HABERLER’S THEORY OF INTERNATIONAL TRADE

(Haberler’s Opportunity Cost Theory)

The Opportunity Cost Theory was put forward by Gottfried Haberler in 1936. With the help of this theory,
Haberler tries to explain the theory of comparative advantage of international trade on the basis of
opportunity cost.
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 first
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 the Ricardian theory, in this theory, Haberler
didn'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:
1. The economic system is in a state of full employment equilibrium.
2. There is perfect competition in commodity and factor markets.
3. Price of each factor equals its marginal product.
4. Price of each commodity equals the marginal cost of producing it.
5. The supply of factors is fixed.
6. The state of technology is given.
7. There are only two countries -A and B.
8. Each country produces two commodities viz. Commodity x and commodity y.
9. There are two factors of production viz. Labour and capital.
10. Factors are perfectly mobile within the country but immobile between countries.
11. 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
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 labour 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 while
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 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 (PPC) 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
Figure 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 below

 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 W1 W2 , 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 W 2 W3 to W1
W2 and from W W1 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 OC 1 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 P 1 P1 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 P 2 P2 , 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, A1 A1 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 A 2 A2 as shown 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 A A as shown in Fig. 1.8 below.

 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.