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- [Alex] In our last video,

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Don Boudreaux used[br]the simple example of Bob and Anne

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to demonstrate[br]comparative advantage.

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In the next two videos,

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we'll dive deeper[br]into comparative advantage

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and give you a homework question

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

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Let's get going.

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Comparative advantage[br]is a theory of trade.

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It explains why people trade,[br]and which goods people should trade

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if they want to maximize[br]their well-being.

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It's actually useful to understand[br]comparative advantage

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to begin with a false theory,

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a very plausible[br]but incorrect theory of trade --

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namely the theory[br]of absolute advantage.

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So let's consider a simple model.

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

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and that we can produce[br]computers or shirts.

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Now let's suppose that in Mexico[br]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[br]to produce one shirt.

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Now let's compare[br]with the United States.

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To make it simple, we'll suppose[br]that in the United States

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it takes just one unit of labor[br]to make one computer,

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and one unit of labor[br]to create one shirt.

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Now, from the absolute advantage[br]theory of trade

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it may seem obvious[br]that there in fact

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will be no trade here.

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It may seem obvious[br]that the United States

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will outcompete Mexico[br]on all margins.

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After all, the United States[br]in this example

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is much more productive[br]at producing computers

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and also more productive[br]at producing shirts than Mexico.

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So this is a case[br]where we might think,

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well the United States[br]is so much better

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at producing[br]both computers and shirts,

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that certainly there's no reason

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for the United States[br]to trade with Mexico,

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its less productive neighbor.

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That's the theory[br]of absolute advantage.

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It's very plausible.[br]It's also very wrong.

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To see why it's wrong,[br]let's take another simple example.

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

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Now, let's stipulate[br]that Martha Stewart

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has an absolute advantage[br]in ironing.

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She has an advantage in ironing[br]just like the United States

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had an advantage in producing[br]computers and shirts

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in the previous example.

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In other words, we'll stipulate[br]that Martha Stewart

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

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So, if Martha Stewart has[br]an absolute advantage in ironing

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should Martha Stewart[br]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[br]which Martha Stewart spends

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ironing her shirts is an hour[br]she's not spending

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doing something else[br]which is even more valuable,

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running her own business[br]for example --

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running her billion-dollar business.

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And in fact in a famous statement,[br]Martha Stewart --

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because she's very wise --

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she said, "I don't always[br]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[br]about why it doesn't make sense

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for Martha Stewart[br]to iron her own shirts.

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The most important point[br]to remember

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is that the important cost[br]is opportunity cost.

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So what is the opportunity cost[br]to Martha Stewart

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of spending an hour[br]ironing her own shirts?

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Well, it could be[br]thousands of dollars, at least.

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Martha Stewart will be better off

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if she specializes in producing[br]her television show,

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and then she trades[br]with someone else

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who has a lower[br]opportunity cost of ironing.

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It doesn't make sense[br]for Martha Stewart

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to iron her own shirts

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because the cost of her doing so

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

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where she's even better,

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and that is producing[br]her own television show.

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So Martha Stewart[br]has a comparative advantage

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in running her business,[br]or to put it slightly differently

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she has a comparative[br]disadvantage in ironing.

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The cost to her of ironing[br]is very high

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

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So Martha Stewart[br]wants to specialize

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in what she is most best at,

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in where she has[br]a comparative advantage.

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Other people are almost as good[br]as her at ironing clothes,

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but they're not as good as her[br]at producing her own TV show.

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

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Let's go back now[br]to our previous example

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of the United States and Mexico.

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So the key to comparative advantage[br]is understanding opportunity cost.

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

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and turn it[br]into an opportunity cost figure.

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So remember[br]what this top figure tells us --

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it tells us for example[br]that in Mexico

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it takes 12 units of labor[br]to produce one computer,

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and in Mexico it takes[br]two units of labor

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to produce one shirt[br]and so forth.

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

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to produce[br]either a computer or a shirt.

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

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

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In other words, to produce[br]an additional computer

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

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Well, in order to get[br]that additional computer,

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we'd have to take labor[br]from shirt production

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and move it[br]into computer production.

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In particular, we have to take[br]one unit of labor

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from shirt production and move it[br]into computer production.

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

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So the opportunity cost

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of one computer[br]in the United States is one shirt.

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What is the opportunity cost[br]of a shirt?

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Well, the opportunity cost[br]of a shirt,

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what you're giving up[br]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[br]of one computer in Mexico?

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So in Mexico, in order to get[br]an additional computer,

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you'd have to transfer labor

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from shirt production[br]into computer production.

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

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You need to transfer[br]12 units of labor.

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In order to get one computer

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you're going to have[br]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[br]to produce one shirt,

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and you've got to move[br]12 units of labor,

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it means that the opportunity cost[br]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[br]six fewer shirts

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in order to get that computer.

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

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

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Okay, so now we have[br]our opportunity costs,

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and now it's actually pretty simple

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because what the theory[br]of comparative advantage says

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

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

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The lowest cost[br]of producing a computer

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is the United States.

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The United States is[br]the low opportunity cost producer

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of computers.

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Now, who is the low cost[br]producer of shirts?

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Well, it's Mexico.

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

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to produce a shirt.

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

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to produce a shirt.

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So you'd much rather[br]produce shirts in Mexico

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where the opportunity cost is lower.

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Okay, so what we're learning here

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is that Mexico ought[br]to specialize in computers

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because they're[br]the low cost producer of --

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excuse me, in shirts

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because they're[br]the low cost producer of shirts.

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The United States ought[br]to specialize more towards computers

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because they're[br]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[br]of the details to you actually

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and some homework questions

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which we'll go over[br]in a future video.

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So question one -- let's suppose[br]that Mexico and the United States

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each have 24 units of labor,

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and that they each devote[br]12 units of labor

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to producing computers

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and 12 units of labor[br]to producing shirts.

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That will be our baseline scenario.[br]So the question is --

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What is total world production[br]in this scenario?

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That's question one.

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Question two.

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Suppose that Mexico[br]specializes in producing

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what it produces[br]at lowest opportunity cost --

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we just saw that was shirts --

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

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from shirts to producing[br]what it produces

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at lowest opportunity cost --[br]that's computers.

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What then[br]is total world production?

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Finally, can trade make[br]both countries better off?

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And here what I'd like you to do[br]is give a concrete example

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of how many units have to be traded[br]from where to where

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in order to make[br]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[br]in terms of a diagram.

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To help you along,[br]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[br]to draw the information is up here.

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If both countries have[br]24 units of labor,

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half devoted to computers,[br]half to shirts, there's no trade,

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so production is equal[br]to consumption

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

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So Mexico, 12 units of labor[br]with computers, 12 shirts.

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How many computers,[br]how many shirts?

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Same for the United States.

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How many computers?[br]How many shirts?

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What's total world production?

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Then suppose[br]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[br]in computers, 24 in shirts.

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United States has 14 units of labor[br]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,[br]with specialization,

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can we now find a way to have trade

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which makes both countries[br]better off?

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And what's the exact,[br]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[br]in a later video.

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Let me just finally give you[br]some concluding comments

0:10:40.950,0:10:42.539
on comparative advantage.

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I want to conclude with a caution

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but also a big picture view[br]of comparative advantage.

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

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in order to explain the theory,

0:10:52.588,0:10:54.476
everyone is made[br]better off by trade.

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In larger examples, trade[br]will increase aggregate wealth,

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but some individuals[br]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[br]have been trading,

0:11:06.343,0:11:08.190
and then because tariffs fall

0:11:08.190,0:11:10.230
or because[br]transportation costs fall,

0:11:10.230,0:11:14.290
if A starts trading with C,[br]then B may be worse off,

0:11:14.290,0:11:17.760
even though A, B and C together[br]have greater aggregate wealth.

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That's just a caution[br]to keep in mind.

0:11:20.170,0:11:21.810
Now here's the big picture.

0:11:21.810,0:11:24.655
Comparative advantage --[br]it applies to people,

0:11:24.655,0:11:26.308
to groups, to countries.

0:11:26.308,0:11:29.344
It's sometimes called[br]the law of association.

0:11:29.344,0:11:31.273
And it's not only[br]a beautiful theory --

0:11:31.273,0:11:34.033
it's a very positive[br]and optimistic theory

0:11:34.033,0:11:37.250
because it says that we all have[br]something to gain from trade.

0:11:37.250,0:11:42.210
It says by working together,[br]we can increase total wealth.

0:11:43.208,0:11:46.689
Moreover we can --[br]I like to phrase this in terms

0:11:46.689,0:11:50.460
of a politically correct slogan:[br]"Diversity is strength."

0:11:50.460,0:11:52.556
You've probably heard[br]that slogan before.

0:11:52.828,0:11:55.440
What comparative advantage[br]adds to this

0:11:55.440,0:11:59.613
is that diversity is strength[br]when combined with trade --

0:11:59.613,0:12:04.360
it's trade which turns diversity[br]into strength.

0:12:04.360,0:12:07.182
That's really the bottom line[br]on comparative advantage.

0:12:07.182,0:12:09.209
We'll be saying more[br]in future videos.

0:12:09.209,0:12:10.239
Thanks.

0:12:11.509,0:12:12.779
- [Narrator] If you want[br]to test yourself,

0:12:12.779,0:12:14.343
click "Practice Questions."

0:12:15.163,0:12:18.391
Or, if you're ready to move on,[br]just click "Next Video."