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, 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. 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. 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. 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.

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. 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, 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.

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.

Other classical economists as a rule took this proposition over from Ricardo without question. 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, perhaps because he had heard McCulloch expound it incorrectly, and still later he raised the question as to whether the doctrine was valid at all.

Sidgwick, it will be remembered, 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. 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.” 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.