An Outline of International Price Theories

CHAPTER I

INTRODUCTION

1. In this essay we intend to give a general survey of the historical development of the theory of international price relationships.

The subject of international price relationships is important for two reasons. Firstly, it forms a special problem of the general theory of pricing. By analysing the price relations between nations, one is able to form a clear conception of the price mechanism of non-competing groups and the parts played by space and distance in the theory of pricing. Secondly, the price relations among nations exercise a dominating influence upon the commercial intercourse among nations. A study of the subject brings to light the factors which determine whether a commodity should be imported, exported or omitted from international trade, the factors which decide how the gains from trade are divided among the trading countries and how the average labourer in a trading country is benefited by trade, and finally the factors which govern the rate of exchange and other prices. There are, therefore, sufficient reasons for a specific study of the subject.

2. The Problems

What is meant by “international price relationship”? That term comprehends four distinct problems: (1) the relation between the value of money in one country and the value of money in other countries; (2) the relation of the price level of one country to the price level in other countries; (3) the price relations of goods of identical technological composition among trading countries; and (4) the comparison of prices of factors of production in different countries. Those are the problems which have been discussed by writers on international price relationships, and all of them are covered by this essay.

The meaning of problem (1) can best be demonstrated by an illustration. Suppose the dollar and the pound to be the monies of two countries, A and B respectively. Let N1, N2, N3, . . . be the commodities in A, and M1, M2, M3, . . . be the commodities in B. Now, if a man has funds in A’s currency deposited in A and funds in B’s currency in B, and he wants to buy a certain quantity of M in B, that would cost, say, £100, there arises the question whether he should pay it with dollars and, if so, how many dollars he should pay. If he could pay with either £100 or $500, the value of £1 is the same as the value of $5. When the currencies of the trading countries are based upon a common metal, like gold, the problem becomes more complicated. There is, then, the problem of the metallic content of each money. If the metallic content of £1 is equal to that of $5 and if the cost of transporting gold is zero, the problem becomes whether the value of £1 is the same as the value of $5. If they are the same, we say that the values of the two currencies are equal. If not, we say that the values of them are not equal.

The first problem or the problem of the comparative values of moneys, is fundamentally a problem of the rate of exchange. To say that the value of £1 is equal to the value of $5 is the same thing as to say that the rate of exchange of £1 is $5.

In problem (2) we investigate the relations, if any, between the average price of M1, M2, M3, . . . on the one hand and the average price of N1, N2, N3, . . . on the other hand. The second and the first problems are often confounded with each other and treated as a single problem. In fact, they are two distinct problems. Problem (1) is a problem of the relation between the average price of M1, M2, . . . in terms of B’s currency and the average price of M1, M2, . . . in terms of A’s currency. Problem (2) is a problem of the relation between the average price of M1, M2. . . in terms of B’s currency and the average price of N1, N2 . . . in terms of A’s currency. The two problems could become one single problem only when N1, N2 . . . are both technologically and economically the same as M1, M2. . . . They cannot be technologically the same, because some goods which are consumed in country A are not consumed in country B and some consumed in the latter are not consumed in the former. Even when they are technologically the same, they cannot be economically the same, because goods which are of identical technological constitution but are not situated in the same place, are not the same commodities from the economic point of view. Rice in China, for example, is not the same commodity as rice in England. For that reason, the general price level in A may be higher or lower than that in B, even when the values of the dollar and the pound are the same.

In addition to the problem of the general price level, there is the problem of sectional price levels. The general price level may be divided into sections in many ways. One division into sections would be (a) the price level of goods which do not enter into international trade, (b) the price level of goods which are exported, and (c) the price level of goods which are imported.

In problem (3) we are concerned mainly with the relation between the price of an article, which enters into international trade, in the exporting country and the price of a similar article (i.e. an article similar from the technical point of view) in the importing country. We also investigate the possible relations between the price of an article, which does not enter into international trade, in one country and the price of a similar article in another trading country.

Problem (4) is the problem of the relations of prices of factors of production in different countries. There is, first of all, the total of the prices paid to all the factors in each country. Since the total of the prices constitutes the aggregate income of the owners of the factors of production in the period under consideration, the problem of the relation of total of the factor prices in different countries is the same as the problem of the comparison of the levels of incomes in different countries. Secondly, we have the problem of the relative positions of the prices of the different factors in different countries. When we come to that question, we shall deal with the reasons why the relation between the price of one factor (say, wage) and that of another factor (say, rent) is not the same in different countries. Finally, there is the problem of the relation between the absolute price of a factor in one country and the absolute price of a technologically similar factor in another country. Under that problem, it is the relation of wages in different countries that requires the most careful consideration.

In distinguishing between those four problems we do not mean that they are unconnected. On the contrary, they are closely related to each other. They may be best viewed as different aspects of the same subject. The first problem, as already indicated, is fundamentally a problem of the rate of exchange. The second, third, and fourth problems involve the comparison of prices in one country with prices in other countries and are insoluble, unless they are attacked together with the problem of the rate of exchange, which makes the comparison of prices possible. The relation between the second and the third problems is still more obvious. It is the average price of individual articles that constitutes the general price level. The third problem is that of the prices of individual articles and is, therefore, closely connected with the second problem, which deals with the general price levels. The relation between the problem of factor prices (i.e. the fourth problem) and the other problems should be emphasized, because the former itself links the different problems together. The problem of factor prices is connected with the problems of product prices (i.e. the second and third problems) in three ways. Firstly, the total price paid to the factors in the preceding period, which is the same thing as the aggregate income of the owners of factors in the preceding period, determines the aggregate expenditure of those owners and, consequently, the total price of all goods in the current period. Secondly, the total price paid for goods in the current period constitutes the total price paid to factors producing those goods. Thirdly, the unit prices of factors of production determine the money costs of production and consequently the prices of goods. There are other connections between those problems, but we need not indicate them at this stage. Let it suffice to say that the four problems are so closely connected that they are simply four aspects of the same subject.

Every one of the problems we are considering raises the fundamental question whether there is always a tendency towards equilibrium or not. If the answer is in the affirmative, the following three questions naturally arise. First, what is the nature of the equilibrium? Second, how can the equilibrium be disturbed? Or, to put the question in other words, what are the possible causes of disturbance? Third, by what mechanism can the disturbance be corrected and the equilibrium be restored?1

Theories of money within a closed community are, in a certain sense, the foundation of “international” theories of money. Since our problem is concerned with international prices and international values of moneys, a knowledge of the theories of money in a closed community is essential to the proper understanding of our problem. Up to about the seventies of the nineteenth century, the development of the theories of money in a closed community was closely connected with the progress of theories of international price relationships. Thus, in our description of earlier writers we have to go briefly into their theories of money.

Moreover, our problem being one of the problems of international economics, it is related to the general theory of international trade. The general theory of international trade goes behind monetary demands and monetary supplies and deals with the more fundamental factors governing international price relationships. It constitutes, in fact, the real foundation for the theory of international price relationships. We, therefore, devote a part of the present survey to the general theory of international trade.

3. A Bird’s-eye View of the History of the Theory of International Price Relationships

In the preceding section we have indicated how the subject of international price relationships might be treated systematically. Unfortunately, it has never been treated upon such lines. The reason is to be found in the fact that theories have been brought forward more as by-products of discussions of practical problems than as results of independent studies. Among the practical problems are sudden and violent rises of prices, variations of rates of exchanges, the effects of the making of a large payment to foreign countries, the desire artificially to increase the national stock of the precious metals, and other national objectives.

We may divide the history of the theory of international price relationships broadly into four periods, in accordance with the nature of those practical problems, the discussions of which are responsible for the development of the theory. The four periods are (1) the mercantilistic period, (2) the classical period, (3) the post-classical period, and (4) the post-war period.2

In the mercantilistic period (i.e. the period from the beginning of the sixteenth century to about the middle of the eighteenth century), people interested in economic problems paid much attention to the question of the national stock of the money metals. They discussed such problems as why a nation should try to increase its stock of precious metals, how a country which did not produce those metals might increase its stock of them, and by what means the metals obtained might be retained. In discussing those problems they went largely into the subject of international price relationships and produced many suggestive views. Firstly, there was general recognition of the fact that there are definite relations among the rate of exchange, the balance of trade, and international specie movements, although opinions in regard to the nature of the relations differed from each other. In the earlier stage, most persons believed that speculation in the foreign exchange market was the main cause of international movements of specie. Gradually, the view that the balance of trade of a country governed the movement of the money metals gained ground. Next, there arose the formulation of the quantity theory of money,3 which connected the supplies of the money metals with the movements of prices. Thirdly, there was the discussion of the problem of the relations between the prices of a trading country and its balance of trade. Opinion was divided between those who believed that “selling dear and buying cheap” would cause a more favourable balance of trade and those who believed that it would cause a less favourable balance. As time went on, the latter view was more generally accepted by the economists of the time. Fourthly, views on those three points were combined to form different doctrines of international price relationships. One of those doctrines was this: A favourable balance of trade would bring precious metals into the country, an inflow of specie meant an increase in the quantity of money at home, an increase in the volume of money at home would raise the prices of all goods, those changes in prices meant “selling dear and buying cheap”, and selling dear and buying cheap would turn the balance of trade against the country. That doctrine is, however, not consistent with the view that a nation should increase its stock of the precious metals. The contradiction involved was noticed at the later stages of the period and attempts were made to escape the difficulty. One group of economists tried to escape from the contradiction by developing the theory that an increase in the volume of money would encourage trade and production, would be accompanied by an increase in the demand for money, and, consequently, would not affect prices and the balance of trade. Another group of economists suggested that, if the government of a country adopted some artificial means to prevent the precious metals imported from influencing prices and trade, the country could continue freely to import those metals.

About the middle of the eighteenth century, the revolt against mercantilism was so strong that this system had to give way to the free trade school. The most important exponents of the doctrines of free trade were the English classical economists. For that reason we call the period (from 1750 to 1848), which succeeded the mercantilistic period, “the classical period.” The earlier stages of the period were characterized by the attempt of the economists of the free trade school to show the impossibility of a country continuing indefinitely to increase its stock of precious metals and the advantages of the international division of labour. Those earlier discussions of the advantages of the international division of labour were followed by the formulation of the classical theory of international trade, which not only demonstrated how trading countries were benefited by trade but also gave a real foundation for the theory of international price relationships. The classical economists, furthermore, gave specific answers to each of the four problems which we have stated in the second section.

During the Napoleonic wars, the abnormal conditions brought about by the wars, e.g. the depreciation of the exchanges and the general rise of prices, naturally evoked much attention in the economic world. The problem of depreciated exchanges narrowed down to the question whether it was the excessive issue of currency or the unfavourable balance of payments which was responsible for the situation. There were three different views. Some thought that the state of the balance of payments was the most important, if not the only, cause of the variations of the rate of exchanges. Others insisted that only monetary factors could be a cause of the disturbance of the rate of exchange. The state of the balance of payments, according to them, would not affect the rate of exchange, because the balance of payments had in itself a tendency to adjust itself and consequently did not require any monetary change or change in the rate of exchange to correct it. Finally, there were many economists who believed that the rate of exchange might be disturbed either by monetary changes or by an adverse balance of international payments. All writers who recognized the monetary factor as a cause of disturbance of the rate of exchange had formed definite ideas concerning the relation between monetary changes and the rate of exchange. They believed in the purchasing power parity doctrine. As to the problem of the general rise of prices, opinions were not divided to the same extent on theoretical points. Most, if not all, of the writers on the subject, agreed in principle that an increase in the volume of money and of bank-notes would lead to a general rise in prices. Many of them, moreover, showed how the increased currency could lead to the rise in prices through an expansion in the volume of lending by the banks.

In the post-classical period, i.e. the period from 1848 to 1918, the development of the theory of international price relationships was first stimulated by the gold discoveries of California and Australia in 1848 and 1851. The gold discoveries called attention to the problem of the effects of an increase in the production of gold upon prices both in the gold producing country and in the countries which do not produce gold. In other words, the gold discoveries stimulated the discussion of the problem of domestic and international price adjustments. In the fifties, emphasis was thrown on the effects of the increased supplies of gold on consumers’ incomes and expenditures, on the prices of factors and on product prices. In the sixties and seventies, economists paid much attention to the role of the market rate of interest in international price adjustments. In the eighties, the mechanism which connected money and prices through changes in the volume of lendings and in the rate of interest was further investigated by a group of English economists. Finally, in the last decade of the nineteenth century, and the beginning of the twentieth century, many excellent restatements of the theory were produced.

In the period since the Great War, there have been two stages: the stage before 1930 and that of the present decade. In the former stage, two problems aroused much attention. They were the rate of exchange of unstable currencies and the corrective mechanism of disturbances in balances of international payments. At first, the discussions of the problem of the rate of exchange of unstable currencies centred on the problem of the initiating cause of exchange depreciation. The theory had been advanced that the state of foreign trade, international capital movements, and other items in the international balance sheet were the source of exchange depreciation. In opposition to that theory, Professor Cassel advanced his version of the purchasing power parity theory. His version is an incorrect one. Later developments are connected mainly with the correction of the mistakes of Professor Cassel.

The problem of the corrective mechanism of disturbances in the balance of payments was discussed with the reparations problem and the problem of international capital movements. Opinions were divided into two groups. One adhered to the classical doctrine. According to that doctrine, an adverse balance of payments of a country would cause a flow of gold out of the country and the outflow of gold meant an increase in the volume of money in foreign countries and a decrease in the volume of money in the country. Those changes in the volumes of moneys would lead to an increase in the prices of goods produced by foreign countries and a fall in the prices of goods produced at home, and consequently imports would be discouraged and exports encouraged and the balance of payments would return to equilibrium. An alternative doctrine was as follows: An adverse balance of payments of a country meant that the aggregate expenditure of the consumers of that country was greater than their aggregate income. The necessary consequence was for those citizens, whose incomes were less than their expenditures, to contract their expenditures on goods. As soon as the expenditure of every individual again equalled his income, the balance of payments of that country would be in equilibrium. Finally, there was the view that the two doctrines were not contradictory of each other and attempts were made to reconcile them.

In the present decade, the theory of international price relationships has taken a new departure with the publication of the works of Professor Ohlin and others. Their main contribution to the theory of international trade is the extension of the mutual-interdependence theory of pricing to the domain of international economics. They investigate the case of joint production, i.e. production with two or more factors of production, and analyse the positions of the demands and supplies of factors of production in the determination of the course of international trade and international price relationships. They also take into due consideration the role of the cost of conveying goods from one country to another.

4. The Plan of the Following Chapters

The following chapters give a general survey of the historical development of the theory of international price relationships. The development of the theory, as already indicated, has been more a by-product of the discussions and controversies on practical problems than the result of specific studies. Few authors have treated the subject systematically. Therefore, we shall not make the logical distinction between the different problems in the theory or between the different aspects of a problem, which we have described in the second section, until it is explicitly or implicitly raised by an author, whose theory we are considering. We shall present each doctrine exactly as each author presented it. Sometimes we shall be unable to do so without going into the details of the controversies over problems of currency, foreign exchanges, commercial policy, etc., which gave rise to the particular theory under examination. Even though the method of presentation involves digression from the subject, the method has two distinct advantages. The first is that the reader is helped to form a correct idea of how the theory was evolved, and the second is that the places of the doctrines in applied economics and their bearing upon the problem of policy are indicated.

In the second chapter, we trace the origin and development of the mercantilistic theories and show to what extent the classical theories were indebted to the mercantilistic writings. The third and the fourth chapters are concerned with the development in the classical period. The third chapter is devoted to the formulation and development of the monetary aspects of the classical theories of international price relationships and to the criticisms levelled against them. The real aspects of the problem and many of the important contributions in the classical period are not dealt with in the chapter. They are dealt with in the fourth chapter, in which we describe the classical theory of international trade and show how it is connected with the classical theory of international price relationships. In the fifth chapter we concern ourselves with the post-classical refinements and restatements of the corrective mechanisms, especially in regard to the effects of an increase of money metals or an increase of bank credits on the price structures of the trading nations. The place of the money rate of interest in international price adjustments is also examined. In the sixth, seventh, and eighth chapters we describe contemporary developments, i.e. developments after 1918. The sixth chapter is concerned with the theories of the exchanges of depreciated currencies; the seventh chapter with the problem of the corrective mechanism of disturbances in the balance of international payments; and the eighth chapter with the development in the present decade. In the concluding chapter we give a brief statement of the present position of the theory.

This inquiry, it must be confessed, is neither comprehensive nor exhaustive. In our historical survey we have selected some authors who had advanced doctrines which, in our opinion, fairly represent the trend of thought of the period in which they lived. The fact that we chose them and not others does not mean that they were the only authors who had advanced those views, nor does it mean that their views were the only views in the period in which they lived. As to the scope of the inquiry, it is limited to the more fundamental aspects of the problem. No attempt, for example, has been made to enter into the effects of international commercial policies (tariffs, quotas, etc.) or of imperfect competition upon the price relations between nations. Furthermore, no details are given of the development of the theory of international cyclical movements of prices, because it is so important that it can be examined only in a separate study.

• 1It is the practice of some economists to divide economic analysis into three departments, viz., statics, comparative statics, and dynamics. Economic statics deals with the conditions of equilibrium, if they exist at all. By conditions of equilibrium we mean those positions in which the price system will remain at rest, once it reaches them, provided that there is no fresh disturbance. That, however, does not imply that conditions of equilibrium must necessarily be reached ultimately by the price system. Comparative statics is concerned with the differences in the conditions of equilibrium in two or more price systems that are due to differences in the given data in the different systems. Economic dynamics deals with the problem, how a change in the fundamental data disturbs the price system and how the disturbances are corrected. It shows us, as Professor Robbins has pointed out, “the actual process of change—the path followed through time between one equilibrium position and the other.” In economic dynamics we have to see whether it is necessary or likely that the original change in data would lead to secondary changes in data. It is mainly because of those secondary changes in data that we have to differentiate between a doctrine of dynamics and one of comparative statics. In the latter we always suppose that when the original data change all other things will remain the same. In dynamics, however, we are not allowed to make the assumption of ceteris paribus.
• 2In dividing history into periods, we find it convenient to use certain dates, but the selected dates are only approximately accurate indicators. Nobody can point to a certain date as marking the exact point of time at which a historical stage or period either terminated or began. Nevertheless, we have to draw some lines of demarcation, however inexact they may be.
• 3The term, quantity theory of money, is sometimes defined as the theory that, in a given period of time, the product of the total volume of goods bought and sold multiplied by the average price of those goods is equal to the volume of the circulation of the medium of exchange. In such general terms, the theory does not indicate whether an increase in the circulation of money would lead to an increase in the volume of the goods or to a rise in their average price. The causal sequence may run either from the volume of the circulation to the average price of the goods transacted, or from the circulation to the volume of those goods. In the strict sense of the term, however, the quantity theory of money assumes the causal relation to run only from the circulation to the average price. We shall, in this essay, use the term in that strict sense. As to the theory that an increase (or decrease) of money would lead to an increase (or decrease) of the volume of goods and transactions, we shall call it “the doctrine that money stimulates trade and production”.