0:00:09.566,0:00:14.310
- In our last video Don Boudreaux[br]used the simple example of Bob and Anne to

0:00:14.490,0:00:18.740
demonstrate comparative advantage. In the[br]next two videos we'll dive deeper into

0:00:18.920,0:00:22.100
comparative advantage, and give you a[br]homework question to test how well you're

0:00:22.280,0:00:25.532
doing in understanding the concept.[br]Let's get going.

0:00:30.092,0:00:34.070
- Comparative advantage is the[br]theory of trade. It explains why people

0:00:34.250,0:00:40.060
trade, and which good people should trade[br]if they want to maximize their well being.

0:00:40.240,0:00:44.520
It's actually useful to understand[br]comparative advantage to begin with a

0:00:44.700,0:00:49.290
false theory. Every plausible but[br]incorrect theory of trade namely the

0:00:49.470,0:00:53.900
theory of absolute advantage. So let's[br]consider a simple model. Let's supposed

0:00:54.080,0:00:58.180
that labor is the only good use in[br]production and that we can produce

0:00:58.360,0:01:04.390
computers or shirts. Let's supposed that[br]in Mexico it takes 12 units of labor to

0:01:04.569,0:01:07.905
produce one computer. Again in Mexico,

0:01:07.905,0:01:11.800
it takes two units of labor[br]to produce one shirt.

0:01:11.980,0:01:15.280
Now let's compare it with the United[br]States. To make it simple, we'll suppose

0:01:15.460,0:01:20.470
in the United States it takes just one[br]unit of labor to make one computer, and

0:01:20.650,0:01:27.610
one unit of labor to create one shirt.[br]Now, from the absolute advantage theory of

0:01:27.790,0:01:32.830
trade, it should-- it may seem obvious[br]that there in fact will be no trade here.

0:01:33.010,0:01:38.660
It may seem obvious that the United[br]States will out compete Mexico on all

0:01:38.840,0:01:44.160
margins. After all, the United States in[br]this example is much more productive at

0:01:44.340,0:01:48.350
producing computers and also more[br]productive at producing shirts than

0:01:48.530,0:01:53.090
Mexico. So this is a case where we might[br]think with the United States is so much

0:01:53.270,0:01:58.480
better at producing both computers and[br]shirts that certainly there's no reason

0:01:58.660,0:02:06.290
for the United States to trade with[br]Mexico, it's less productive neighbor.

0:02:06.470,0:02:11.770
That's the theory of absolute advantage,[br]it's very plausible, it's also very wrong.

0:02:11.950,0:02:15.780
To see why it's wrong, let's take another[br]simple example. Here's a picture of Martha

0:02:15.960,0:02:21.400
Stewart ironing her shirt. Now, let's[br]stipulate that Martha Stewart has an

0:02:21.580,0:02:26.300
absolute advantage in ironing. She has an[br]advantage in ironing just like the United

0:02:26.480,0:02:30.340
States had an advantage in producing[br]computers and shirts in the previous

0:02:30.520,0:02:33.657
example. In other words, we'll stipulate[br]that Martha Stewart

0:02:33.657,0:02:38.705
can iron a shirt better and in[br]less time than anyone else.

0:02:38.800,0:02:43.186
So if Martha Stewart has an[br]absolute advantage in ironing

0:02:43.200,0:02:50.010
should Martha Stuart iron her own[br]shirts? Of course the answer here is, no.

0:02:50.190,0:02:56.110
Why not? Well every hour which Martha[br]Stuart Spends ironing her shirts is an

0:02:56.290,0:03:01.410
hour she's not spending doing something[br]else which is even more valuable, running

0:03:01.590,0:03:06.530
her own business for example. Running her[br]billion dollar business, and in fact in a

0:03:06.710,0:03:11.520
famous statement, Martha Stuart because[br]she's very wise she said, "I don't always

0:03:11.700,0:03:16.490
do all of my own ironing, even though I[br]wish that I could." Let's take a little

0:03:16.670,0:03:21.120
bit more detail about why it doesn't make[br]sense for Martha Stuart to iron her own

0:03:21.300,0:03:27.190
shirts. The most important point to[br]remember is that the important cause is

0:03:27.370,0:03:32.470
opportunity cost. So what is the[br]opportunity cost of Martha Stewart of

0:03:32.650,0:03:37.330
spending an hour ironing her own shirts?[br]Well, it could be thousands of dollars, at

0:03:37.510,0:03:43.700
least. Martha Stewart would be better off[br]if she specializes in producing her

0:03:43.880,0:03:48.580
television show, and then she trade with[br]someone else who has a lower opportunity

0:03:48.760,0:03:54.360
cost of ironing. It doesn't make sense for[br]Martha Stewart to iron her own shirts

0:03:54.540,0:03:59.200
because the cost of her doing so is[br]devoting her time to something where she's

0:03:59.380,0:04:05.000
even more valuable or she even better and[br]that is producing her own television show.

0:04:05.180,0:04:11.050
So Martha Stewart has a comparative[br]advantage in running her business, or to

0:04:11.230,0:04:15.910
put it slightly differently she has a[br]comparative disadvantage in ironing. The

0:04:16.089,0:04:21.810
cost of her of ironing is very high[br]precisely because she is so much more

0:04:21.990,0:04:28.970
productive at other tasks. So Martha[br]Stewart wants to specialized in what she

0:04:29.150,0:04:34.840
is most best at in where she has a[br]comparative advantage. Other people who

0:04:35.020,0:04:40.590
are almost as good as her at ironing[br]clothes but they're not as good as her at

0:04:40.770,0:04:44.466
producing her own TV show. So that's why[br]Martha Stewart shouldn't

0:04:44.466,0:04:46.069
iron her own shirts.

0:04:46.600,0:04:51.660
Let's go back now to our previous example[br]of the United States and Mexico. So the

0:04:51.840,0:04:55.870
key to comparative advantage is[br]understanding opportunity cost. So let's

0:04:56.050,0:05:00.810
take this previous figure we had from a[br]previous slide and turn it into an

0:05:00.990,0:05:06.280
opportunity cost figure. So remember what[br]this top figure tells us, it tells us for

0:05:06.460,0:05:11.210
example that in Mexico it takes 12 units[br]of labor to produce one computer, and in

0:05:11.390,0:05:16.230
Mexico it takes two units of labor to[br]produce one shirt and so forth. Okay, for

0:05:16.410,0:05:19.220
the United States, it just takes one unit[br]of labor to produce either

0:05:19.220,0:05:21.085
a computer or a shirt.

0:05:21.400,0:05:27.460
Okay, now let's begin with an easy case.[br]What's the opportunity cost of one

0:05:27.640,0:05:34.080
computer in the United States? In other[br]words, to produce an additional computer

0:05:34.260,0:05:38.780
in the United States, what would we have[br]to give up? Well, in order to get that

0:05:38.960,0:05:43.070
additional computer, we'd have to take[br]labor from shirt production and move it

0:05:43.250,0:05:47.760
into computer production. In particular,[br]we have to take one unit of labor from

0:05:47.940,0:05:53.280
shirt production and move it into computer[br]production. That would get us one more

0:05:53.460,0:05:58.970
computer at the cost of one shirt. So the[br]opportunity cost of one computer in the

0:05:59.150,0:06:04.390
United States is one shirt.[br]What is the opportunity cost of a shirt?

0:06:04.570,0:06:08.250
Well, the opportunity cost of a shirt,[br]what you're giving up to produce an extra

0:06:08.430,0:06:15.640
shirt is one computer. Okay, slightly[br]harder case, what's the opportunity cost

0:06:15.820,0:06:23.030
of one computer in Mexico? So in Mexico,[br]in order to get an additional computer,

0:06:23.210,0:06:28.210
you'd have to transfer labor from shirt[br]production into computer production. But

0:06:28.390,0:06:32.160
how many units of labor you need to[br]transfer? You need to transfer 12 units of

0:06:32.340,0:06:37.270
labor in order to get one computer, you're[br]going to have to take 12 units of labor

0:06:37.450,0:06:42.830
from shirt production. That means how many[br]fewer shirts? Since it takes two units of

0:06:43.010,0:06:48.160
labor to produce one shirt, and you've got[br]to move 12 units of labor. It means that

0:06:48.340,0:06:53.820
the opportunity cost of one computer is[br]six shirts. If you need an additional

0:06:54.000,0:06:59.940
computer, it's going to cost you six fewer[br]shirts in order to get that computer.

0:07:00.120,0:07:03.700
Going the other way, in order to get an[br]additional shirt, you're going to have to

0:07:03.880,0:07:10.270
give up one-sixth of a computer. Okay, so[br]now we have our opportunity cost, and now

0:07:10.450,0:07:14.970
it's actually pretty simple because what[br]the theory of comparative advantage says

0:07:15.150,0:07:20.990
is that you should produce, or you can[br]produce at lowest cost. So who here has

0:07:21.170,0:07:28.230
the lowest cost of producing a computer?[br]The lowest cost of producing a computer is

0:07:28.410,0:07:32.760
the United States. The United States is[br]the low opportunity cost producer of

0:07:32.940,0:07:42.870
computers. Now, who is the low cost[br]producer of shirts? Well, it's Mexico. In

0:07:43.050,0:07:47.980
Mexico, you're only giving up one-sixth of[br]a computer to produce a shirt. In the

0:07:48.160,0:07:51.720
United States, you're giving up one[br]computer to produce a shirt. So you'd much

0:07:51.900,0:07:59.050
rather produce shirts in Mexico where the[br]opportunity cost is lower. Okay, what

0:07:59.230,0:08:05.470
we're learning here is that Mexico ought[br]to specialize in computers because they're

0:08:05.650,0:08:10.530
the low cost producer of-- excuse me, in[br]shirts because they're the low cost

0:08:10.710,0:08:14.250
producer of shirts. The United States[br]ought to specialize more

0:08:14.430,0:08:19.810
towards computers because they're the low[br]cost producer of computers. Let's look in

0:08:19.990,0:08:24.200
more detail. So I'm going to leave some of[br]the details to you actually and some

0:08:24.380,0:08:28.180
homework questions which will go over in[br]the future video.

0:08:28.360,0:08:32.250
So question one, let's supposed in Mexico[br]and in the United States each have 24

0:08:32.429,0:08:38.049
units of labor, and that each devote 12[br]units of labor to producing computers and

0:08:38.230,0:08:43.240
12 units of labor to producing shirts.[br]That will be our base line scenario.

0:08:43.419,0:08:47.228
The question is, "What is total world[br]production in this scenario?"

0:08:47.228,0:08:48.802
That's question one.

0:08:48.802,0:08:54.590
Question two, supposed that Mexico[br]specializes in producing what it produces

0:08:54.770,0:08:59.200
at lowest opportunity cost, we just saw[br]that was shirts and supposed that the U.S.

0:08:59.380,0:09:05.020
transfers two units of labor from shirts[br]to producing what it produces at lowest

0:09:05.200,0:09:11.850
opportunity cost, that's computers. What[br]it then is total world production?

0:09:12.030,0:09:16.860
Finally, can trade make both countries[br]better off? Here what I'd like you to do

0:09:17.040,0:09:22.580
is give a concrete example of how many[br]units have to be traded from where to

0:09:22.760,0:09:27.350
where in order to make both countries[br]better off, if that in fact is possible.

0:09:27.530,0:09:31.610
So to help you along a little bit, I know[br]that was a mouthful. Let's take a look at

0:09:31.790,0:09:37.500
this in terms of a diagram. To help you[br]along, I want you to fill in these tables.

0:09:37.680,0:09:42.520
So our basic table from which you're going[br]to draw the information is up here. If

0:09:42.700,0:09:47.090
both countries have 24 units of labor,[br]half devoted to computers, half to shirts.

0:09:47.270,0:09:52.220
There's no trade so production is equal to[br]consumption in this first example. What is

0:09:52.400,0:09:53.940
production going to be?

0:09:54.120,0:09:57.990
So Mexico, 12 units of labor with[br]computers, 12 shirts. How many computers,

0:09:58.170,0:10:00.260
how many shirts? Same for the United[br]States.

0:10:00.440,0:10:04.820
How many computers? How many shirts?[br]What's total world production? Then

0:10:05.000,0:10:08.920
supposed we have specialization, what's[br]production is going to be? So Mexico has

0:10:09.100,0:10:14.430
zero units of labor in computers, 24 in[br]shirts. United States has 14 units of

0:10:14.610,0:10:19.200
labor in computers, 10 in shirts. What's[br]production in each cases? What is the

0:10:19.380,0:10:25.010
total for the world? Then finally, can[br]we-- with production, with specialization,

0:10:25.190,0:10:31.360
can we now find a way to have trade which[br]make both countries better off? What's the

0:10:31.540,0:10:35.760
exact-- or what a exact price ratio with[br]that trade will occur.

0:10:35.940,0:10:40.370
We'll take that up in an later video. Let[br]me just finally give you some concluding

0:10:40.550,0:10:42.353
comments on comparative advantage.

0:10:43.400,0:10:46.900
I want to conclude with the caution but[br]also a big picture of view of comparative

0:10:47.080,0:10:50.950
advantage. In the two country first in[br]examples, I've been working with in order

0:10:51.130,0:10:56.240
to explain the theory. Everyone is made[br]better off by trade. In larger examples,

0:10:56.420,0:11:00.720
trade will increase aggregate wealth, but[br]some individuals can be made where it's

0:11:00.900,0:11:06.270
off. That should make perfect sense after[br]all. If A and B have been trading, and

0:11:06.450,0:11:10.900
then because terrace cost fall or because[br]transportation cost fall. If A starts

0:11:11.080,0:11:16.130
trading with C, then B maybe worse off,[br]even though A, B and C together have

0:11:16.310,0:11:19.990
greater aggregate wealth. That's just a[br]caution to keep in mind.

0:11:20.170,0:11:24.630
Now here's the big picture. Comparative[br]advantage, it applies to people, to

0:11:24.810,0:11:29.730
groups, to countries, and sometimes called[br]the law of association. It's not only a

0:11:29.910,0:11:34.730
beautiful theory. It's very positive and[br]optimistic theory because it says that we

0:11:34.910,0:11:41.010
all have something to gain from trade. It[br]says by working together, we can increase

0:11:41.190,0:11:47.460
total wealth. More over we can-- I like to[br]phrase this in terms of a politically

0:11:47.640,0:11:52.690
correct slogan. "Diversity is strength",[br]you've probably heard that slogan before.

0:11:52.870,0:11:58.230
What comparative advantage adds to this is[br]that diversity and strength when combined

0:11:58.410,0:12:04.086
with trade, its trade which turns[br]diversity into strength.

0:12:04.360,0:12:06.882
That's really the bottom line on[br]comparative advantage.

0:12:06.882,0:12:09.839
We'll be saying more in future videos.[br]Thanks.

0:12:11.629,0:12:14.071
- If you want to test[br]yourself, click Practice Questions

0:12:15.022,0:12:18.361
or if you're ready to move on,[br]just click Next Video.