Decreasing costs refer to a fall in average or marginal costs as output expands. In a pure theoretical sense, Haberler contends that, decreasing costs are the consequence of increase in demand for the product led by foreign trade. In fact, the decreasing costs result when increasing returns tend to operate on account of internal and external economies of large-scale production.
Graham’s Thesis :
In analysing the problem of international trade under decreasing costs, Professor F. B. Graham subscribes to an opposite view in the classical dogma that specialisation based on comparative cost I advantage leads to an increase in the volume of output of the trading countries.
His contention is that I under free trade conditions, when a country is induced to specialisation on the basis of comparative cost industries and give up decreasing-cost industries, its aggregate real income will be less than before trade. Suppose two goods, wine and cloth, are produced and wine is subject to diminishing returns or increasing cost while cloth has increasing returns or decreasing costs.
Now the country having comparative cost advantage in wine, when it specialises in producing wine, shifts its resources from increasing returns industry to diminishing returns industry and to that extent its total real income will be reduced after specialisation under free trade, while, the other country specialising in decreasing cost industry (in producing cloth) will be benefited in the process.
To illustrate the point, say England and Portugal produce cloth and wine. Before trade, the price ratio in England is 100 units of wine to 100 units of cloth, and that in Portugal it is 100 units of wine to 80 units of cloth. Thus, England has a comparative cost advantage in producing cloth and Portugal has in wine. Let us assume that the international exchange ratio is set as: 100 units of wine to 100 units of cloth.
Now, when Portugal concentrates on wine production, her cloth production contracts, say by 8,000 units. The diversified factors from cloth to wine will produce less than 10,000 units of wine, say 8,500 units on account of diminishing returns.
Exchange ratio being 1: 1.8,500 units of wine will get in exchange 8,500 units of cloth from England. Now, again if Portugal contracts her cloth production by shifting the same amount of the factors as before for employing them in wine production, the cloth output this time may be curtailed by 7,000 units because cost increases in the contracting decreasing cost industry (cloth industry).
On the other hand, wine output rises only to 7,300 units due to the operation of law of diminishing returns. Under trade these 7,300 units of wine will get 7,30(1 units of English cloth in exchange. Hence, Portugal’s after trade position is: 8,500 + 7,300 = 15,80(11 units of cloth, while before trade, for the same efforts it was originally producing 8,000 + 8,000= I 16,000 units of cloth domestically. That means, under foreign trade Portugal loses 200 units of cloth,
From the above example, it follows thus, that guided by the comparative cost doctrine, an unfortunate country which specialises in increasing cost industries against the decreasing coat industries becomes worse off with the expansion of trade, its real income would decline in terms of both goods than in the absence of trade. For this reason, Graham strongly advocates for the protection policy rather than free trade for such an unfortunate country.
Haberler, however, vehemently criticised Graham’s contention of decreasing costs. Graham’ conclusion would be valid only if his assumption that cost decreases with expansion of output and increases with contraction in the decreasing cost industry is acceptable. Graham’s conclusion that decreasing cost industry contracts due to foreign competition rests on the assumption that there is perfect competition in that industry.
Haberler regards this as an impossible phenomenon, as the industry subject to decreasing cost will tend to have monopoly rather than competition. And when there is monopoly in an industry, the monopolist has full control over his supply, so he will expand his output to lower his marginal cost, under a situation of falling price, and not contract the output, as visualised by Graham.
Moreover, Graham has failed to distinguish between average and marginal relationship, while setting out his analysis. It is the marginal and not the average cost which is the main determinant of equilibrium output and price. Hence, no resources will be transferred from one industry to another, when a loss in the marginal revenue product results thereby. It is impossible to see under profit maximising rule followed by the producer that he transfers resources and forgoes production of Q units of cloth to get Z units of wine, when Z is less than Q.
Haberler, however, contends that Graham’s thesis has some validity when decreasing costs is the outcome of external economies enjoyed by all the firms, which are internal to the industry as a whole.
In this case only, each firm will not be induced to expand even though, industry may gain by further expansion. And when there is increasing foreign competition, the industry may even contract its output which would deprive the firm of its previous external economies, so costs will rise with the contraction of industry. Under this situation, protection is essential. But, here too, it is difficult to have an empirical measurement of external economies to devise an appropriate protection policy.
Most of the modern economists, however, do not subscribe to Graham’s thesis and affirm that, decreasing costs tend to strengthen rather than weaken the case of international trade, which leads to complete specialisation in due course.
It has been said that when monopoly emerges under decreasing costs condition, protection will only strengthen the monopolistic position; a free trade, which will encourage competition, will help in preventing the growth of undue monopoly. For this reason, decreasing costs due to internal economies becomes the most commendable argument for advocating free trade rather than protection.