Public Policy Analysis

MPA 404 Lecture 26

Previous Lecture Brief

Trade and why it is so important

The example of trade leading to increase in consumption

The concept of absolute and comparative advantage

The concept of specialization

This argument is true for all other countries of the world, at least theoretically. There are, of course, other factors that affect trade between countries. For example, politics and history may stop countries from trading with each other, although there may be advantage to both. India and Pakistan can certainly benefit by trading with each other, but politics usually does not allow that to happen.

Opportunity cost, and comparative advantage, lead to another important implication: specialization. It is a matter of common observation that all people in a locality, region, country or the globe do not perform a single function. Instead, people perform different functions, and have different jobs in which they specialize. Even inside a particular field, there are numerous specializations. For example, in the field of industry, people specialize in various fields like machinery, industrial engineering, production, defense, food and beverages, etc. This concept of specialization is usually traced to Adam Smith, who gave the famous example of production of pins in a factory. He mentioned how the production involves different stages and different people (who specialize in rolling, straightening and polishing), although he never mentioned that this specialization came about due to the concept of opportunity cost (it was first stated by Ricardo).

Showcasing comparative advantage through example

Consider the following table and calculations.

Meat Potatoes

Farmer 8 32

Rancher 8 16

Another simple example of calculating a comparative advantage.

Country A Country B

Cars 30 m 35 m

Trucks 6 m 21m

Another Example.

Country A Country B

Wheat 200 50

TV’s 100 50

The sources of comparative advantage: The case of comparative advantage and its role in specialization and productivity was stated above. But what gives rise to comparative advantage? Some of the sources of accumulating a comparative advantage are listed below.

Natural Endowments The case of natural endowments leading to comparative advantage was first discussed by David Ricardo, who used the above cited example of Portugal and England. Since England was naturally endowed with an environment and soil that was favorable to raising cattle and sheep, and Portugal was endowed with an environment and soil that was conducive to growing grapes, England would be better off by producing wool and Portugal by producing wine. Hence, in this way, natural endowments may lead to specialization.

Acquired Endowments Countries like Japan represent cases where comparative advantage can be garnered by acquiring resources from the outside, and then producing products in which it specializes. Japan has little or no resource like oil or steel of its own, but imports it and uses its superior human capital (technology, highly educated workers, etc) to make cars in which it specializes.

Superior Knowledge This comes from having education institutions that offer high quality education, a well developed R&D base, and continuous investment in research to innovate and further improve. The research and human capital is then diverted to a specific field for productivity improvements.

Specialization Comparative advantage leads to specialization, but specialization can also lead to development of a comparative advantage. In technical terms, it’s two-way causality. The Swiss have been making watches for a long time, and over time, developed a specialty in them to the extent that it gave them a comparative advantage.

Geography and Complementarity Suppose a place has a particular natural resource, which has a high demand outside that place. But due to low human capital, poor infrastructure, technological backwardness, etc, it cannot develop or exploit that resource. It might happen that outsiders, who want that resource in order to make use of it for their advantage, would come to that area, transfer their technology and knowhow to the local populace, develop the infrastructure, etc. in the process, the area would develop a comparative advantage in that resource. The clearest example is of oil producing countries like Saudi Arabia. They were once extremely backward in terms of development indicators, but had oil which became so precious after the invention of motor car. Thus, the outsiders came to these poor countries to exploit oil, and over time, it has resulted in these particular countries developing a comparative advantage in oil and oil related products.