- Gottfried Haberler has explained the law of comparative advantage theory in terms of opportunity cost theory. He has relaxed the assumption of labour theory of value while explaining law of comparative advantage based on opportunity cost.
- Opportunity cost of a first 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.
- Opportunity Cost is defined as the value of a factor in its next best alternative use or it is the cost of foregone or sacrificed alternatives. It is also defined as the value of the benefit that is sacrificed by choosing an alternative.
- No assumption is made here that labor is the only factor of production or that labor is homogeneous. Nor is it assumed that the cost or price of a commodity depends on or can be inferred exclusively from its labor content. Consequently, the nation with the lower opportunity cost in the production of a commodity has a comparative advantage in that commodity.
- For example, if in the absence of trade the United States must give up two-thirds of a unit of cloth to release just enough resources to produce one additional unit of wheat domestically, then the opportunity cost of wheat is two-thirds of a unit of cloth (i.e., 1W = 2/ 3C in the United States). If 1W = 2C in the United Kingdom, then the opportunity cost of wheat (in terms of the amount of cloth that must be given up) is lower in the United States than in the United Kingdom, and the United States would have a comparative (cost) advantage over the United Kingdom in wheat.
- In a two-nation, two-commodity world, the United Kingdom would then have a comparative advantage in cloth. According to the law of comparative advantage, the United States should specialize in producing wheat and export some of it in exchange for British cloth.
- This is exactly what was concluded earlier with the law of comparative advantage based on the labor theory of value, but now the explanation is based on the opportunity cost theory.
The Production Possibility Frontier under Constant Costs
- Opportunity costs can be illustrated with the production possibility frontier, or transformation curve.
- The production possibility frontier is a curve that shows the alternative combinations of the two commodities that a nation can produce by fully utilizing all of its resources with the best technology available to it.
- Table gives the (hypothetical) production possibility schedules of wheat (in million bushels/year) and cloth (in million yards/year) for the United States and the United Kingdom. We see that the United States can produce 180W and 0C, 150W and 20C, or 120W and 40C, down to 0W and 120C.
- For each 30W that the United States gives up, just enough resources are released to produce an additional 20C. That is, 30W = 20C. Thus, the opportunity cost of one unit of wheat in the United States is 1W = 2/ 3C and remains constant.
- On the other hand, the United Kingdom can produce 60W and 0C, 50W and 20C, or 40W and 40C, down to 0W and 120C. It can increase its output by 20C for each 10W it gives up. Thus, the opportunity cost of wheat in the United Kingdom is 1W = 2C and remains constant.
- The United States and United Kingdom production possibility schedules given in Table are graphed as production possibility frontiers in Figure 1. Each point on a frontier represents one combination of wheat and cloth that the nation can produce.
- For example, at point A, the United States produces 90W and 60C. At point A, the United Kingdom produces 40W and 40C. Points inside, or below, the production possibility frontier are also possible but are inefficient, in the sense that the nation has some idle resources and/or is not using the best technology available to it.
- On the other hand, points above the production frontier cannot be achieved with the resources and technology currently available to the nation. The downward, or negative, slope of the production possibility frontiers in Figure 1 indicates that if the United States and the United Kingdom want to produce more wheat, they must give up some of their cloth production.
- The fact that the production possibility frontiers of both nations are straight lines reflects the fact that their opportunity costs are constant. That is, for each additional 1W to be produced the United States must give up 2/3C and the United Kingdom must give up 2C, no matter from which point on its production possibility frontier the nation starts.
- Constant opportunity costs arise when (1) resources or factors of production are either perfect substitutes for each other or used in fixed proportion in the production of both commodities and (2) all units of the same factor are homogeneous or of exactly the same quality. Then, as each nation transfers resources from the production of cloth to the production of wheat, it will not have to use resources that are less and less suited to wheat production, no matter how much wheat it is already producing. The same is true for the production of more cloth.
- Thus, we have constant costs in the sense that the same amount of one commodity must be given up to produce each additional unit of the second commodity. Although opportunity costs are constant in each nation, they differ among nations, providing the basis for trade. Constant costs are not realistic, however.
The Production Frontier with Increasing Costs
It is more realistic for a nation to face increasing rather than constant opportunity costs. Increasing opportunity costs mean that the nation must give up more and more of one commodity to release just enough resources to produce each additional unit of another commodity.
- Increasing opportunity costs result in a production frontier that is concave from the origin (rather than a straight line).
- Figure 2 shows the hypothetical production frontier of commodities X and Y for Nation 1 and Nation 2.
- Both production frontiers are concave from the origin, reflecting the fact that each nation incurs increasing opportunity costs in the production of both commodities.
- Suppose that Nation 1 wants to produce more of commodity X, starting from point A on its production frontier. Since at point A the nation is already utilizing all of its resources with the best technology available, the nation can only produce more of X by reducing the output of commodity Y. Figure 2 shows that for each additional batch of 20X that Nation 1 produces, it must give up more and more Y. The increasing opportunity costs in terms of Y that Nation 1 faces are reflected in the longer and longer downward arrows in the figure 2, and result in a production frontier that is concave from the origin.
- Nation 1 also faces increasing opportunity costs in the production of Y. This could be demonstrated graphically by showing that Nation 1 has to give up increasing amounts of X for each additional batch of 20Y that it produces.
- However, instead of showing this for Nation 1, we demonstrate increasing opportunity costs in the production of Y with the production frontier of Nation 2 in Figure 2. Moving upward from point A’ along the production frontier of Nation 2, we observe leftward arrows of increasing length, reflecting the increasing amounts of X that Nation 2 must give up to produce each additional batch of 20Y.
- Thus, concave production frontiers for Nation 1 and Nation 2 reflect increasing opportunity costs in each nation in the production of both commodities.