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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

XII. “Opportunity Cost” Analysis as a Substitute for Real Cost Analysis

The Austrian school presented a theory of value in which “real costs” as understood by the English classical economists had no place, and, except for technological coefficients of production, no cost analysis was included. The original Austrian theory of value did not so much contest as ignore the existence of “real costs” and the considerations which led the English classical school to assign to them an important influence over relative prices.1 Yielding to the pressure of controversial discussion, the Austrians eventually made some minor concessions to such influence, but failed to incorporate these concessions satisfactorily into their general theory,2 and continued to present their theory on the basis of a set of special assumptions whose responsibility for most of its distinctive features they never emphasized and, I believe, never recognized.3

The Austrian theory of value has recently taken on a new lease of life under distinguished and enthusiastic sponsorship under the designation of the “opportunity cost” or “alternative [product] cost” or “displaced [product] alternative” theory of value. This originally was except for the label an identical reproduction of the Austrian theory of value. In response to criticism, it is now incorporating real-cost considerations into its analysis more fully than did the original Austrian school, although its exponents have denied the legitimacy of such considerations more unrestrainedly than did the original “Austrians.” This opportunity-cost theory has recently been applied to the theory of international trade as a substitute for the doctrine of comparative costs in terms of real costs, and has occasionally been presented as accomplishing all that the latter professed to do while escaping all of its difficulties. I will first examine the criticisms by the opportunity-cost theorists of the legitimacy and relevance of real-cost analysis, and then consider the positive substitute they offer for it.

The opportunity-cost theorists interpret “real costs” or “disutilities” as signifying “pain costs” (often as signifying labor-pain costs only), and they apparently deny that pain costs have any bearing on prices, or perhaps any existence. Whether or not there is such a thing as “pain,” and if there is, whether or not its presence at the margin or earlier is a factor in determining the quantity of work or saving which will be done, are questions which the economist is, as such, incompetent to answer, whether in the affirmative or in the negative. Fortunately, however, no answer to these question is required by a theory of value of any species which has ever had wide currency. “Real cost” or “dis-utility” has not, as far as I know, ever been used as a synonym for “pain” in some precise psychological sense, and in real-cost analysis pleasure relinquished and pain endured are alike treated as real costs, without attempt to distinguish them, and without any purpose which such distinction could serve. I am not even certain that Ricardo, or J. S. Mill, or Cairnes, or Taussig ever used the term “pain” in their analyses. In so far as the pleasure-pain terminology was used, the usage of the ordinary classical economist, though never rigorously defined as far as I know, seems to have been essentially that of Bishop Berkeley many years before:

Sensual pleasure, quâ pleasure, is good and desirable by a wise man. But if it be contemptible, ‘tis not quâ pleasure but quâ pain, or cause of pain, or (which is the same thing) of loss of greater pleasure.4

Every problem in economic welfare is a problem in the maximization of the surplus of income, in some sense significant for welfare, over outgo, also in some sense significant for welfare. The classical school, in the doctrine of comparative costs, attacked welfare problems from the point of view of how the outgo necessary to obtain a given unit of income could be minimized, and as outgo, or real cost, they included pleasures surrendered of certain though not all kinds, the one kind omitted being the pleasure derivable from an alternative product. They also, as we shall see in the next chapter, dealt with problems of welfare, including the problem of trade policy, from the income angle, from the point of view of maximizing the total income from a given outgo in terms of real cost, where the forgone pleasure derivable from an alternative product was treated as an alternative inceome, not as a cost. The two approaches are complemetary, rather than contradictory. Provided every element affecting relative prices is given proper consideration, it does not matter, except on purely terminological considerations, whether they are treated as costs or as forgone incomes. But the opportunity-cost theory, as originally expounded, not only left out of consideration some important factors affecting price, but denied, by implication at least, that they were entitled to consideration.

Second, the opportunity-cost theorists stress the fact that prices are the outcome of the choices of individuals as between alternatives, with the implication that this differentiates their theory from real-cost theory. I know of no individualistic theory of exchange value, ancient or modern, which is not a theory of the consequences for relative prices of the choices made by individuals between alternatives, and the differences between the various theories are essentially differences in the range of alternatives choice between which they treat as significant for price formation. The notion occasionally encountered that the classical economists believed that in some way real costs fashioned prices to conform to themselves without the intervention of choices between alternatives exercised by individuals in the market seems to me a myth which cannot be substantiated by chapter and verse or any other sort of evidence.

The opportunity-cost doctrine, in its original form and in the only form in which its pretensions to being a revolutionary departure from real-cost value theorizing have any basis, treated choice between alternative products (or choice between the utilities derivable from the consumption of alternative products) as the only choice significant for price determination. In this theory the only true cost is foregone product, and relative prices are held to be determined solely by preferences between products and by the technical coefficients of production. In real-cost value theorizing, preferences as between products play a role in the determination of values, but so also do preferences between occupations for their own sakes, as activities, pleasurable or painful, and because of the modes and locations of life necessarily associated with them, and also preferences between employment and (voluntary) non-employment of the factors, and even between existence and non-existence of the factors. In the comparative-cost doctrine, where the problem of trade policy is dealt with from the point of view of under what foreign-trade policy a unit of a given commodity will be procured at the minimum real cost, the problem of choice between alternative products is abstracted from, but free scope is left for consideration of all the other relevant alternatives between which choice must be made. In situations, however, where, for whatever reason, any choice between occupations, or between employment and non-employment, is a matter of indifference to the individuals concerned, comparison of the products of alternative allocations of the productive services will alone be relevant both for the explanation of the determination of relative prices and for the appraisal in welfare terms of the relative desirability of alternative allocations. In such situations, only analysis on the income side is necessary, and real-cost analysis is irrelevant. The classical school, as will be shown in the next chapter, did have recourse to analysis on the income side, but their main emphasis was on costs, and where, as in the case of land use, real costs were absent or unimportant, their analysis was defective. But even in such situations, the opportunity-cost form of the income approach has no obvious advantages as compared to an outright income approach, and has the disadvantage that by its forced restriction to two commodities and its stress on physical quantities it distracts attention from the complications presented by a variety of alternative products and from the utility or welfare aspects of variations in the components and in the distribution of the real income.

The opportunity-cost theory was first applied to the problem of gain or loss from foreign trade as a substitute for the doctrine of comparative real cost by Haberler,5 who claimed for it that it was adequate for the purpose and had the advantage over the doctrine of comparative costs that the use of the factors in variable proportions presented no difficulties for it. In his presentation, Haberler made use of a production-indifference curve, and the indifference-curve approach has been further elaborated, on similar lines, by Lerner6 and Leontief.7 I will endeavor to show, by an examination of the indifference-curve approach, that the opportunity-cost analysis faces difficulties on the “real income” side of the problem analogous to those involved in real-cost analysis, and that it avoids the difficulties involved in real-cost analysis for the most part only by ignoring the existence of some of the considerations which real-cost analysis takes into account.

The theory is presented in chart XI8 in terms of so-called indifference curves. Any point on the curve AB represents by its

distance from the horizontal axis the maximum amount of copper and by its distance from the vertical axis the maximum amount of wheat which can simultaneously be produced by the country in question with its existing stocks of the productive factors. The slope of the tangent to the AB curve at any point represents the alternative product cost of copper in terms of wheat, or the number of units copper which must be sacrificed to obtain an additional unit of wheat. In the absence of foreign trade, the relative exchange values of the two commodities must correspond to their alternative product costs, so that, e.g., if at the margin two units of copper must be sacrificed to obtain an additional unit of wheat, then under equilibrium two units of copper must exchange for one unit of wheat. The curve MM′ is supposed to be a “consumption-indifference curve” for this country, tangent at some point, K, to the production curve AB, and points on it represent combinations of copper and wheat which would be equally “valued” by the community. At point K, where the two curves have a common tangent, mm′, the alternative costs and the relative values of the two commodities would correspond. The point K is therefore the equilibrium point, in the absence of foreign trade, and od units of copper and oc units of wheat will be produced and consumed.

Suppose that if trade is opened with the outside world copper will be imported from abroad in exchange for wheat on the terms indicated by the slope of the FF′ line, which is tangent at G to the production curve, AB, and at H to another consumption indifference curve of our country, NN′, which is higher than MM′, and is therefore taken to represent a greater total utility than MM′. If the slope of FF′ is taken to represent the equilibrium terms of exchange of copper for wheat under foreign trade, our country will under equilibrium produce og copper and oe wheat; will consume oh copper and of wheat; and will import gh copper and export fe wheat. The amount of copper and of wheat available to it for consumption will therefore both be greater under foreign trade than in the absence of such trade. Whatever the slope or the point of tangency with the production curve AB of the FF′ line, provided it is not the same as the mm′ line, foreign trade will result in our country having available for consumption a combination of copper and wheat which will be on a higher consumption-indifference curve than MM′ and therefore will indicate a greater total utility than MM′, although less may be consumed of one of the commodities under foreign trade than in the absence of such trade. Foreign trade, therefore, necessarily results in gain. Such is the opportunity-cost theory as applied to the problem of gain from trade.

It is first to be noted that a true “consumption-indifference curve” must refer to a single valuing individual, and that the MM′ curve, representing as it does a country as a whole, can be given meaning only if it is understood as representing the various combinations of copper and wheat which would have equal market value when the distribution of income was such as was consistent with the production of od copper and oc wheat. For every other productive combination, there would be another and different family of equal-value-combination curves, some of which would intersect the MM′ curve—an impossibility if these were genuine consumption-indifference curves, independent of the actual allocation of production. Similar qualifications must be made with reference to the NN′ curve. The NN′ curve cannot, therefore, be accepted as necessarily representing a higher total utility, i.e., a higher “real income,” than MM′.

The opportunity-cost approach encounters, therefore, on the income side, the same type of difficulty of weighting in the absence of knowledge of the proper weights as does the real-cost approach on the cost side. It remains to be demonstrated that the opportunity-cost approach avoids the difficulties on the cost side only by avoiding recognition of the considerations which give rise to these difficulties. Let us return to the production or AB curve, and examine its implications. On a true production-indifference curve, any two points would represent the product-combinations resulting from two allocations of productive activity equally attractive to the choosing agent after due consideration had been given to everything associated with such activity except the product outcome. As presented, the AB curve constitutes merely a series of maximum-possible combinations of product when a given stock of productive factors is employed, presumably to its physical maximum. In an actual situation, the actual product-combination would not be on this curve, but would be somewhere below it, if the amounts of the factors, or the extent to which they prefer leisure to employment, were dependent on the rates of remuneration and if the equilibrium rates of remuneration were lower (or higher) than those rates which would induce each factor to render the maximum amount of productive service of which it was physically capable. Even if the extent of employment of the factors was fixed, their allocation as between copper and wheat would be dependent, not only, as is assumed in the diagram and in the opportunity-cost theory, by the relative demands for copper and wheat and the productivity functions of the factors with respect to copper and wheat, but also by the relative preferences of the factors as between employment in copper production and in wheat production. Given the existence of such preferences, then even for a single individual the true production-indifference curve would not be AB, but some other curve lower than AB at some points at least, and higher at none. The opportunity-cost theory thus escapes the difficulties connected with preferences for leisure as compared to employment, preferences as between employments and variability of the supplies of the factor, only by ignoring them.

Haberler, in his later and more qualified exposition of the opportunity-cost theory as a substitute for the doctrine of comparative real costs, does take up the case of equalizing differences in wages, which I claim presents a difficulty for the opportunity-cost theory but not for the doctrine of comparative costs. He confines himself, however, to saying that “obviously the correct procedure” is “to take into account the advantages and disadvantages of different occupations other than the money wages” 9 which appears to me like an abandonment of the opportunity-cost doctrine as an alternative product-cost doctrine. He gives a reference, however, to an article by Lionel Robbins, “where it is shown how this and similar cases can be dealt with by the opportunity-cost doctrine.” The only relevant material I can find in this article is the following passage:10

All economic changes are capable of being exhibited as forms of exchange. And hence, as Wicksteed has shown, they can be exhibited further as the resultant of demand operating within a given technical environment. It has been said that this becomes impossible if account be taken of the so-called other advantages and disadvantages of different occupations. Professor Viner ... has urged this particular objection. The difficulty, however, seems to be capable of a simple solution. If the other advantages and disadvantages are treated as joint products, the Wicksteed constructions can still be maintained.

In this passage, and elsewhere in the same article, except for the suggestion he makes that, in effect, “value of alternative product” be substituted for “alternative product” in the formula, Robbins is verbally adhering to the original opportunity-cost doctrine, the doctrine that the cost of production of product A is the alternative product, B, whose production is forgone if A is produced. But the doctrine which he here expounds has no point of conflict with analysis in terms of real costs except in choice of terminology and in its implied suggestions that its emphasis upon choice between alternatives is novel and that, even in this vale of tears, man is required to choose only between attractive alternatives. By calling the excess of pleasurableness of occupation A over occupation B a “joint product” of A—and presumably by calling the excess of irksomeness of occupation C over occupation D a subtraction from the product of C, or, perhaps, by denying that occupations can be irksome—the “product” terminology is retained while proper account is taken of the significance for prices of choices between other alternatives than products. By the same terminological procedure, I suppose, if the alternative to producing E were producing F plus increased leisure, the increased leisure would also be termed a product, of “not-working,” I take it. If a smaller product now should be chosen in preference to a larger product of the same kind in the future, such terminological virtuosity would not be overtaxed if required to find some way of expressing this preference as a preference for a larger “product” over a smaller one. But if the opportunity-cost theorists are now prepared to admit that all of the factors regarded by the real-cost theorists as influencing the determination of prices should be taken into account in explaining their determination and in appraising their significance, their insistence upon calling all of these factors “products” and their imputation of serious error to those of us who persist in regarding “real costs” as a better term for some of them, will not dampen the ardor of my welcome to them as belated converts to analysis in terms of real costs. Even with the aid, however, of the genuine contribution which the opportunity-cost technique can make to the treatment of land-use costs, the doctrine of comparative costs succeeds in demonstrating the profitability of trade only subject to the fairly important assumptions and qualifications examined above. In the next chapter I will endeavor to show that analysis of the strictly income aspects of foreign trade adds strength in certain respects to, but reveals additional weaknesses in other respects in, the case for free trade, and leaves it in that state of persuasiveness associated with incomplete demonstration which seems to be a universal characteristic of propositions of economic theory relating to questions involving human welfare.

Chapter IX

GAINS FROM TRADE: THE MAXIMIZATION OF REAL INCOME

It is the mark of an educated man to look for precision in each class of things just so far as the nature of the subject admits; it is evidently equally foolish to accept probable reasoning from a mathematician and to demand from a rhetorician scientific proofs.—Aristotle, Ethica Nichomachea, 1094 b, as cited by T. V. Smith, International Journal of Ethics, XLVI (1936), 385.

[1]For an admission of this by Böhm-Bawerk, see his “One word more on the ultimate standard of value,” Economic journal, IV (1894), 720–21.

[2]Böhm-Bawerk, as far as I know, never abandoned his original position that money costs of production are determined solely by (technological costs and) the demands for the factors of production. But if disutilities can influence values, as he conceded, they can do so only through their influence on money costs. Wieser, making concessions to the irksomeness of labor as a value-determining factor, concluded that “Services of equal utility, but of different degrees of hardship, are so regulated in regard to value that the more troublesome labor is more highly appraised” (Natural value, 1893, p. 198) but failed to explain how this extraordinary result was brought about.

[3]They assumed, for instance, uniform rates of pay in all occupations for each kind of productive service, and fixed amounts of labor irrespective of the rates at which its services were remunerated. The quantity of capital, in the sense of the amount of postponement of consumption, or, given the amounts of the other factors, in the sense of the “average length of the productive period,” they took to be a function of the rate of interest, but by confining their emphasis to the increase in product which resulted from a lengthening of the productive period they avoided the necessity of treating postponement or abstinence from immediate consumption as a cost even though it were irksome.

[4]“Commonplace book,” Berkeley, Works, Fraser ed., 1871, IV, 457.

[5]“Die Theorie der komparativen Kosten,” loc. cit., pp. 357 ff.; Der internationale Handel, 1933, pp. 132 ff.; English ed., The theory of international trade, 1936, pp. 175 ff. It had been used, as a supplement to the doctrine of comparative real cost, by Pareto, in response to a suggestion from Barone. See supra, p. 509.

[6]A. Lerner, “The diagrammatical represcntation of cost conditions in international trade,” Economica, XII (1932), 346–56.

[7]W. W. Leontief, “The use of indifference curves in the analysis of foreign trade,” Quarterly journal of economics, XLVII (1933), 493–503.

[8]Chart XI was originally prepared for and presented in a lecture given by me at the London School of Economics in January, 1931. It is in its essentials similar to the later and more elaborate constructions of Lerner and Leontief. For my present purpose, which is to stress the limitations rather than the possibilities of this approach, my simpler diagram suffices, but as exhibitions of geometrical ingenuity their constructions are far superior. No use is made here of the EE1 line in chart XI.

[9]Theory of international trade, p. 197.

[10]Lionel Robbins, “Remarks upon certain aspects of the theory of costs,” Economic journal, XLIV (1934), 2, note 5. If “forms of exchange” means “results of choices between alternatives of all kinds” and if “demand” is read to mean “preferences between alternatives of all kinds” instead of what it usually means in economic theory, I would not think of objecting to what is claimed, except for the references to the Wicksteed constructions, which, however reinterpreted, are either wrong or useless.