WEBVTT

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- [Alex] In our last video,

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Don Boudreaux used
the simple example of Bob and Anne

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to demonstrate
comparative advantage.

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In the next two videos,

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we'll dive deeper
into comparative advantage

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and give you a homework question

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to test how well you're doing
in understanding the concept.

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Let's get going.

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Comparative advantage
is the theory of trade.

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It explains why people trade,
and which good people should trade

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if they want to maximize
their well being.

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It's actually useful to understand
comparative advantage

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to begin with a false theory,

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a very plausible
but incorrect theory of trade --

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namely the theory
of absolute advantage.

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So let's consider a simple model.

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Let's suppose that labor
is the only good used in production

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and that we can produce
computers or shirts.

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Let's suppose that in Mexico
it takes 12 units of labor

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to produce one computer.

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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.

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To make it simple, we'll suppose
in the United States

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it takes just one unit of labor
to make one computer,

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and one unit of labor
to create one shirt.

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Now, from the absolute advantage
theory of trade it should --

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it may seem obvious
that there in fact will --

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be no trade here.

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It may seem obvious
that the United States

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will outcompete Mexico
on all margins.

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After all, the United States
in this example

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is much more productive
at producing computers

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and also more productive
at producing shirts than Mexico.

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So this is a case
where we might think,

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with the United States
so much better

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at producing
both computers and shirts,

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that certainly there's no reason

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for the United States
to trade with Mexico,

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its less productive neighbor.

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That's the theory
of absolute advantage.

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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.

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Here's a picture of Martha Stewart
ironing her shirt.

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Now, let's stipulate
that Martha Stewart

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has an absolute advantage
in ironing.

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She has an advantage in ironing
just like the United States

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had an advantage in producing
computers and shirts

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in the previous example.

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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 Stewart
iron her own shirts?

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Of course the answer here is, no.

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Why not?

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Well, every hour
which Martha Stewart spends

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ironing her shirts is an hour
she's not spending

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doing something else
which is even more valuable,

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running her own business
for example --

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running her billion-dollar business.

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And in fact in a famous statement,
Martha Stewart --

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because she's very wise --

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she said, "I don't always
do all of my own ironing,

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even though I wish that I could."

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Let's take a little bit more detail
about why it doesn't make sense

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for Martha Stewart
to iron her own shirts.

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The most important point
to remember

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is that the important cause
is opportunity cost.

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So what is the opportunity cost
to Martha Stewart

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of spending an hour
ironing her own shirts?

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Well, it could be
thousands of dollars, at least.

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Martha Stewart would be better off

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if she specializes in producing
her television show,

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and then she trades
with someone else

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who has a lower
opportunity cost of ironing.

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It doesn't make sense
for Martha Stewart

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to iron her own shirts
because the cost of her doing so

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is devoting her time to something
where she's even more valuable

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or she's even better,

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and that is producing
her own television show.

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So Martha Stewart
has a comparative advantage

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in running her business,
or to put it slightly differently

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she has a comparative
disadvantage in ironing.

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The cost to her of ironing
is very high

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precisely because she is so much
more productive at other tasks.

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So Martha Stewart wants
to specialize in what she is best at,

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in where she has
a comparative advantage.

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Other people are almost as good
as her at ironing clothes,

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but they're not as good as her
at producing their own TV show.

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So that's why Martha Stewart
shouldn't iron her own shirts.

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Let's go back now
to our previous example

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of the United States and Mexico.

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So the key to comparative advantage
is understanding opportunity cost.

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So let's take this previous figure
we had from a previous slide

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and turn it
into an opportunity cost figure.

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So remember
what this top figure tells us --

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it tells us for example
that in Mexico

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it takes 12 units of labor
to produce one computer,

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and in Mexico it takes
two units of labor

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to produce one shirt
and so forth.

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Okay, for the United States,
it just takes one unit of labor

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to produce
either a computer or a shirt.

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Okay, now let's begin
with an easy case.

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What's the opportunity cost of
one computer in the United States?

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In other words, to produce
an additional computer

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in the United States,
what would we have to give up?

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Well, in order to get
that additional computer,

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we'd have to take labor
from shirt production

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and move it
into computer production.

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In particular, we have to take
one unit of labor

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from shirt production and move it
into computer production.

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That would get us one more computer
at the cost of one shirt.

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So the opportunity cost

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of one computer
in the United States is one shirt.

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What is the opportunity cost
of a shirt?

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Well, the opportunity cost
of a shirt,

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what you're giving up
to produce an extra shirt,

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is one computer.

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Okay, slightly harder case --

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what's the opportunity cost
of one computer in Mexico?

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So in Mexico, in order to get
an additional computer,

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you'd have to transfer labor

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from shirt production
into computer production.

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But how many units of labor
do you need to transfer?

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You need to transfer
12 units of labor

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in order to get one computer.

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You're going to have
to take 12 units of labor

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from shirt production.

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That means how many fewer shirts?

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Since it takes two units of labor
to produce one shirt,

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and you've got to move
12 units of labor.

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It means that the opportunity cost
of one computer is six shirts.

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If you need an additional computer,

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it's going to cost you
six fewer shirts

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in order to get that computer.

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Going the other way, in order
to get an additional shirt,

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you're going to have to give up
one-sixth of a computer.

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Okay, so now we have
our opportunity cost,

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and now it's actually pretty simple

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because what the theory
of comparative advantage says

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is that you should produce,
or you can produce at lowest cost.

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So who here has the lowest cost
of producing a computer?

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The lowest cost
of producing a computer

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is the United States.

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The United States is
the low opportunity cost producer

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of computers.

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Now, who is the low cost
producer of shirts?

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Well, it's Mexico.

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In Mexico, you're only giving up
one-sixth of a computer

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to produce a shirt.

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In the United States,
you're giving up one computer

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to produce a shirt.

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So you'd much rather
produce shirts in Mexico

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where the opportunity cost is lower.

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Okay, what we're learning here

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is that Mexico ought
to specialize in computers

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because they're
the low cost producer of --

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excuse me, in shirts

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because they're
the low cost producer of shirts.

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The United States ought
to specialize more towards computers

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because they're
the low cost producer of computers.

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Let's look in more detail.

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So I'm going to leave some
of the details to you actually

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and some homework questions

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which we'll go over
in the future video.

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So question one -- let's suppose
in Mexico and in the United States

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each have 24 units of labor,

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and that each devote
12 units of labor

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to producing computers

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and 12 units of labor
to producing shirts.

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That will be our baseline 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 -- suppose that Mexico
specializes in producing

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what it produces
at lowest opportunity cost --

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we just saw that was shirts --

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and suppose that the U.S.
transfers two units of labor

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from shirts to producing
what it produces

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at lowest opportunity cost --
that's computers.

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What then
is total world production?

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Finally, can trade make
both countries better off?

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Here what I'd like you to do
is give a concrete example

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of how many units have to be traded
from where to where

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in order to make
both countries better off,

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if that in fact is possible.

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So to help you along a little bit --

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I know that was a mouthful --

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Let's take a look at this
in terms of a diagram.

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To help you along,
I want you to fill in these tables.

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So our basic table

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from which you're going
to draw the information is up here.

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If both countries have
24 units of labor,

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half devoted to computers,
half to shirts,

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there's no trade,

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so production is equal
to consumption

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in this first example --
what is production going to be?

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

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How many computers,
how many shirts?

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Same for the United States.

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How many computers?
How many shirts?

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What's total world production?

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Then suppose
we have specialization --

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what's production is going to be?

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So Mexico has zero units of labor
in computers, 24 in shirts.

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United States has 14 units of labor
in computers, 10 in shirts.

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What's production in each case?

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What is the total for the world?

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Then finally, can we --

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with production,
with specialization,

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can we now find a way to have trade

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which makes both countries
better off?

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What's the exact,
or what's a exact price ratio

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at which that trade will occur?

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We'll take that up
in a later video.

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Let me just finally give you
some concluding comments

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on comparative advantage.

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I want to conclude with a caution

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but also a big picture view
of comparative advantage.

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In the two country/person examples
I've been working with

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in order to explain the theory,

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everyone is made
better off by trade.

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In larger examples, trade
will increase aggregate wealth,

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but some individuals
can be made worse off.

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And that should make perfect sense.

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After all, if A and B
have been trading,

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and then because tariffs fall

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or because
transportation costs fall,

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if A starts trading with C,
then B may be worse off,

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even though A, B and C together
have greater aggregate wealth.

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That's just a caution
to keep in mind.

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Now here's the big picture.

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Comparative advantage --
it applies to people,

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to groups, to countries.

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It's sometimes called
the law of association.

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And it's not only
a beautiful theory --

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it's a very positive
and optimistic theory

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because it says that we all have
something to gain from trade.

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It says by working together,
we can increase total wealth.

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Moreover we can --
I like to phrase this in terms

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of a politically correct slogan:
"Diversity is strength."

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You've probably heard
that slogan before.

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What comparative advantage
adds to this

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is that diversity and strength
when combined with trade --

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it's 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.

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Thanks.

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- [Narrator] If you want
to test yourself,

00:12:12.629 --> 00:12:15.022
click "Practice Questions."

00:12:15.022 --> 00:12:18.361
Or, if you're ready to move on,
just click "Next Video."