Public Policy Analysis MPA 404 Lecture 25

Previous Lecture Further explanation of Game Theory with examples Article on how Perth tackled its water crisis

Trade We’ve already discussed how trade has proved to be such a beneficial and substantial part of the economic growth of China and India, two of the biggest success stories in terms of economic growth in the world. Same is the case for the other nations of the world. To varying degrees, trade has contributed to their economic growth over time. That is one reason studying trade is so important: without economic growth, its impossible to improve welfare, and trade is a substantial part of this growth story (at least the modern one). The push for economic growth, or the government programs/policies aimed at economic growth, are perhaps the most important aspect of public policy. Put simply, government’s aim to promote the welfare of the masses is the dominant aspect of governance in any country. And this aim is not achievable without exploiting the trade potential. Therefore, following from economic growth, trade policy is part of public policy aimed at enhancing the opportunities, income and thus welfare of the masses (as demonstrated by the graphical analysis in previous lectures).

Trade: The Rationale One of the core beliefs in economics is that voluntary exchange makes everybody better off. International trade is an extension of this concept, whereby nations are better off by exchanging goods with each other. To understand, let’s start with a simple example to illustrate what was stated above. Suppose there are two farmers, Farmer I and Farmer II. Both produce two items, meat and potatoes, which they consume themselves. Time to produce 1 KG of MeatPotato Farmer 130 minutes10 minutes Farmer 210 minutes15 minutes

So what would they be producing in 10 hours? In 5 hours? What will be their consumption bundle without trade and with trade?

Clearly, the above table illustrates that both farmers are better off when they trade with each other. In other words, they can add to their consumption by trading. And that is the very essence of trade: expansion of consumption opportunities or consumption possibilities. We can easily expand the above analysis to countries around the globe. Like farmer I and farmer II, countries can expand their consumption choices by trading with other countries. Absolute Advantage, Comparative Advantage and Specialization The concept and discussion of trade would be incomplete without the discussion of absolute and comparative advantage. Absolute advantage, in terms of trade, relates to the total quantity produced. In the above example, farmer I has an absolute advantage in the production of potatoes (he produces more), while farmer II has an absolute advantage in the production of meat. Yet even if a country has an absolute advantage in the production of everything, it may still choose to produce only a certain amounts of goods and import other goods from other countries. The reason is Comparative advantage.

In economic terminology, comparative advantage is derived from the concept of Opportunity cost, which is the cost of next best alternative. In simple words, when people look at comparative advantage (and opportunity cost), they think in terms of cost. A country has a comparative advantage in a product if it can produce that product at a lesser cost than others. The concept of comparative advantage was first discussed by David Ricardo, an economist and member of British legislature in the 19 th century. An implication of this concept is that countries should produce that good in which their opportunity cost is low. Recognizing this, Ricardo suggested that England should produce wool and Portugal should produce wine, and trade it with each other. Modern day examples of practical implication of absolute and comparative advantage are many, and easily visible. Take the example of USA, the world’s biggest economy and arguably the most technologically advanced society producer. There is no doubt that if its producers or government want, they can produce most of the goods in a larger quantity compared to many other countries in the world. But they choose not to. For example, they can produce more agricultural products in quantity than most of the other nations of the world. Yet US imports most of the agricultural products from other countries. The reason is that their opportunity cost of producing agricultural products is more compared to the other countries. In other words, the US does not have a comparative advantage in the production of agricultural goods. Instead, its economy enjoys comparative advantage in the production of other goods (services, banking, industry, military hardware, technology, education, etc). Thus, they resort to producing/consuming those goods.