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International Trade and Finance

Notes importance of terms of trade can nullify the advantages to be obtained from international
specialization resulting from trade. Strictly from the country’s point of view (or national as opposed
to global standpoint) it is the consumption gains that matter; and consumption gains for a country
are determined solely by international terms of trade. Production gains could, if terms of trade go
against the country, go away to the other side i.e. to the foreign countries. The Third World countries,
which allegedly suffer adverse terms of trade today, are increasingly getting frustrated with the
mechanism of international trade which is benefiting the advanced industrial countries
disproportionately. A mutually beneficial trade requires, as a pre-condition, a mechanism of
international trade (or interdependence) consistent with equity or justice in trading terms.
3.3 Opportunity Cost and the Pure Theory of Trade

So far in this unit, the free trade doctrine has been discussed in terms of alabour theory of value in
which the value of a commodity is determined by the amount of labour time used in its production.
Following on from Smith and Ricardo, economists in the nineteenth century subsequently modified
and finally abandoned the labour theory of value. It was replaced with the familiar economics ‘toolbox’
of the present day, in which the value of a commodity is related to its market price, which depends
not only on supply and cost conditions, but also on demand.
Neo-classical trade theory

The economists who later overturned the labour theory of value were from continental Europe as
well as from Britain. Jean Baptiste Say (1767–1832) was French. Though afirm disciple of Smith, he
was the first economist to break away entirely from the labour theory of value. He is generally credited
as developing the forerunner of formal equilibrium analysis. Of the three ‘founders’ of the marginal
utility school in the late nineteenth century, Jevons was from England, Menger from Austria (Vienna)
and Walras from Switzerland (Lausanne).
The ‘neo-classical’ thinkers, led by Jevons, Menger and Walras, developed theories of an economic
system based on large numbers of producers and consumers. Given a competitive market economy,
prices would guide consumers and bring about the most efficient allocation of resources in order to
maximise society’s income. Neo-classical economists also made great use of mathematical and
geometric exposition in order to show functional relationships between important variables such as
price and quantity demanded. The use of mathematics ensured greater rigour in the development of
their theories.
This is the context in which economists have developed the pure theory of trade. The pure theory of
trade treats international trade within the framework of neoclassical theory. It carries through to the
present day Adam Smith’s belief in the invisible hand of the market, competition and the benefits of
laissez-faire policy in relation to international exchange. The pure theory abandons the labour theory
of value. Instead it is based on rigorous analysis of consumer and producer behaviour.
The pure theory of trade can be developed through a system of equations and this is the most exact
way of presenting it. In this unit, however, we rely on a simple geometric exposition instead of on
equations.
Opportunity cost

The doctrine of free trade holds good even if we discard the labour theory of value. The Austrian
economist Gottfried Haberler first demonstrated this in the 1930s, utilising the concept of ‘opportunity
cost’. If the concept of the ‘indifference curve’ is also introduced into the analysis, it becomes possible
for the first time to demonstrate the gains in real income from trade. What follows here is a simplified
form of the pure theory of trade based on Haberler’s Theory of International Trade (1933).
Assume two countries, the US and UK, and two commodities, wheat and cloth. The purpose of the
analysis is to demonstrate that the UK gains from specialising in the production of cloth in which it
has a comparative advantage, and exporting it to the US in exchange for wheat in which it has a
comparative disadvantage. The gains from trade come about because the domestic opportunity cost
of cloth in terms of wheat differs from the international opportunity cost of cloth and wheat.

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