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- In our last video, Don Boudreaux
used the simple example of Bob and Anne to

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demonstrate comparative advantage. In the
next two videos, we'll dive deeper into

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comparative advantage and give you a
homework question to test how well you're

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doing in understanding the concept.
Let's get going.

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- Comparative advantage is the
theory of trade. It explains why people

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trade, and which good people should trade
if they want to maximize their well being.

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It's actually useful to understand
comparative advantage to begin with a

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false theory: a very plausible but
incorrect theory of trade, namely the

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theory of absolute advantage. So let's
consider a simple model. Let's suppose

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that labor is the only good used in
production and that we can produce

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computers or shirts. Let's suppose that
in Mexico it takes 12 units of labor to

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produce one computer. Again in Mexico,

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it takes two units of labor
to produce one shirt.

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Now let's compare it with the United
States. To make it simple, we'll suppose

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in the United States it takes just one
unit of labor to make one computer, and

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one unit of labor to create one shirt.
Now, from the absolute advantage theory of

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trade, it should-- it may seem obvious
that there in fact will-- be no trade here.

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It may seem obvious that the United
States will outcompete Mexico on all

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margins. After all, the United States in
this example is much more productive at

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producing computers and also more
productive at producing shirts than

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Mexico. So this is a case where we might
think, with the United States so much

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better at producing both computers and
shirts, that certainly there's no reason

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for the United States to trade with
Mexico, its less productive neighbor.

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That's the theory of absolute advantage.
It's very plausible; it's also very wrong.

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To see why it's wrong, let's take another
simple example. Here's a picture of Martha

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Stewart ironing her shirt. Now, let's
stipulate that Martha Stewart has an

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absolute advantage in ironing. She has an
advantage in ironing just like the United

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States had an advantage in producing
computers and shirts in the previous

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example. In other words, we'll stipulate
that Martha Stewart

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can iron a shirt better and in
less time than anyone else.

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So if Martha Stewart has an
absolute advantage in ironing

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should Martha Stuart iron her own
shirts? Of course the answer here is, no.

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Why not? Well, every hour which Martha
Stuart Spends ironing her shirts is an

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hour she's not spending doing something
else which is even more valuable, running

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her own business for example, running her
billion dollar business. And in fact in a

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famous statement, Martha Stuart because
she's very wise she said, "I don't always

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do all of my own ironing, even though I
wish that I could." Let's take a little

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bit more detail about why it doesn't make
sense for Martha Stuart to iron her own

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shirts. The most important point to
remember is that the important cause is

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opportunity cost. So what is the
opportunity cost to Martha Stewart of

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spending an hour ironing her own shirts?
Well, it could be thousands of dollars, at

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least. Martha Stewart would be better off
if she specializes in producing her

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television show, and then she trades with
someone else who has a lower opportunity

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cost of ironing. It doesn't make sense for
Martha Stewart to iron her own shirts

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because the cost of her doing so is
devoting her time to something where she's

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even more valuable or she even better and
that is producing her own television show.

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So Martha Stewart has a comparative
advantage in running her business, or to

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put it slightly differently she has a
comparative disadvantage in ironing. The

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cost of her of ironing is very high
precisely because she is so much more

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productive at other tasks. So Martha
Stewart wants to specialize in what she

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is best at, in where she has a
comparative advantage. Other people

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are almost as good as her at ironing
clothes, but they're not as good as her at

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producing their own TV show. So that's why
Martha Stewart shouldn't

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iron her own shirts.

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Let's go back now to our previous example
of the United States and Mexico. So the

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key to comparative advantage is
understanding opportunity cost. So let's

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take this previous figure we had from a
previous slide and turn it into an

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opportunity cost figure. So remember what
this top figure tells us: it tells us for

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example that in Mexico it takes 12 units
of labor to produce one computer, and in

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Mexico it takes two units of labor to
produce one shirt and so forth. Okay, for

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the United States, it just takes one unit
of labor to produce either

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a computer or a shirt.

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Okay, now let's begin with an easy case.
What's the opportunity cost of one

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computer in the United States? In other
words, to produce an additional computer

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in the United States, what would we have
to give up? Well, in order to get that

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additional computer, we'd have to take
labor from shirt production and move it

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into computer production. In particular,
we have to take one unit of labor from

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shirt production and move it into computer
production. That would get us one more

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computer at the cost of one shirt. So the
opportunity cost of one computer in the

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United States is one shirt.
What is the opportunity cost of a shirt?

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Well, the opportunity cost of a shirt,
what you're giving up to produce an extra

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shirt, is one computer. Okay, slightly
harder case, what's the opportunity cost

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of one computer in Mexico? So in Mexico,
in order to get an additional computer,

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you'd have to transfer labor from shirt
production into computer production. But

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how many units of labor do you need to
transfer? You need to transfer 12 units of

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labor in order to get one computer. You're
going to have to take 12 units of labor

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from shirt production. That means how many
fewer shirts? Since it takes two units of

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labor to produce one shirt, and you've got
to move 12 units of labor. It means that

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the opportunity cost of one computer is
six shirts. If you need an additional

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computer, it's going to cost you six fewer
shirts in order to get that computer.

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Going the other way, in order to get an
additional shirt, you're going to have to

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give up one-sixth of a computer. Okay, so
now we have our opportunity cost, and now

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it's actually pretty simple because what
the theory of comparative advantage says

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is that you should produce, or you can
produce at lowest cost. So who here has

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the lowest cost of producing a computer?
The lowest cost of producing a computer is

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the United States. The United States is
the low opportunity cost producer of

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computers. Now, who is the low cost
producer of shirts? Well, it's Mexico. In

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Mexico, you're only giving up one-sixth of
a computer to produce a shirt. In the

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United States, you're giving up one
computer to produce a shirt. So you'd much

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rather produce shirts in Mexico where the
opportunity cost is lower. Okay, what

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we're learning here is that Mexico ought
to specialize in computers because they're

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the low cost producer of-- excuse me, in
shirts because they're the low cost

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producer of shirts. The United States
ought to specialize more

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towards computers because they're the low
cost producer of computers. Let's look in

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more detail. So I'm going to leave some of
the details to you actually and some

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homework questions which will go over in
the future video.

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So question one, let's supposed in Mexico
and in the United States each have 24

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units of labor, and that each devote 12
units of labor to producing computers and

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12 units of labor to producing shirts.
That will be our base line scenario.

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The question is, "What is total world
production in this scenario?"

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That's question one.

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Question two, supposed that Mexico
specializes in producing what it produces

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at lowest opportunity cost, we just saw
that was shirts and supposed that the U.S.

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transfers two units of labor from shirts
to producing what it produces at lowest

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opportunity cost, that's computers. What
it then is total world production?

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Finally, can trade make both countries
better off? Here what I'd like you to do

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is give a concrete example of how many
units have to be traded from where to

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where in order to make both countries
better off, if that in fact is possible.

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So to help you along a little bit, I know
that was a mouthful. Let's take a look at

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this in terms of a diagram. To help you
along, I want you to fill in these tables.

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So our basic table from which you're going
to draw the information is up here. If

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both countries have 24 units of labor,
half devoted to computers, half to shirts.

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There's no trade so production is equal to
consumption in this first example. What is

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production going to be?

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So Mexico, 12 units of labor with
computers, 12 shirts. How many computers,

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how many shirts? Same for the United
States.

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How many computers? How many shirts?
What's total world production? Then

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supposed we have specialization, what's
production is going to be? So Mexico has

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zero units of labor in computers, 24 in
shirts. United States has 14 units of

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labor in computers, 10 in shirts. What's
production in each cases? What is the

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total for the world? Then finally, can
we-- with production, with specialization,

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can we now find a way to have trade which
make both countries better off? What's the

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exact-- or what a exact price ratio with
that trade will occur.

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We'll take that up in an later video. Let
me just finally give you some concluding

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comments on comparative advantage.

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I want to conclude with the caution but
also a big picture of view of comparative

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advantage. In the two country first in
examples, I've been working with in order

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to explain the theory. Everyone is made
better off by trade. In larger examples,

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trade will increase aggregate wealth, but
some individuals can be made where it's

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off. That should make perfect sense after
all. If A and B have been trading, and

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then because terrace cost fall or because
transportation cost fall. If A starts

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trading with C, then B maybe worse off,
even though A, B and C together have

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greater aggregate wealth. That's just a
caution to keep in mind.

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Now here's the big picture. Comparative
advantage, it applies to people, to

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groups, to countries, and sometimes called
the law of association. It's not only a

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beautiful theory. It's very positive and
optimistic theory because it says that we

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all have something to gain from trade. It
says by working together, we can increase

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total wealth. More over we can-- I like to
phrase this in terms of a politically

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correct slogan. "Diversity is strength",
you've probably heard that slogan before.

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What comparative advantage adds to this is
that diversity and strength when combined

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with trade, its trade which turns
diversity into strength.

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That's really the bottom line on
comparative advantage.

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We'll be saying more in future videos.
Thanks.

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- If you want to test
yourself, click Practice Questions

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or if you're ready to move on,
just click Next Video.