The Influence Of Transport Costs

6. In the previous analysis I have neglected transport costs. However, the consideration of these does not affect the essentials of the problem we are examining.

Following Marshall, we may consider them as an element of the total supply prices of the goods concerned.f If C and I are, respectively, the domestic prices • Suppose that in equilibrium conditions 3,600 units of cotton were exchanged for 6,000 of iron, the volume of trade being thus reduced by one-half compared with the former assumed conditions. Let us suppose, as before, R = 6, and the same elasticity for both demand curves (= — 2). The payment of 120,000 units of Egyptian money by Egypt to Germany would then cause the exchange rate to increase from 6 to about 6 ■ 67.

t The Pure Theory of Foreign Trade (Series of reprints of scarce tracts: London School of Economics, vol. i, 1930, p. 2).

for cotton and iron, and xC and yl are the cost of transporting a unit of each commodity, then the total supply prices will be C(i + x) and /(i + y). If, further, we suppose that each country carries its own goods to the other country, equation (4) may be written in a slightly modified form:

We have, therefore:

This equation shows that R depends also on the ratio of transport costs.

I he real terms of trade are not — but —--. The factors — and ---,

however, are not independent. If, for instance, x increases, it means that the

supply price of cotton delivered in Germany increases. This will affect —, in different measures according as Germany's demand for cotton, has an elasticity equal to, greater than, or less than, unity. In the first case the value of M(i + x)

—-r remains unchanged, and the value of R is therefore not affected by

the change in the cost of transport. In the second case the value of 777———\

increases, and Egypt's money depreciates in terms of marks; while the converse happens in the third case.*

It will be observed that the expression-—-indicates the price of cotton in Germany, in terms of German money. Indeed, for Germans, the price of one cotton unit is equal to the price of one iron unit (including transport costs) multiplied by the number of iron units which must be given for one cotton unit. From equation (10) we have, therefore, if the price of cotton in Germany in terms of German money is indicated by Cm,

that is to say the rate of exchange between piastres and marks is equal to the ratio of the price of cotton in terms of piastres to the price of cotton in terms of marks, allowing for cost of transport.!

iv. exchange rates in the case of very elastic schedules of international demand for commodities 7. Up to this point we have considered two countries which, by hypothesis, produced and exported different commodities. We have seen that variations

* It is obvious that not only changes in transport costs, but any other non-monetary cause resulting in changes in supply prices, will affect R in the sense described in the text.

f Formula (10) is given by Professor Pigou in "The Foreign Exchanges" (Quarterly Journal of Economics, November 1922, p. 37). As shown in the text this can be easily deduced from Formula (9).

in the international demand for goods, or payments caused by non-merchandise transactions, can cause considerable divergences between the internal and external value of a currency. When, as actually happens, many countries trade together and the transactions cover a great variety of goods, the variations of the foreign exchange of a country, caused by fluctuations in the home demand for a given commodity, provoke reactions in the international demand for other

goods, which puts a limit to the variations of the factor — in equation (6) and x>

therefore to the variations of the exchange rate. Moreover, if the variations of factor are much greater—as happened in many countries during and after o the World War because or the monetary inflation—the variations of the second factor of equation (6) can be regarded as insignificant as compared with those of the first factor.

8. Now there is a further problem. It may be that country X produces some goods of international character which are identical with those produced by other countries. If the exchange rate of X is permanently depreciated it means that prices, computed in gold, of these goods will be permanently lower in X than in the world market. But how is this possible in view of the tendency for the equalization of world prices ?

To this one can reply that often the various countries which produce goods of the same name actually produce different articles.* That applies especially to manufactured articles but often, also, to products of the soil. Egyptian cotton is different from that of America and India. Now, it is true that a correlation exists between the prices of all varieties of the same commodity, but experience shows that differences in prices between single varieties can fluctuate considerably, more or less in proportion to the possibility of substituting one kind for another. For example, the depreciation of Egyptian money after September 1931 resulted in a fall in the gold price of Egyptian cotton. This fall was smaller in the price of that variety of cotton (Ashmouni) which is most nearly interchangeable with American cotton.

If different countries produce the same goods, then the articles in question are often produced under conditions of increasing cost. Let us suppose that the marginal cost of wheat in Egypt in Egyptian money is 120 and in Germany in German money, 20. If, following a rise in the Egyptian demand for iron, the external value of Egyptian money falls, the export of wheat from Egypt to Germany will be stimulated. The production of wheat will be increased in Egypt and lessened in Germany; therefore the marginal cost rises in the former country and falls in the latter. In the new situation of equilibrium we shall have, for example, the price of wheat in Egypt: 121-5; in Germany, i9'6; exchange rate, 6 '20. (In this argument no account is taken of transport costs.)

It will be observed that, again, the German price is equal to the Egyptian price multiplied by the rate of exchange. But the statement, which is often made, that the Purchasing Power Parity doctrine is valid for international commodities, would be rather misleading in the case just considered. The

Taussig, Principles of Economics, New York, 1925, vol. i, p. 492.

essence of this doctrine is to show, in the words of the Bullion Report, that the course of exchange with foreign countries forms "the best general criterion from which any inference can be drawn as to the sufficiency or excess of paper money in circulation." Now, in the case of international commodities the equivalence between exchange rates and price ratios always holds true (ignoring costs of transport and other expenses); but if the conditions of international demand vary, exchange rates will also vary, even when the monetary conditions of the countries concerned remain constant, so that exchange rates are no longer the index of these conditions.

9. Moreover, the fact that a country, X, produces—or is able to produce—in large quantities goods of an international character which are similar to those produced by other countries, has a great influence on the foreign exchange value of that country's currency. Indeed, it makes more elastic the foreign demand for goods produced by X as well as the demand for foreign goods by X. Consequently, as soon as X's money falls in external value, owing to an increase in the demand for some foreign goods by X or following the payment of a tribute, a big rise in the foreign demand for goods from X is stimulated and at the same time the demand for other foreign goods by X is restricted. These reactions tend to moderate the effects on the barter terms of trade and on the foreign exchanges of the initial disequilibrium of the balance of payments. However, the original rate of exchange will not be restored. For at this rate the country under consideration would again have an unfavourable balance of trade, which would again bring about a depreciation of her currency. The increase in the demand for foreign goods, which we assumed at the outset, will therefore exercise a permanent influence on the barter terms of trade and on exchange rates. This influence, which had been ignored by the supporters of an extreme Purchasing Power Parity doctrine, has been well pointed out by Professor Taussig and other economists. But it seems to me that too little stress has been laid by some critics of Cassel's theory on the fact that the shifts in exchange rates will be kept within narrow limits when international demand schedules are very elastic. In many countries the great bulk of exports and imports consists of competitive articles. Therefore the elasticities of international demand will tend to be very high even if the articles concerned (wheat, cotton, sugar, etc.) are of such a kind that the domestic demand for them has little elasticity.

Also in the case when a country on a paper-money basis has to make remittances abroad arising out of non-merchandise operations as interest payments, war indemnities, loans and the like, neither the barter terms of trade nor the exchange rates will be substantially affected in the long run (even if the debtor country has to transfer large sums), when the foreign demand for the goods of the country concerned and its own demand for imported goods are very elastic. Now, as Marshall showed, this is the case for a great modern industrial country—Germany is one such—with great resources. In this case the Purchasing Power Parity theory is approximately valid, when it refers to exportable commodities.

In conclusion, there is a fundamental difference between the methods of action of the two factors which influence foreign exchanges in the case of a paper standard. A fall in the internal value of a currency tends to be reflected to its full extent, without any modification, on the foreign exchanges. A change of the balance of payments, on the other hand, provokes compensations which substantially limit the effect of it on the exchanges.

v. relations between exchange rates and prices of domestic commodities

10. No explicit mention has been made so far of domestic commodities. It is clear that, there is no necessary relation between exchange rates and the absolute prices of such domestic commodities as, owing to difficulties of transport or from other causes, have but a local market. However, if we compare, not absolute exchange rates and absolute commodity prices, but indices of exchange rates and prices, which measure percentage changes from the positions of a base year, it might be asked whether formula (6) holds good, when we substitute indices of domestic prices for those of export prices.

It is clear that this substitution involves the assumption that, when the price-level of a country varies from monetary causes, both the prices of domestic and of exported commodities are affected in a uniform way, so that their percentage changes are the same.

Now, as Mr. Keynes observes, in the assumption that different price-levels will move in the same way, there is "an important element of truth, when the initial disturbance has been of a monetary character."* In fact, when the prices of export goods rise more than those of domestic goods, labour and capital will shift towards the production of the former class of goods; and the converse will happen when prices of export goods are lower than those of domestic goods. But—though the direction of the changes in the prices of both categories of goods will tend to be the same—the extent of the change will generally be different, even if the conditions of international demand do not change. The reasons for the failure of different price-levels to move together are clearly explained by Mr. Keynes.

We may therefore conclude that, generally speaking, formula (6) will be at best only approximately valid if we substitute for U and S the indices of domestic prices (for instance cost of living indices) in the countries concerned, or a compound index of general prices (prices of domestic and export commodities jumbled together).

11. In conclusion, there is no doubt that an appreciable divergence can be established in certain conditions and maintained even for a considerable time between the external value of a paper currency and its internal value, measured by the prices of domestic goods. This divergence is, besides, often the symptom of a situation which, though it may last for a considerable time, is likely in the long run to develop some counteracting tendencies. Suppose that X exports only one commodity, the foreign demand for which diminishes. The external value of X's currency will fall substantially, owing to the fact that X does not produce other goods suitable for export. Wages and prices of domestic commodities will be comparatively low in X, in terms of foreign currencies. As long as deficiency of technical knowledge, transport difficulties, the inability of X's

producers to adapt their articles to the requirements of foreign purchasers, lack of an export organization and of foreign knowledge of X's articles, or many other possible causes, prevent an expansion of X's exports, the situation described above will last; but it will surely change little by little under the stimulus of low wages and low domestic prices. That is to say, little by little X will attempt to develop new branches of economic activity, thus replacing more and more, on the one hand, foreign commodities by domestic ones, and, on the other hand, exporting new articles. (Something like that is now happening in Egypt.) It may also be that X becomes a promising field for investment. In this way, by degrees, exchange rates will become less unfavourable to X and its prices in terms of foreign currencies will be brought nearer to the level of foreign prices.

We may therefore conclude that as long as there is a considerable discrepancy between exchange rates and price parities, there is no really stable equilibrium either in trade or in production or as regards the international value of the paper standards. While the Purchasing Power Parity doctrine proves quite inadequate to describe the facts observed in short periods, it acquires more significance when we consider it as the expression of fundamental forces acting for longer periods.*

* For a more detailed treatment of the subject of this Appendix the reader is referred to the author's paper, "The Purchasing Power Parity Doctrine" (Egypte Contemporaine, vol. xxv, Cairo, 1934).

CHAPTER III*

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