig. 1.7 implying that the country is now capable of producing a much larger amount of labour intensive commodities. 

Again, if only the supply of capital increases, the PPC will shift from AA to A₃A₃ as shown in Fig. 1.8. It implies that the country is now capable of producing a much larger amount of capital intensive commodities. 

Technological progress increases the productivity of a nation’s factors of production and has the same general effect on the production possibilities as an increase in the supply of its factors of production. In respect of technological advances, we may consider the following three different cases.

Neutral Innovation: This refers to an innovation that increases the productivity of all factors by the same proportion. This will cause a uniform or symmetrical outward shift in the nation’s PPC as shown in Fig. 1.6.

Labour Saving Innovation: This refers to an innovation that increases the labour productivity. Ceteris paribus, a labour saving innovation will cause the PPC to shift from AA to A₂A₂ as shown in Fig. 1.7.

Capital Saving Innovation: A capital saving innovation increases the productivity of capital and causes the PPC curve to shift from AA to A₃A₃ as shown in 1.8. 

Constant Opportunity Cost Curve 

In Figure 3.1, commodity-xis measured along the horizontal axis and commodity-y is measured on the vertical axis. AB is the opportunity cost curve. At every point on the straight line or opportunity cost curve AB Marginal Rate of Transformation (MRT) remains equal. That is  

That is along the curve, the marginal cost of producing commodity-x and commodity-y remains unchanged and production of both the commodities is governed by constant returns to scale or constant opportunity cost. In this, all factors are equally efficient in all lines of production. 

 Increasing Opportunity Cost Curve 

Figure 3.2 representsthe case of increasing cost condition. In the figure, AB is concave to the origin i.e. 

It means that for production of each extra unit of commodityx a larger unit (amount) of commodity-y is to be forgone. 

Decreasing Opportunity Cost Curve 

Figure 3.3 representsthe case of decreasing cost condition. It is the case of decreasing cost condition or increasing returns. In figure 3.3, AB is opportunity cost curve and it is convex to the origin. Here, the Marginal Rate of Transformation (MRT) is decreasing.

It means that for production of extra unit of commodity-x a smaller amount of commodity-y is to be forgone. The convexity of the opportunity curve implies a negative slope indicating a decreasing MRT_xy.  International trade in terms of opportunity cost under three returns to scale condition . Returns to scale: the rate at which output changes as the quantities of all inputs are varied in the same proportion. If for example, inputs are doubled and as a result output is also doubled, constant return to scale exist. If output goes by less than the doubling of inputs, decreasing returns to scale prevails. Finally, if output goes by more than the doubling of inputs, returns to scale will be increasing returns to scale. 

 Constant Opportunity Cost and International Trade 

The MRT xy is constant and the opportunity cost curve is a straight line when the production process is governed by constant returns to scale. Thus, the relative cost of producing the commodities x and y remains constant irrespective of the ratio in which they are demanded. If the slopes of the opportunity cost curves of two countries are same, i.e. the opportunity cost curves are parallel to each other, then in this case no trade is possible between them. This can be explained with the help of Figure 3.4. 

In Figure 3.4, AB and A₁B₁ are opportunity cost curves of country A and country B respectively. AB and A₁B₁ i.e. the opportunity cost curves are parallel as their slopes are equal.  

  and    are the slopes of AB and A₁B₁ respectively and   

Figure 3.4: International trade does not take place when slopes of opportunity cost curves are same.

From Figure 3.4 it can be seen that as the cost ratios of A and B are equal therefore no international trade between the countries take place. The gains from international trade can emerge only when the slopes of opportunity curves are different. This has been explained with the help of Figure 3.5. 

Figure 3.5: International trade take place when slopes of opportunity cost curves are different 

In Figure 3.5, AB and AB₁ are opportunity curves of Country A and B respectively. The slopes of opportunity curves AB and AB₁ are different. The slopes of AB and AB₁ signify that country A has comparative advantage in the production of commodity-y over country B and country B has comparative advantage in the production of commodity-x over country A. Therefore, country A specialises in the production of y and country B specialises in the production of x. The exchange ratio between country A and country B is shown by dotted line AB₁ . Suppose country A wants to consume at R on AB₁ , then A can export AS (NR) quantity of Y and import SR (or AN) quantity of commodity x. Similarly, if country B wants to consume at AR₁ on AB₁ , then country B can export S₁ B₁ (or R₁ N₁ )quantity of x and import R₁ S₁ or B₁ N₁ quantity of commodity-y. the opportunity cost curve AB shows that as quantity of commodity Y can be exchanged for ST quantity of X in the domestic market. But as international trade takes place in between A and B, as quantity of commodity y can be exchanged for SR quantity of x. Therefore, countryA gains TR quantity of commodityX, in the same way B₁ S₁ quantity of commodity-x can be exchanged for S₁ T₁ quantity of commodity-Y in the domestic market. While international trade permits the exchange of B₁ S₁ quantity of x for R1 S1 quantity of y. Thus the country B gains R1 T1 (=R₁ S₁ -T₁ S₁ ) quantity of commodity-y. 

 Increasing Opportunity Cost and International Trade

When the production process is governed by decreasing returns to scale the opportunity cost is increasing. The international trade in this situation between country A and B can be explained with the help of Figure 3.6.  The case of country A: In Figure 3.6, AB is the opportunity cost curve for country A. It is concave to the origin. EE is the domestic price ratio line before trade in country A. EE is tangent to the opportunity cost curve AB at R. FF is the international price ratio line. FF is tangent to AB at S. 

Figure 3.6: Increasing opportunity cost and international trade 

Country A specialises in the production of y and if the point of consumption in A is at T then A will export SN quantity of y to import NT quantity of x. The consumption point T will lie on a higher community indifference curve from the point r before trade. So A will increase its welfare after trade. The case of Country B: In Figure3.7,A₁ B₁ is the opportunity cost curve of country B.Before international trade, E₁ E₁ is the domestic price ratio line and it is tangent to A₁B₁at R₁. 

Figure 3.7: Increasing opportunity cost and international trade 

When international trade takes place F₁ F₁ is the international price ratio line and it is tangent to A₁ B₁ at S₁ . Country B specialises in the production of x. if the point of consumption is T₁ country B will export N₁S₁ quantity of x and import N₁ T₁ quantity of y. Country B will get higher satisfaction at T₁ than at R₁ . When equilibrium situation is achieved by A and B, the export of SN quantity of y equals the import of N₁ T₁ quantity of y and export of N₁ S1 quantity of x equals the import of NT quantity of x. 

Decreasing Opportunity Cost and International Trade 

When the production process in both countries A and B are governed by decreasing returns to scale, the opportunity cost curves are convex to the origin. The international trade in this situation has been explained with the help of Figure 3.8. 

In Figure 3.8, AB and A₁ B₁ are the opportunity curves of country A and B respectively. EE is the domestic price ratio for country A and FF is the domestic price ratio for country B. Before international trade, EE is tangent to AB at R and it is production equilibrium for country A and at that point, price line EE becomes equal to the MRTxy. Similarly, in the absence of international trade, the FF is tangent to A₁ B₁ at point S which determines the production equilibrium for country B. When international trade takes place, the international exchange ratio line is AB₁ .

Figure 3.8: Decreasing opportunity cost and international trade  

The position of opportunity cost curve and the greater steepness of domestic price line EE relative to international exchange ratio line AB₁ shows that A will specialise completely in the production of y and it will export y and import commodity x. while, the position of opportunity cost curve A₁ B₁ and relatively greater steepness of AB₁ than domestic price ratio line FF, determines that country B will specialise completely in the production of commodity x. Thus country B will export commodity x and import commodity y.

The point of consumption equilibrium for A and B determined by the tangency between opportunity cost curves and the international exchange ratio line AB₁ . This tangency point will provide a higher level of satisfaction than points R and S. Thus, there will be gains from international trade for both the countries A and B. 

 ADVANTAGES OF HABERLER'S OPPORTUNITY COST THEORY 

Harberler's opportunity cost theory has the following advantages:

• It is more exact, precise and scientific in explanation of international trade than real cost approach. It has better applicability than Ricardian approach as it discarded the labour theory of value and attempted to build the model of international trade more realistically with the assumptions like two or more factors of production.
• Haberler's theory explained the international theory in situations of constant, increasing and decreasing returns to scale.
• Haberler also tried to explain the international trade theory when costs are increasing, decreasing and constant.
• Haberler took into account the factor substitution while explaining gains from international trade. 

DRAWBACKS OF HABERLER'S OPPORTUNITY COST THEORY 

Though Haberler's opportunity cost theory is very relevant to the international trade, it has some limitations. These are:

• According to Jacob Viner, opportunity cost theory was inferior to the real cost approach.He claimed that opportunity cost theory failed to measure real costs in terms of strain, sacrifice and disutility.
• Jacob Viner also criticised the opportunity cost theory on the ground that it neglects the changes in the factor supplies.
• The opportunity cost theory is based on many unrealistic and invalid assumptions like absence of external economies of scale or diseconomies of scale and perfect competition in both product and factor markets fixed factor supplies etc.
• Jacob Viner also criticised the opportunity cost theory on the ground that it failed to take into account the preference for leisure vis-à-vis income. Though Jacob Viner put several objections against the Haberler's opportunity cost theory, those were not valid. In fact all these limitations are disapproved by many economists like Kemp, V.C. Walsh, Samuelson etc.