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• Preface
• Studies In the Theory of International Trade
• Chapter I: English Theories of Foreign Trade, Before Adam Smith: I
• I. Introduction
• II. “ Mercantilism” and “bullionism”
• III. the Balance-of-trade Doctrine
• IV. Reasons For Wanting More Bullion
• V. Employment and the Balance of Trade
• Chapter II: English Theories of Foreign Trade, Before Adam Smith: Ii
• I. Legislative Proposals of Mercantilists
• II. the Collapse of Mercantilist Doctrine
• III. Some Modern Interpretations of English Mercantilism
• Chapter III: The Bullionist Controversies: I. The Inflation Phase
• I. the Participants In the Controversy
• II. the Factual Background
• III. Premium On Bullion As Evidence of Excess Issue: the Bullionist Position
• IV. Qualifications Conceded By the Bullionists
• V. Possible Objections to the Bullionist Position
• VI. the Anti-bullionist Position
• VII. the Balance of Payments Argument
• VIII. the Possibility of Excess Issue By Banks
• IX. Responsibility For the Excess Issue: Bank of England Vs. Country Banks
• X. Responsibility For Excess Issue: the Credit Policy of the Bank of England
• Chapter IV: The Bullionist Controversies: II. The Deflation Phase
• I. the Resumption of Cash Payments
• II. Responsibility of Resumption For the Fall In Prices
• III. the Economic Effect of Changing Price Levels
• IV. Ricardo's Position On the Gold Standard
• V. Reform Without Departure From the Metallic Standard
• VI. Paper Standard Currencies
• Chapter V: English Currency Controversies, 1825–1865
• I. Introduction
• II. the “currency School” -“banking School” Controversy
• III. the “palmer Rule ”
• IV. the Bank Act of 1844
• V. the Possibility of Overissue of Convertible Bank Notes
• VI. the Role of Deposits, Bills of Exchange, and “credit” In the Currency System
• VII. the Technique of Credit Control
• VIII. the Relation Between Bank of England Operations and Specie Movements
• IX. Currency Reform Proposals
• Chapter VI: The International Mechanism Under a Simple Specie Currency
• I. Introductory
• II. the Mechanism According to Hume
• III. an Omitted Factor? Relative Changes In Demand As an Equilibrating Force
• IV. Prices In the Mechanism: the Concept of “price Levels ”
• V. the “terms-of-trade” Concept
• VI. the Prices of “domestic” Commodities
• VII. the Mechanism of Transfer of Unilateral Payments In Some Recent Literature
• VIII. a Graphical Examination of Pigou's Analysis 1
• IX. Some Elaborations On the Basis of Pigou's Analysis
• X. an Alternative Solution
• XI. Types of Disturbance In International Equilibrium
• XII. Specie Movements and Velocity of Money
• XIII. Commodity Flows and Relative Price Levels
• XIV. Exchange Rates
• XV. A Criticism of the Purchasing-power Parity Theory 1
• Chapter VII: The International Mechanism In Relation to Modern Banking Processes
• I. Automatic Vs. Managed Currencies
• II. Primary and Secondary Expansion of Means of Payments
• III. Short-term Loans In the International Mechanism
• IV. Primary and Secondary Expansion In Canada , 1900–13
• V. the International Mechanism and Business Cycles
• Chapter VIII: Gains From Trade: the Doctrine of Comparative Costs
• I. the Nature and Origin of the Doctrine
• II. the Division of the Gain From Trade
• III. Trade In More Than Two Commodities
• IV. Trade Between More Than Two Countries
• V. Transportation Costs
• VI. Increasing and Decreasing Costs
• VII. Prices, Money Costs, and Real Costs
• VIII. Dependence of Comparative Cost Doctrine On a Real-cost Theory of Value
• IX. Differences In Wage Rates In Different Occupations
• X. Variable Proportions of the Factors and International Specialization
• XI. Variable Proportions of the Factor and Comparative Real Costs
• XII. “ Opportunity Cost” Analysis As a Substitute For Real Cost Analysis
• Chapter IX: Gains From Trade: the Maximization of Real Income
• I. “ Mass of Commodities” and “sum of Enjoyments”: Ricardo and Malthus
• II. Reciprocal Demand and the Terms of Trade
• III. Terms of Trade and the Amount of Gain From Trade
• IV. “ Net Benefit” In International Trade: Marshall
• V. Total Net Utility Derived From International Trade: Edgeworth
• VI. the Gain From Trade Measured In Money
• Appendix: a Note On the Scope and Method of the Theory of International Trade

VII. Prices, Money Costs, and Real Costs

The doctrine of comparative costs was stated by Ricardo and his followers in terms of “real” costs as distinguished from money costs. It has been interpreted by some modern writers as if it denied that prices, or money costs, or “expenses of production,” had anything to do with the course of foreign trade, and as if a reformulation of the theory of international trade in terms of prices or of money costs would of itself involve a correction of Ricardo or would introduce into the theory an element not already included in the classical expositions thereof. This view, however, involves a total miscomprehension of the classical theory.

For all the classical writers it was common doctrine, as has already been argued,1 that under free trade, and in the absence of transportation costs, prices of identical internationally-traded commodities would be uniform in all countries when expressed in the same currency. It was also common doctrine that the prices of commodities produced within a country would be, or would tend to be, proportional to their money costs of production, that differences in supply prices were the immediate determinant of the course of trade, and, therefore, that differences in money costs of production determined the course of trade. They extended their analysis to real costs not as a substitute for analysis in terms of money costs, but in order to show that, although trade was immediately governed by price and money-cost differences, these differences in prices and money costs reflected differences in real costs and were therefore significant for welfare appraisals.2 The real-cost analysis was intended, therefore, to give significance to the analysis in pecuniary terms, and not to replace it.

For the classical school, the immediate determinant of whether a particular commodity will be obtained abroad or at home, or exported, is the absolute difference in the prices at which domestic and foreign producers are willing to furnish it.3 Actual market prices being assumed to be everywhere equal in the absence of transportation costs, commodities will be exported or imported according as their domestic supply prices or money costs of production are absolutely lower or higher than their foreign supply prices or money costs of production expressed in the same currency. Some writers, however, transferring Ricardo's comparative-cost doctrine too abruptly into the realm of money costs and prices, have argued that trade is, or should be, governed by comparative differences in money costs even in the absence of absolute differences in money costs.

A glaring case is an anonymous pamphlet published in 1818, which has been reprinted and recommended to the favorable attention of modern scholars by Arnold Plant.4 The main thesis of the pamphlet is that it is profitable to merchants to export a commodity, A, selling at a higher price at home than abroad and to import a commodity, B, if the ratio of the home price of A to the home price of B is lower than the ratio of the foreign price of A to the foreign price of B:

The advantage of any trade, where one article is to be exported, and either mediately or immediately to be exchanged for another to be imported, depends on the proportion between the quantities of the two articles that may be bought for the same price in the one market being effectually different from the proportion between the quantities of the same two articles that may be bought in the other market for one and the same price: that article, the home price of any proposed quantity of which will buy less of the other article (at home) than the foreign price of the same quantity of that article will abroad, being the one to export, and the other the one to import: in other words, that article (of the two) which is, relatively to the other, cheaper at home than abroad, being the one to export, and the other the one to import.

Observe: it matters nothing whether the article, thus comparatively cheaper, be really cheaper ordearer than in the other market; but only that it should be cheaper, if paid for in that other article. As for example, silk stockings, bought with brandy in England, may be cheaper than in France. A gallon of brandy may buy more than in France; though perhaps, absolutely, silk stockings may be as cheap in France as in England, or cheaper.5

But if the supply price of silk stockings is higher in England than in France, no sensible merchant will voluntarily export stockings to France in exchange for brandy when money can be exported instead.6 As Plant points out, the author's exposition, much of it algebraic, is of excellent quality. Unfortunately, however, the algebra is wasted on the exposition of a fallacy. This and other similar instances,7 of failure to see that it is absolute differences and not merely comparative ones which matter when it is prices and money costs and not real costs which are under consideration, were sometimes the result of a laudable desire to meet the argument, that in the absence of protection a country might find it impossible to withstand foreign competition abroad or in its domestic market because its price level was too high, by demonstrating that export could be profitably carried on regardless of the general price level. The classical economists would of course have met this argument in another manner, by contending that England could not long maintain a price level so high as to shut off all exports and that forces would operate automatically, through gold movements, to restore a relationship between the English and the outside price levels under which a normal volume of exports could be maintained with profit to the individual exporters.

Walras, in his only treatment of the theory of international trade, made almost exactly the converse error, and applied to costs in terms of quantities of the factors reasoning valid only for costs in money terms:

Notre pays serait arrivé, en dernière analyse, à faire du blé en faisant du drap. II aurait ainsi substitue les coéfficients de fabrication de l'eé;tranger aux siens propres pour le blé, en même temps que l'etranger opérait la substitution inverse pour le drap. Là est l'essence du libre exchange, et les deux substitutions sont correalatives.8

What Walras's proposition amounts to is that under trade the prices of the products of the two countries must be proportional to their real costs. Instead of being universally valid, this proposition will be valid only in the special case where—assuming labor to be the only cost—wage rates are uniform in both countries under trade. The only generally valid proposition which can be made as to the real costs at which imports are obtained is that they will be lower than—or in the limiting case equal to—the real costs at which they could have been produced at home. If each country has an absolute advantage in the production of its export commodity, and if wage rates are not uniform in both countries, one of the countries will obtain its import commodity at a real cost to itself lower than its real cost in its country of origin while the other country will obtain its import commodity at a real cost to itself higher than its real cost in its country of origin. If one of the countries is at an absolute disadvantage in the production of both commodities, that country cannot possibly obtain its import commodity at a real cost to itself as low as that at which it is produced in its country of origin.

Ricardo, assuming perfect occupational mobility of the factors at home and imperfect international mobility of the factors, held that while the relative values of home-produced commodities were governed by their relative real costs of production, this rule did not hold for commodities produced in different countries:

The same rule which regulates the relative value of commodities in one country does not regulate the relative value of the commodities exchanged between two or more countries.... In one and the same country, profits are, generally speaking, always on the same level; or differ only as the employment of capital may be more or less secure and agreeable. It is not so between different countries.9

Other classical economists as a rule took this proposition over from Ricardo without question.10 It seems, however, to have worried Torrens. While he stated the doctrine himself at times, he seemed at one time to believe that in doing so he was disagreeing with Ricardo,11 perhaps because he had heard McCulloch expound it incorrectly,12 and still later he raised the question as to whether the doctrine was valid at all.13

Sidgwick, it will be remembered,14 took issue with the doctrine that the relative values of the products of different countries were not proportional to their relative costs, but in his argument he seemed to mean money cost rather than real cost by “cost,” whereas in the Ricardian doctrine “cost” meant real cost. At one point, however, Sidgwick presents some conclusions which would be true if he used cost to mean real cost, but would not be true if he used cost to mean money cost.15 He repeats an illustration of J. S. Mill's, where England exports cloth in exchange for Spanish wine, and adds a third commodity, corn, which is produced in both countries. He argues that since in England, where both cloth and corn are produced, their values must be determined by their relative costs of production, and similarly in Spain the values of corn and wine must also be determined by their relative costs of production, therefore the relative values of cloth and wine must also be determined by their relative costs of production, if there are no transportation costs. If values here mean prices and if “costs” mean “money costs,” this is correct, and Mill would have agreed. Since the price of corn must be the same in both countries, and since in England the price of cloth: price of corn::money cost of cloth:money cost of corn, and in Spain the price of wine:price of corn::money cost of wine:money cost of corn, therefore the price of cloth:price of wine::money cost of cloth:money cost of wine. So far there is no difficulty, except in seeing why Sidgwick thought that he was differing from Mill. But at this point Sidgwick appends a note which is not intelligible if he is not using cost to mean real cost, and is simply a concession of his whole case against Mill if he is so using it: “It does not of course follow that the wine and cloth will exchange for each other in proportion to their respective costs; since, if (as Mill supposes) labor and capital are imperfectly mobile, the cost of producing corn may be different in the two countries.” 16 If Sidgwick is conceding that the prices of wine and cloth will not be proportional to their real costs of production, he is accepting Mill's entire case. If he is denying that the prices of wine and cloth will be proportional to their money costs of production, he is denying his own theory of value, and apparently contradicting the accompanying text.17

[1]Cf. supra, pp. 314 ff.

[2]In considering the profitability of trade for a particular country, it is to be noted, its own money costs matter only as they are proportional to the real costs, whereas the real costs of the outside world matter only as they are reflected in foreign supply prices. It does not matter to an importing country why its imports are cheap, provided they can be relied upon to remain cheap. The proper basis for determining the profitability of trade to a particular country, therefore, is the comparison of its own relative real costs for different commodities with foreign relative supply prices of the same commodities.

[3]Cf. Ricardo, Principles, Works, p. 100: “The motive which determines us to import a commodity, is the discovery of its relative cheapness abroad: it is the comparison of its price abroad with its price at home.” Ibid., p. 78: “Every transaction in commerce is an independent transaction. Whilst a merchant can buy cloth in England for £45, and sell it with the usual profit in Portugal, he will continue to export it from England.”

[4]A letter on the true principles of advantageous exportation [1818], reprinted in Economics, XIII (1933), 40-50. Plant, in his introduction, says of it that “here is a formal, generalized statement of the main principle [of comparative cost] by an obvious master of precise theoretical exposition,” and that “The anonymous author of this tract should take his place with Ricardo, J. S. Mill, Longfield, Mangoldt and Edgeworth as one of the outstanding exponents of the theory of international trade in the nineteenth century.”

[5]Ibid., p. 45. (Italics in original text.)

[6]The author meets this objection by conceding that while the profit would be greater if money were exported instead of stockings, there would still be some profit in exporting the stockings in exchange for brandy. (Ibid., p. 48.) But why not export the money, which would appear less troublesome as well as more profitable? Better doctrine on this point was expounded by a contemporary writer, in the following passage: Whoever exports an article, sells it for as high a price as he can obtain; but he must find the commodity he brings back, after paying his own expenses, at least equal in value to what he exported: if this were not the case, he would lose by the trade, and would give it up. If money is the article brought back, the money must be capable of purchasing at least an equal quantity of the commodity exported, or the trade would be abandoned. (Thomas Hopkins, Economical enquiries relative to the laws which regulate rent, profit, wages, and the value of money, 1822, p. 84.)

[7]Cf., e.g., W. Cockburn, Commercial economy: or the evils of a metallic currency, 2d ed., 1819, p. 5: If a merchant were to purchase a quantity of cotton goods for £100, and send them to Petersburgh and sell them for £50, it would appear at first sight almost certain, that he had made a bad commercial experiment. But the fact might be otherwise. If with his £50 he were to purchase hemp, which hemp, on its arrival in London, sold for £200, the speculation on the whole would turn out beneficial.

[8]Léon Walras, Etudes d'économie politique appliquée,1898, p.236

[9]Principles, Works, pp. 75-76. Assuming as he presumably does here that the proportion of labor to capital is within a country uniform in all industries, and that wages are uniform in all occupations, uniformity of the interest rate in all occupations involves proportionality of prices of domestically produced commodities to labor-time or “real” costs.

[10]Edgeworth, later, called it the “negative clause” of the principle of comparative costs, and held it to be superfluous: “that the value of articles in the international market is not proportioned to the cost—the ‘efforts and sacrifice’—incurred by the respective producers, is superfluous, if the definition here proposed is adopted. Why should there be any correspondence between cost and value in the absence of the conditions, proper to domestic trade, on which that equality depends?” Papers relating to political economy, 1925, II, 6.

[11]Cf. the report of his speech in the House of Commons, July 3, 1832, Hansard, Parliamentary debates, 3d series, XIV, 19: Now the error in this case [referring to an argument that it did not matter to England whether a foreign country took goods or money in exchange for its own goods] sprang out of another of still more universal acceptation; namely, that great maxim of the Ricardo school of economists, that as the value of a commodity in the home market depended on the cost—the labor—of production, so must it be in a foreign market. He would maintain, that though this principle was true of domestic policy, yet that it was not it that regulated the exchangeable value in a foreign market. What we received in return for our goods in foreign markets did not depend on the cost of producing these foreign articles, but on the demand that existed in the foreign market for our commodities.

[12]Cf. Mallet's account of the discussion at the Political Economy Club, April 5, 1832, Political Economy Club, Minutes of proceedings, VI (1921), 234: The discussion at last ran into a question of value, what constituted value in exchange—and on this rock it split, and left us all at sea. McCulloch, boldly standing by Ricardo's doctrine, that equal quantities of labor are equal in value all over the world—and Torrens and Malthus treating it as a ridiculous notion.

[13]In 1844 there was discussed at the Political Economy Club the question put by Torrens: “Was Ricardo correct in stating that ‘the same rule which regulates the relative value of commodities in the country, does not regulate the relative value of the commodities exchanged between two or more countries’?” Torrens was not present, but McCulloch is reported as having held that Ricardo's chapter on foreign trade was faulty, and that in practice only such commodities are imported as foreign countries produce more cheaply, whether in terms of money costs or of real costs not being indicated.—Political Economy Club, Minutes of proceedings, VI (1921), 291.—It seems that McCulloch never accepted Ricardo's doctrine that comparative disadvantage in real cost could make importation profitable even though accompanied by absolute advantage in real cost, and his exposition of the doctrine appears always to have been in terms of absolute, as well as comparative, advantage. (Cf. McCulloch, Principles of political economy, 4th ed., 1849, chap. v.)

[14]Supra, p. 470, note 4.

[15]Sidgwick, Principles, and ed., 1887, pp. 205-07.

[16]Ibid., Principles, 2d ed., p. 207, note.

[17]If it be assumed that at this stage of his argument Sidgwick has unconsciously lapsed into using the term “cost” in Mill's sense of real costs, then a suggestion by Edgeworth (Papers, II, p. 30) offers a means of reconciling his main text with this note. If “determined by cost of production,” be read to mean merely “affected or influenced by cost of production,” then, of course, the relative values of the products of different countries can be “determined” by their real costs of production without being proportional to them. This would reconcile the note with the text, but would make Sidgwick agree wholly with Mill when he was giving the same meaning to the terms he uses.