Opportunity Cost Theory

-Gottfried Haberler

Opportunity Cost Theory

The Opportunity cost of anything is the value of the alternatives or other opportunities which have to be foregone in order to obtain that particular thing.

Opportunity Cost Theory

Assume that a given amount of productive resources can produce either 10 units of cloth or 20 units of wine. Then the opportunity cost of 1 unit of cloth is 2 units of wine. Opportunity cost approach defines cost in terms of the value of the alternatives of other opportunities which have to be foregone in order to achieve a particular thing .

Opportunity Cost Theory

A nation with a lower opportunity costs of production of commodity has a comparative advantage in that commodity and comparative disadvantage in the other commodity.

Opportunity Cost Theory

Suppose, the opportunity cost of 1 unit of X is 2 units of Y in country A and 1.5 unit of Y in country B,
Then, country A must specialize in production of Y and import its requirement of X from B B should specialize in the production of X and import Y from A rather than producing at home.

Opportunity Cost Theory

Assumptions:
Two-country, two-commodity model Only two factor of production ..i.e., labor and capital Factors of productions are perfectly mobile within a country but immobile between countries. Factors of production are fixed in supply Perfect competition There is full employment in the country The price of each factor is equal to its marginal productivity in each employment. The price of each commodity is equal to its marginal cost of production. No technological change International trade is free

Opportunity Cost Theory

Conclusion Opportunity cost theory demonstrates that trade is beneficial as long as opportunity costs differ. It recognizes the existence of many different kinds of productive factors where as Ricardo considered only labour. The theory is a refinement of the Ricardian theory.

Factor Endowment Theory

Developed by Swedish economist Eli Heckscher and his student Bertil Ohlin. Paul Samuelson and Wolfgang Stolpersignificant contributions Consists of 2 important theorems
Hechscher-Ohlin Theorem Factor Price Equalization Theorem

Heckscher-Ohlin Theorem
This theory examines
the reasons for comparative cost differences in production And states that a country has comparative advantage in the production of that commodity which uses more intensively the countrys more abundant factor.

Heckscher-Ohlin Theorem
Explained the basis of International trade in terms of factor endowments. An addition to the classical theory. Addressed the reasons for why the comparative cost differences exist internationally.

Heckscher-Ohlin Theorem
They attribute international differences in comparative costs to:
Different prevailing endowments of the factors of production. The fact that production of various commodities requires that the factors of production be used with different degrees of intensity.

Heckscher-Ohlin Theorem
Thus, the theory states that
A country will specialize in the production and export of goods whose production requires a relatively large amount of the factor with which the country is relatively well endowed.

Heckscher-Ohlin Theorem
In the model,
Factors of production are regarded as scarce or abundant in relative terms and not in absolute terms. i.e., one factor is regarded as scarce or abundant in relation to the quantum of other factors

Heckscher-Ohlin Theorem
A country can be regarded as richly endowed with capital only if the ratio of capital to other factors is higher when compared to other countries .
(i) In country A: Supply of Labour= 25 units Supply of Capital= 20 units Capital- Labour ratio= 0.8 (ii) In country B: Supply of Labour= 12 units Supply of Capital= 15 units Capital- Labour ratio= 1.25

Heckscher-Ohlin Theorem
In the above mentioned illustration,
Even though country A has more capital in absolute terms, country B is more richly endowed with capital because the ratio of capital to labour in country A(0.8) is less than in country B (1.25)

Pattern of Trade Under Heckscherohlin Model

Capital intensive goods

Capital abundant country

Labor abundant country

Labor intensive goods

Heckscher-Ohlin Theorem
Assumptions: Both product and factor markets in both countries are characterized by perfect competition. Factors of productions are mobile Factors are of identical quality in both countries Factor supplies in each country are fixed. Fully employed in both the countries. Factor endowments of one country vary from that of the other. Free trade between countries. Transportation cost is nil
Techniques of producing identical goods are same in both countries. Factor intensity various between goods Production is subject to the law of constant returns