0:00:09.566,0:00:11.490 - [Alex] In our last video, 0:00:11.490,0:00:14.490 Don Boudreaux used[br]the simple example of Bob and Anne 0:00:14.490,0:00:15.920 to demonstrate[br]comparative advantage. 0:00:15.920,0:00:18.920 In the next two videos, 0:00:18.920,0:00:19.920 we'll dive deeper[br]into comparative advantage 0:00:19.920,0:00:22.280 and give you a homework question 0:00:22.280,0:00:25.532 to test how well you're doing[br]in understanding the concept. 0:00:26.675,0:00:29.675 Let's get going. 0:00:30.092,0:00:34.070 Comparative advantage[br]is the theory of trade. 0:00:34.250,0:00:37.240 It explains why people trade,[br]and which good people should trade 0:00:37.240,0:00:40.240 if they want to maximize[br]their well being. 0:00:40.240,0:00:44.520 It's actually useful to understand[br]comparative advantage 0:00:44.700,0:00:46.470 to begin with a false theory, 0:00:46.470,0:00:49.470 a very plausible[br]but incorrect theory of trade -- 0:00:49.470,0:00:51.080 namely the theory[br]of absolute advantage. 0:00:51.080,0:00:54.080 So let's consider a simple model. 0:00:54.080,0:00:58.180 Let's suppose that labor[br]is the only good used in production 0:00:58.360,0:01:01.569 and that we can produce[br]computers or shirts. 0:01:01.569,0:01:04.569 Let's suppose that in Mexico[br]it takes 12 units of labor 0:01:04.569,0:01:07.905 to produce one computer. 0:01:07.905,0:01:08.980 Again, in Mexico, 0:01:08.980,0:01:11.980 it takes two units of labor[br]to produce one shirt. 0:01:11.980,0:01:12.980 Now let's compare it[br]with the United States. 0:01:12.980,0:01:15.460 To make it simple, we'll suppose[br]in the United States 0:01:15.460,0:01:20.470 it takes just one unit of labor[br]to make one computer, 0:01:20.650,0:01:24.790 and one unit of labor[br]to create one shirt. 0:01:24.790,0:01:27.790 Now, from the absolute advantage[br]theory of trade it should -- 0:01:27.790,0:01:30.010 it may seem obvious[br]that there in fact will -- 0:01:30.010,0:01:33.010 be no trade here. 0:01:33.010,0:01:38.660 It may seem obvious[br]that the United States 0:01:38.840,0:01:41.340 will outcompete Mexico[br]on all margins. 0:01:41.340,0:01:44.340 After all, the United States[br]in this example 0:01:44.340,0:01:45.530 is much more productive[br]at producing computers 0:01:45.530,0:01:48.530 and also more productive[br]at producing shirts than Mexico. 0:01:48.530,0:01:50.270 So this is a case[br]where we might think, 0:01:50.270,0:01:53.270 with the United States[br]so much better 0:01:53.270,0:01:55.660 at producing[br]both computers and shirts, 0:01:55.660,0:01:58.660 that certainly there's no reason 0:01:58.660,0:02:03.470 for the United States[br]to trade with Mexico, 0:02:03.470,0:02:06.470 its less productive neighbor. 0:02:06.470,0:02:08.950 That's the theory[br]of absolute advantage. 0:02:08.950,0:02:11.950 It's very plausible;[br]it's also very wrong. 0:02:11.950,0:02:15.780 To see why it's wrong,[br]let's take another simple example. 0:02:15.960,0:02:18.580 Here's a picture of Martha Stewart[br]ironing her shirt. 0:02:18.580,0:02:21.580 Now, let's stipulate[br]that Martha Stewart 0:02:21.580,0:02:23.480 has an absolute advantage[br]in ironing. 0:02:23.480,0:02:26.480 She has an advantage in ironing[br]just like the United States 0:02:26.480,0:02:30.340 had an advantage in producing[br]computers and shirts 0:02:30.520,0:02:31.520 in the previous example. 0:02:31.520,0:02:33.657 In other words, we'll stipulate[br]that Martha Stewart 0:02:33.657,0:02:38.705 can iron a shirt better[br]and in less time than anyone else. 0:02:38.800,0:02:43.186 So if Martha Stewart has[br]an absolute advantage in ironing 0:02:43.200,0:02:47.190 should Martha Stewart[br]iron her own shirts? 0:02:47.190,0:02:50.190 Of course the answer here is, no. 0:02:50.190,0:02:53.290 Why not? 0:02:53.290,0:02:56.290 Well, every hour[br]which Martha Stewart spends 0:02:56.290,0:02:58.590 ironing her shirts is an hour[br]she's not spending 0:02:58.590,0:03:01.590 doing something else[br]which is even more valuable, 0:03:01.590,0:03:03.710 running her own business[br]for example -- 0:03:03.710,0:03:06.710 running her billion-dollar business. 0:03:06.710,0:03:08.700 And in fact in a famous statement,[br]Martha Stewart -- 0:03:08.700,0:03:11.700 because she's very wise -- 0:03:11.700,0:03:13.670 she said, "I don't always[br]do all of my own ironing, 0:03:13.670,0:03:16.670 even though I wish that I could." 0:03:16.670,0:03:21.120 Let's take a little bit more detail[br]about why it doesn't make sense 0:03:21.300,0:03:24.370 for Martha Stewart[br]to iron her own shirts. 0:03:24.370,0:03:27.370 The most important point[br]to remember 0:03:27.370,0:03:29.650 is that the important cause[br]is opportunity cost. 0:03:29.650,0:03:32.650 So what is the opportunity cost[br]to Martha Stewart 0:03:32.650,0:03:34.510 of spending an hour[br]ironing her own shirts? 0:03:34.510,0:03:37.510 Well, it could be[br]thousands of dollars, at least. 0:03:37.510,0:03:43.700 Martha Stewart would be better off 0:03:43.880,0:03:45.760 if she specializes in producing[br]her television show, 0:03:45.760,0:03:46.760 and then she trades[br]with someone else 0:03:46.760,0:03:48.760 who has a lower[br]opportunity cost of ironing. 0:03:48.760,0:03:51.540 It doesn't make sense[br]for Martha Stewart 0:03:51.540,0:03:54.540 to iron her own shirts[br]because the cost of her doing so 0:03:56.380,0:03:59.380 is devoting her time to something[br]where she's even more valuable 0:03:59.380,0:04:02.180 or she's even better, 0:04:02.180,0:04:05.180 and that is producing[br]her own television show. 0:04:05.180,0:04:08.230 So Martha Stewart[br]has a comparative advantage 0:04:08.230,0:04:11.230 in running her business,[br]or to put it slightly differently 0:04:11.230,0:04:15.910 she has a comparative[br]disadvantage in ironing. 0:04:16.089,0:04:21.810 The cost to her of ironing[br]is very high 0:04:21.990,0:04:28.970 precisely because she is so much[br]more productive at other tasks. 0:04:29.150,0:04:32.020 So Martha Stewart wants[br]to specialize in what she is best at, 0:04:32.020,0:04:35.020 in where she has[br]a comparative advantage. 0:04:35.020,0:04:37.770 Other people are almost as good[br]as her at ironing clothes, 0:04:37.770,0:04:40.770 but they're not as good as her[br]at producing their own TV show. 0:04:40.770,0:04:44.466 So that's why Martha Stewart[br]shouldn't iron her own shirts. 0:04:46.600,0:04:48.840 Let's go back now[br]to our previous example 0:04:48.840,0:04:51.840 of the United States and Mexico. 0:04:51.840,0:04:55.870 So the key to comparative advantage[br]is understanding opportunity cost. 0:04:56.050,0:05:00.810 So let's take this previous figure[br]we had from a previous slide 0:05:00.990,0:05:03.460 and turn it[br]into an opportunity cost figure. 0:05:03.460,0:05:06.460 So remember[br]what this top figure tells us -- 0:05:06.460,0:05:08.390 it tells us for example[br]that in Mexico 0:05:08.390,0:05:11.390 it takes 12 units of labor[br]to produce one computer, 0:05:11.390,0:05:13.410 and in Mexico it takes[br]two units of labor 0:05:13.410,0:05:16.410 to produce one shirt[br]and so forth. 0:05:16.410,0:05:19.220 Okay, for the United States,[br]it just takes one unit of labor 0:05:19.220,0:05:21.085 to produce[br]either a computer or a shirt. 0:05:21.400,0:05:27.460 Okay, now let's begin[br]with an easy case. 0:05:27.640,0:05:34.080 What's the opportunity cost of[br]one computer in the United States? 0:05:34.260,0:05:35.960 In other words, to produce[br]an additional computer 0:05:35.960,0:05:38.960 in the United States,[br]what would we have to give up? 0:05:38.960,0:05:40.250 Well, in order to get[br]that additional computer, 0:05:40.250,0:05:43.250 we'd have to take labor[br]from shirt production 0:05:43.250,0:05:44.940 and move it[br]into computer production. 0:05:44.940,0:05:47.940 In particular, we have to take[br]one unit of labor 0:05:47.940,0:05:53.280 from shirt production and move it[br]into computer production. 0:05:53.460,0:05:58.970 That would get us one more computer[br]at the cost of one shirt. 0:05:59.150,0:06:01.570 So the opportunity cost 0:06:01.570,0:06:02.570 of one computer[br]in the United States is one shirt. 0:06:02.570,0:06:04.570 What is the opportunity cost[br]of a shirt? 0:06:04.570,0:06:08.250 Well, the opportunity cost[br]of a shirt, 0:06:08.430,0:06:12.820 what you're giving up[br]to produce an extra shirt, 0:06:12.820,0:06:13.820 is one computer. 0:06:13.820,0:06:15.820 Okay, slightly harder case -- 0:06:15.820,0:06:20.210 what's the opportunity cost[br]of one computer in Mexico? 0:06:20.210,0:06:23.210 So in Mexico, in order to get[br]an additional computer, 0:06:23.210,0:06:25.390 you'd have to transfer labor 0:06:25.390,0:06:28.390 from shirt production[br]into computer production. 0:06:28.390,0:06:32.160 But how many units of labor[br]do you need to transfer? 0:06:32.340,0:06:34.450 You need to transfer[br]12 units of labor 0:06:34.450,0:06:35.450 in order to get one computer. 0:06:35.450,0:06:37.450 You're going to have[br]to take 12 units of labor 0:06:37.450,0:06:40.010 from shirt production. 0:06:40.010,0:06:43.010 That means how many fewer shirts? 0:06:43.010,0:06:45.340 Since it takes two units of labor[br]to produce one shirt, 0:06:45.340,0:06:48.340 and you've got to move[br]12 units of labor. 0:06:48.340,0:06:53.820 It means that the opportunity cost[br]of one computer is six shirts. 0:06:54.000,0:06:57.120 If you need an additional computer, 0:06:57.120,0:06:58.120 it's going to cost you[br]six fewer shirts 0:06:58.120,0:07:00.120 in order to get that computer. 0:07:00.120,0:07:03.700 Going the other way, in order[br]to get an additional shirt, 0:07:03.880,0:07:07.450 you're going to have to give up[br]one-sixth of a computer. 0:07:07.450,0:07:10.450 Okay, so now we have[br]our opportunity cost, 0:07:10.450,0:07:12.150 and now it's actually pretty simple 0:07:12.150,0:07:15.150 because what the theory[br]of comparative advantage says 0:07:15.150,0:07:18.170 is that you should produce,[br]or you can produce at lowest cost. 0:07:18.170,0:07:21.170 So who here has the lowest cost[br]of producing a computer? 0:07:21.170,0:07:28.230 The lowest cost[br]of producing a computer 0:07:28.410,0:07:29.940 is the United States. 0:07:29.940,0:07:32.940 The United States is[br]the low opportunity cost producer 0:07:32.940,0:07:40.050 of computers. 0:07:40.050,0:07:41.050 Now, who is the low cost[br]producer of shirts? 0:07:41.050,0:07:43.050 Well, it's Mexico. 0:07:43.050,0:07:45.160 In Mexico, you're only giving up[br]one-sixth of a computer 0:07:45.160,0:07:48.160 to produce a shirt. 0:07:48.160,0:07:49.160 In the United States,[br]you're giving up one computer 0:07:49.160,0:07:51.900 to produce a shirt. 0:07:51.900,0:07:56.230 So you'd much rather[br]produce shirts in Mexico 0:07:56.230,0:07:59.230 where the opportunity cost is lower. 0:07:59.230,0:08:02.650 Okay, what we're learning here 0:08:02.650,0:08:05.650 is that Mexico ought[br]to specialize in computers 0:08:05.650,0:08:07.710 because they're[br]the low cost producer of -- 0:08:07.710,0:08:10.710 excuse me, in shirts 0:08:10.710,0:08:11.710 because they're[br]the low cost producer of shirts. 0:08:11.710,0:08:14.430 The United States ought[br]to specialize more towards computers 0:08:14.430,0:08:19.810 because they're[br]the low cost producer of computers. 0:08:19.990,0:08:21.380 Let's look in more detail. 0:08:21.380,0:08:24.380 So I'm going to leave some[br]of the details to you actually 0:08:24.380,0:08:25.380 and some homework questions 0:08:25.380,0:08:28.360 which we'll go over[br]in the future video. 0:08:28.360,0:08:32.250 So question one -- let's suppose[br]in Mexico and in the United States 0:08:32.429,0:08:35.230 each have 24 units of labor, 0:08:35.230,0:08:36.230 and that each devote[br]12 units of labor 0:08:36.230,0:08:38.230 to producing computers 0:08:38.230,0:08:40.419 and 12 units of labor[br]to producing shirts. 0:08:40.419,0:08:43.419 That will be our baseline scenario. 0:08:43.419,0:08:47.228 The question is -- "What is total[br]world 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 -- suppose that Mexico[br]specializes in producing 0:08:54.770,0:08:56.380 what it produces[br]at lowest opportunity cost -- 0:08:56.380,0:08:59.380 we just saw that was shirts -- 0:08:59.380,0:09:02.200 and suppose that the U.S.[br]transfers two units of labor 0:09:02.200,0:09:05.200 from shirts to producing[br]what it produces 0:09:05.200,0:09:09.030 at lowest opportunity cost --[br]that's computers. 0:09:09.030,0:09:12.030 What then[br]is total world production? 0:09:12.030,0:09:16.860 Finally, can trade make[br]both countries better off? 0:09:17.040,0:09:19.760 Here what I'd like you to do[br]is give a concrete example 0:09:19.760,0:09:22.760 of how many units have to be traded[br]from where to where 0:09:22.760,0:09:24.530 in order to make[br]both countries better off, 0:09:24.530,0:09:27.530 if that in fact is possible. 0:09:27.530,0:09:28.790 So to help you along a little bit -- 0:09:28.790,0:09:31.790 I know that was a mouthful -- 0:09:31.790,0:09:34.680 Let's take a look at this[br]in terms of a diagram. 0:09:34.680,0:09:37.680 To help you along,[br]I want you to fill in these tables. 0:09:37.680,0:09:39.700 So our basic table 0:09:39.700,0:09:42.700 from which you're going[br]to draw the information is up here. 0:09:42.700,0:09:44.270 If both countries have[br]24 units of labor, 0:09:44.270,0:09:47.270 half devoted to computers,[br]half to shirts, 0:09:47.270,0:09:49.400 there's no trade, 0:09:49.400,0:09:52.400 so production is equal[br]to consumption 0:09:52.400,0:09:53.940 in this first example --[br]what is production going to be? 0:09:54.120,0:09:57.990 So Mexico, 12 units of labor[br]with computers, 12 shirts. 0:09:58.170,0:09:59.170 How many computers,[br]how many shirts? 0:09:59.170,0:10:00.440 Same for the United States. 0:10:00.440,0:10:02.000 How many computers?[br]How many shirts? 0:10:02.000,0:10:05.000 What's total world production? 0:10:05.000,0:10:06.100 Then suppose[br]we have specialization -- 0:10:06.100,0:10:09.100 what's production is going to be? 0:10:09.100,0:10:14.430 So Mexico has zero units of labor[br]in computers, 24 in shirts. 0:10:14.610,0:10:19.200 United States has 14 units of labor[br]in computers, 10 in shirts. 0:10:19.380,0:10:22.190 What's production in each case? 0:10:22.190,0:10:23.190 What is the total for the world? 0:10:23.190,0:10:25.913 Then finally, can we -- 0:10:25.913,0:10:28.636 with production,[br]with specialization, 0:10:28.636,0:10:29.636 can we now find a way to have trade 0:10:29.636,0:10:31.540 which makes both countries[br]better off? 0:10:31.540,0:10:32.940 What's the exact,[br]or what's a exact price ratio 0:10:32.940,0:10:35.940 at which that trade will occur? 0:10:35.940,0:10:37.550 We'll take that up[br]in a later video. 0:10:37.550,0:10:40.550 Let me just finally give you[br]some concluding comments 0:10:40.550,0:10:42.353 on comparative advantage. 0:10:43.400,0:10:44.400 I want to conclude with a caution 0:10:44.400,0:10:47.080 but also a big picture view[br]of comparative advantage. 0:10:47.080,0:10:50.950 In the two country/person examples[br]I've been working with 0:10:51.130,0:10:53.420 in order to explain the theory, 0:10:53.420,0:10:56.420 everyone is made[br]better off by trade. 0:10:56.420,0:10:57.900 In larger examples, trade[br]will increase aggregate wealth, 0:10:57.900,0:11:00.900 but some individuals[br]can be made worse off. 0:11:00.900,0:11:03.450 And that should make perfect sense. 0:11:03.450,0:11:06.450 After all, if A and B[br]have been trading, 0:11:06.450,0:11:08.080 and then because tariffs fall 0:11:08.080,0:11:11.080 or because[br]transportation costs fall, 0:11:11.080,0:11:13.310 if A starts trading with C,[br]then B may be worse off, 0:11:13.310,0:11:16.310 even though A, B and C together[br]have greater aggregate wealth. 0:11:16.310,0:11:19.990 That's just a caution[br]to keep in mind. 0:11:20.170,0:11:21.810 Now here's the big picture. 0:11:21.810,0:11:24.810 Comparative advantage --[br]it applies to people, 0:11:24.810,0:11:26.910 to groups, to countries. 0:11:26.910,0:11:29.910 It's sometimes called[br]the law of association. 0:11:29.910,0:11:31.576 And it's not only[br]a beautiful theory -- 0:11:31.576,0:11:33.243 it's a very positive[br]and optimistic theory 0:11:33.243,0:11:34.910 because it says that we all have[br]something to gain from trade. 0:11:34.910,0:11:41.010 It says by working together,[br]we can increase total wealth. 0:11:41.190,0:11:47.460 Moreover we can --[br]I like to phrase this in terms 0:11:47.640,0:11:49.870 of a politically correct slogan:[br]"Diversity is strength." 0:11:49.870,0:11:52.870 You've probably heard[br]that slogan before. 0:11:52.870,0:11:58.230 What comparative advantage[br]adds to this 0:11:58.410,0:12:01.360 is that diversity and strength[br]when combined with trade -- 0:12:01.360,0:12:04.360 it's trade which turns diversity[br]into strength. 0:12:04.360,0:12:06.882 That's really the bottom line[br]on comparative advantage. 0:12:06.882,0:12:08.629 We'll be saying more[br]in future videos. 0:12:08.629,0:12:11.629 Thanks. 0:12:11.629,0:12:12.629 - [Narrator] If you want[br]to test yourself, 0:12:12.629,0:12:15.022 click "Practice Questions." 0:12:15.022,0:12:18.361 Or, if you're ready to move on,[br]just click "Next Video."