1 00:00:09,706 --> 00:00:10,790 - [Alex] In our last video, 2 00:00:10,790 --> 00:00:14,224 Don Boudreaux used the simple example of Bob and Anne 3 00:00:14,224 --> 00:00:16,080 to demonstrate comparative advantage. 4 00:00:16,560 --> 00:00:17,610 In the next two videos, 5 00:00:17,610 --> 00:00:20,120 we'll dive deeper into comparative advantage 6 00:00:20,120 --> 00:00:21,290 and give you a homework question 7 00:00:21,290 --> 00:00:24,585 to test how well you're doing in understanding the concept. 8 00:00:24,585 --> 00:00:25,576 Let's get going. 9 00:00:30,092 --> 00:00:32,727 Comparative advantage is a theory of trade. 10 00:00:32,727 --> 00:00:37,153 It explains why people trade, and which goods people should trade 11 00:00:37,153 --> 00:00:39,427 if they want to maximize their well-being. 12 00:00:40,060 --> 00:00:43,486 It's actually useful to understand comparative advantage 13 00:00:43,486 --> 00:00:45,342 to begin with a false theory, 14 00:00:45,342 --> 00:00:48,775 a very plausible but incorrect theory of trade -- 15 00:00:48,775 --> 00:00:51,080 namely the theory of absolute advantage. 16 00:00:51,464 --> 00:00:53,274 So let's consider a simple model. 17 00:00:53,274 --> 00:00:56,936 Let's suppose that labor is the only good used in production 18 00:00:56,936 --> 00:01:00,154 and that we can produce computers or shirts. 19 00:01:00,154 --> 00:01:04,273 Now let's suppose that in Mexico it takes 12 units of labor 20 00:01:04,273 --> 00:01:06,522 to produce one computer. 21 00:01:06,522 --> 00:01:07,865 Again, in Mexico, 22 00:01:07,865 --> 00:01:11,723 it takes two units of labor to produce one shirt. 23 00:01:11,723 --> 00:01:14,010 Now let's compare with the United States. 24 00:01:14,010 --> 00:01:16,700 To make it simple, we'll suppose that in the United States 25 00:01:16,700 --> 00:01:19,983 it takes just one unit of labor to make one computer, 26 00:01:19,983 --> 00:01:23,506 and one unit of labor to create one shirt. 27 00:01:23,915 --> 00:01:28,660 Now, from the absolute advantage theory of trade 28 00:01:28,660 --> 00:01:31,360 it may seem obvious that there in fact 29 00:01:31,360 --> 00:01:32,870 will be no trade here. 30 00:01:32,870 --> 00:01:35,601 It may seem obvious that the United States 31 00:01:35,601 --> 00:01:39,785 will outcompete Mexico on all margins. 32 00:01:39,785 --> 00:01:42,258 After all, the United States in this example 33 00:01:42,258 --> 00:01:45,387 is much more productive at producing computers 34 00:01:45,387 --> 00:01:49,159 and also more productive at producing shirts than Mexico. 35 00:01:49,575 --> 00:01:50,980 So this is a case where we might think, 36 00:01:50,980 --> 00:01:53,710 well the United States is so much better 37 00:01:53,710 --> 00:01:56,340 at producing both computers and shirts, 38 00:01:56,340 --> 00:01:58,485 that certainly there's no reason 39 00:01:58,485 --> 00:02:01,896 for the United States to trade with Mexico, 40 00:02:01,896 --> 00:02:05,008 its less productive neighbor. 41 00:02:06,470 --> 00:02:08,733 That's the theory of absolute advantage. 42 00:02:08,950 --> 00:02:11,909 It's very plausible. It's also very wrong. 43 00:02:11,909 --> 00:02:14,692 To see why it's wrong, let's take another simple example. 44 00:02:14,969 --> 00:02:17,757 Here's a picture of Martha Stewart ironing her shirt. 45 00:02:18,022 --> 00:02:20,894 Now, let's stipulate that Martha Stewart 46 00:02:20,894 --> 00:02:23,711 has an absolute advantage in ironing. 47 00:02:23,975 --> 00:02:27,080 She has an advantage in ironing just like the United States 48 00:02:27,080 --> 00:02:29,753 had an advantage in producing computers and shirts 49 00:02:29,753 --> 00:02:31,284 in the previous example. 50 00:02:31,284 --> 00:02:34,027 In other words, we'll stipulate that Martha Stewart 51 00:02:34,027 --> 00:02:38,762 can iron a shirt better and in less time than anyone else. 52 00:02:39,265 --> 00:02:43,186 So, if Martha Stewart has an absolute advantage in ironing 53 00:02:43,638 --> 00:02:46,286 should Martha Stewart iron her own shirts? 54 00:02:46,870 --> 00:02:49,772 Of course the answer here is, no. 55 00:02:50,080 --> 00:02:51,177 Why not? 56 00:02:51,446 --> 00:02:54,378 Well, every hour which Martha Stewart spends 57 00:02:54,378 --> 00:02:58,017 ironing her shirts is an hour she's not spending 58 00:02:58,017 --> 00:03:01,045 doing something else which is even more valuable, 59 00:03:01,045 --> 00:03:03,274 running her own business for example -- 60 00:03:03,274 --> 00:03:05,501 running her billion-dollar business. 61 00:03:05,501 --> 00:03:08,238 And in fact in a famous statement, Martha Stewart -- 62 00:03:08,238 --> 00:03:09,997 because she's very wise -- 63 00:03:09,997 --> 00:03:13,448 she said, "I don't always do all of my own ironing, 64 00:03:13,448 --> 00:03:15,387 even though I wish that I could." 65 00:03:15,869 --> 00:03:19,261 Let's take a little bit more detail about why it doesn't make sense 66 00:03:19,261 --> 00:03:22,046 for Martha Stewart to iron her own shirts. 67 00:03:22,830 --> 00:03:24,981 The most important point to remember 68 00:03:24,981 --> 00:03:29,023 is that the important cost is opportunity cost. 69 00:03:29,489 --> 00:03:32,495 So what is the opportunity cost to Martha Stewart 70 00:03:32,495 --> 00:03:34,830 of spending an hour ironing her own shirts? 71 00:03:35,291 --> 00:03:38,233 Well, it could be thousands of dollars, at least. 72 00:03:38,563 --> 00:03:41,350 Martha Stewart will be better off 73 00:03:41,350 --> 00:03:45,255 if she specializes in producing her television show, 74 00:03:45,255 --> 00:03:47,126 and then she trades with someone else 75 00:03:47,126 --> 00:03:50,307 who has a lower opportunity cost of ironing. 76 00:03:50,307 --> 00:03:52,580 It doesn't make sense for Martha Stewart 77 00:03:52,580 --> 00:03:54,400 to iron her own shirts 78 00:03:54,400 --> 00:03:56,927 because the cost of her doing so 79 00:03:56,927 --> 00:04:01,230 is devoting her time to something where she's even more valuable 80 00:04:01,230 --> 00:04:03,161 where she's even better, 81 00:04:03,161 --> 00:04:05,490 and that is producing her own television show. 82 00:04:06,128 --> 00:04:09,255 So Martha Stewart has a comparative advantage 83 00:04:09,255 --> 00:04:12,690 in running her business, or to put it slightly differently 84 00:04:12,690 --> 00:04:15,826 she has a comparative disadvantage in ironing. 85 00:04:15,826 --> 00:04:19,532 The cost to her of ironing is very high 86 00:04:19,532 --> 00:04:24,323 precisely because she is so much more productive at other tasks. 87 00:04:24,659 --> 00:04:27,852 So Martha Stewart wants to specialize 88 00:04:27,852 --> 00:04:30,852 in what she is most best at, 89 00:04:30,852 --> 00:04:33,646 in where she has a comparative advantage. 90 00:04:34,114 --> 00:04:37,770 Other people are almost as good as her at ironing clothes, 91 00:04:37,770 --> 00:04:42,261 but they're not as good as her at producing her own TV show. 92 00:04:42,630 --> 00:04:46,099 So that's why Martha Stewart shouldn't iron her own shirts. 93 00:04:46,450 --> 00:04:48,520 Let's go back now to our previous example 94 00:04:48,520 --> 00:04:51,216 of the United States and Mexico. 95 00:04:51,580 --> 00:04:55,067 So the key to comparative advantage is understanding opportunity cost. 96 00:04:55,579 --> 00:04:59,711 So let's take this previous figure we had from a previous slide 97 00:04:59,711 --> 00:05:02,672 and turn it into an opportunity cost figure. 98 00:05:02,984 --> 00:05:05,659 So remember what this top figure tells us -- 99 00:05:05,659 --> 00:05:08,184 it tells us for example that in Mexico 100 00:05:08,184 --> 00:05:11,159 it takes 12 units of labor to produce one computer, 101 00:05:11,159 --> 00:05:13,146 and in Mexico it takes two units of labor 102 00:05:13,146 --> 00:05:15,543 to produce one shirt and so forth. 103 00:05:16,008 --> 00:05:18,676 Okay, for the United States, it just takes one unit of labor 104 00:05:18,676 --> 00:05:21,085 to produce either a computer or a shirt. 105 00:05:21,400 --> 00:05:24,869 Okay, now let's begin with an easy case. 106 00:05:25,448 --> 00:05:30,055 What's the opportunity cost of one computer in the United States? 107 00:05:30,787 --> 00:05:34,081 In other words, to produce an additional computer 108 00:05:34,081 --> 00:05:36,849 in the United States, what would we have to give up? 109 00:05:37,887 --> 00:05:39,803 Well, in order to get that additional computer, 110 00:05:39,803 --> 00:05:42,118 we'd have to take labor from shirt production 111 00:05:42,118 --> 00:05:44,705 and move it into computer production. 112 00:05:45,001 --> 00:05:47,706 In particular, we have to take one unit of labor 113 00:05:47,706 --> 00:05:51,089 from shirt production and move it into computer production. 114 00:05:51,606 --> 00:05:56,025 That would get us one more computer at the cost of one shirt. 115 00:05:56,296 --> 00:05:57,713 So the opportunity cost 116 00:05:57,713 --> 00:06:01,494 of one computer in the United States is one shirt. 117 00:06:02,014 --> 00:06:04,200 What is the opportunity cost of a shirt? 118 00:06:04,474 --> 00:06:06,577 Well, the opportunity cost of a shirt, 119 00:06:06,577 --> 00:06:08,770 what you're giving up to produce an extra shirt, 120 00:06:08,770 --> 00:06:10,570 is one computer. 121 00:06:10,834 --> 00:06:13,780 Okay, slightly harder case -- 122 00:06:14,062 --> 00:06:18,914 what's the opportunity cost of one computer in Mexico? 123 00:06:19,471 --> 00:06:22,945 So in Mexico, in order to get an additional computer, 124 00:06:22,945 --> 00:06:24,605 you'd have to transfer labor 125 00:06:24,605 --> 00:06:27,420 from shirt production into computer production. 126 00:06:28,136 --> 00:06:30,273 But how many units of labor do you need to transfer? 127 00:06:30,273 --> 00:06:32,825 You need to transfer 12 units of labor. 128 00:06:33,175 --> 00:06:35,300 In order to get one computer 129 00:06:35,300 --> 00:06:37,450 you're going to have to take 12 units of labor 130 00:06:37,450 --> 00:06:38,959 from shirt production. 131 00:06:38,959 --> 00:06:41,116 That means how many fewer shirts? 132 00:06:41,629 --> 00:06:44,287 Since it takes two units of labor to produce one shirt, 133 00:06:44,287 --> 00:06:47,079 and you've got to move 12 units of labor, 134 00:06:47,079 --> 00:06:51,824 it means that the opportunity cost of one computer is six shirts. 135 00:06:52,443 --> 00:06:54,325 If you need an additional computer, 136 00:06:54,325 --> 00:06:57,330 it's going to cost you six fewer shirts 137 00:06:57,330 --> 00:06:59,286 in order to get that computer. 138 00:06:59,997 --> 00:07:03,189 Going the other way, in order to get an additional shirt, 139 00:07:03,189 --> 00:07:06,567 you're going to have to give up one-sixth of a computer. 140 00:07:06,911 --> 00:07:09,773 Okay, so now we have our opportunity costs, 141 00:07:10,040 --> 00:07:11,491 and now it's actually pretty simple 142 00:07:11,491 --> 00:07:14,891 because what the theory of comparative advantage says 143 00:07:14,891 --> 00:07:19,170 is that you should produce, or you can produce at lowest cost. 144 00:07:19,850 --> 00:07:24,660 So who here has the lowest cost of producing a computer? 145 00:07:25,672 --> 00:07:27,987 The lowest cost of producing a computer 146 00:07:27,987 --> 00:07:29,442 is the United States. 147 00:07:29,442 --> 00:07:32,602 The United States is the low opportunity cost producer 148 00:07:32,602 --> 00:07:34,006 of computers. 149 00:07:34,497 --> 00:07:38,476 Now, who is the low cost producer of shirts? 150 00:07:39,223 --> 00:07:42,562 Well, it's Mexico. 151 00:07:42,825 --> 00:07:46,470 In Mexico, you're only giving up one-sixth of a computer 152 00:07:46,470 --> 00:07:47,821 to produce a shirt. 153 00:07:47,821 --> 00:07:49,860 In the United States, you're giving up one computer 154 00:07:49,860 --> 00:07:51,162 to produce a shirt. 155 00:07:51,162 --> 00:07:54,304 So you'd much rather produce shirts in Mexico 156 00:07:54,304 --> 00:07:57,559 where the opportunity cost is lower. 157 00:07:57,858 --> 00:08:00,757 Okay, so what we're learning here 158 00:08:00,757 --> 00:08:05,116 is that Mexico ought to specialize in computers 159 00:08:05,116 --> 00:08:08,240 because they're the low cost producer of -- 160 00:08:08,240 --> 00:08:09,646 excuse me, in shirts 161 00:08:09,646 --> 00:08:11,840 because they're the low cost producer of shirts. 162 00:08:12,120 --> 00:08:16,490 The United States ought to specialize more towards computers 163 00:08:16,490 --> 00:08:19,321 because they're the low cost producer of computers. 164 00:08:19,612 --> 00:08:20,995 Let's look in more detail. 165 00:08:21,791 --> 00:08:24,033 So I'm going to leave some of the details to you actually 166 00:08:24,033 --> 00:08:25,600 and some homework questions 167 00:08:25,600 --> 00:08:28,188 which we'll go over in a future video. 168 00:08:28,460 --> 00:08:31,822 So question one -- let's suppose that Mexico and the United States 169 00:08:31,822 --> 00:08:34,128 each have 24 units of labor, 170 00:08:34,128 --> 00:08:36,480 and that they each devote 12 units of labor 171 00:08:36,480 --> 00:08:37,786 to producing computers 172 00:08:37,786 --> 00:08:40,311 and 12 units of labor to producing shirts. 173 00:08:40,577 --> 00:08:44,039 That will be our baseline scenario. So the question is -- 174 00:08:44,039 --> 00:08:47,228 What is total world production in this scenario? 175 00:08:47,228 --> 00:08:48,626 That's question one. 176 00:08:48,626 --> 00:08:49,860 Question two. 177 00:08:49,860 --> 00:08:53,770 Suppose that Mexico specializes in producing 178 00:08:53,770 --> 00:08:56,380 what it produces at lowest opportunity cost -- 179 00:08:56,380 --> 00:08:58,410 we just saw that was shirts -- 180 00:08:58,410 --> 00:09:01,657 and suppose that the U.S. transfers two units of labor 181 00:09:01,657 --> 00:09:04,698 from shirts to producing what it produces 182 00:09:04,698 --> 00:09:07,503 at lowest opportunity cost -- that's computers. 183 00:09:07,847 --> 00:09:11,334 What then is total world production? 184 00:09:12,030 --> 00:09:15,556 Finally, can trade make both countries better off? 185 00:09:15,556 --> 00:09:19,182 And here what I'd like you to do is give a concrete example 186 00:09:19,182 --> 00:09:23,290 of how many units have to be traded from where to where 187 00:09:23,290 --> 00:09:25,080 in order to make both countries better off, 188 00:09:25,080 --> 00:09:26,963 if that in fact is possible. 189 00:09:27,483 --> 00:09:29,177 So to help you along a little bit -- 190 00:09:29,177 --> 00:09:30,927 I know that was a mouthful -- 191 00:09:30,927 --> 00:09:33,681 let's take a look at this in terms of a diagram. 192 00:09:34,680 --> 00:09:37,455 To help you along, I want you to fill in these tables. 193 00:09:37,680 --> 00:09:38,682 So our basic table 194 00:09:38,682 --> 00:09:41,980 from which you're going to draw the information is up here. 195 00:09:41,980 --> 00:09:44,800 If both countries have 24 units of labor, 196 00:09:44,800 --> 00:09:47,930 half devoted to computers, half to shirts, there's no trade, 197 00:09:47,930 --> 00:09:49,941 so production is equal to consumption 198 00:09:49,941 --> 00:09:53,584 in this first example -- what is production going to be? 199 00:09:54,111 --> 00:09:57,350 So Mexico, 12 units of labor with computers, 12 shirts. 200 00:09:57,350 --> 00:09:59,170 How many computers, how many shirts? 201 00:09:59,170 --> 00:10:00,440 Same for the United States. 202 00:10:00,440 --> 00:10:02,000 How many computers? How many shirts? 203 00:10:02,000 --> 00:10:04,546 What's total world production? 204 00:10:04,546 --> 00:10:06,560 Then suppose we have specialization -- 205 00:10:06,560 --> 00:10:08,074 what's production is going to be? 206 00:10:08,074 --> 00:10:12,668 So Mexico has zero units of labor in computers, 24 in shirts. 207 00:10:12,668 --> 00:10:17,190 United States has 14 units of labor in computers, 10 in shirts. 208 00:10:17,190 --> 00:10:18,705 What's production in each case? 209 00:10:18,705 --> 00:10:20,800 What is the total for the world? 210 00:10:20,800 --> 00:10:23,559 Then finally, can we -- 211 00:10:23,559 --> 00:10:25,651 with production, with specialization, 212 00:10:25,651 --> 00:10:28,131 can we now find a way to have trade 213 00:10:28,131 --> 00:10:30,653 which makes both countries better off? 214 00:10:30,653 --> 00:10:34,070 And what's the exact, or what's a exact price ratio 215 00:10:34,070 --> 00:10:35,672 at which that trade will occur? 216 00:10:35,955 --> 00:10:38,220 We'll take that up in a later video. 217 00:10:38,220 --> 00:10:40,950 Let me just finally give you some concluding comments 218 00:10:40,950 --> 00:10:42,539 on comparative advantage. 219 00:10:43,249 --> 00:10:44,870 I want to conclude with a caution 220 00:10:44,870 --> 00:10:47,590 but also a big picture view of comparative advantage. 221 00:10:48,165 --> 00:10:50,651 In the two country/person examples I've been working with 222 00:10:50,651 --> 00:10:52,588 in order to explain the theory, 223 00:10:52,588 --> 00:10:54,476 everyone is made better off by trade. 224 00:10:55,074 --> 00:10:58,800 In larger examples, trade will increase aggregate wealth, 225 00:10:58,800 --> 00:11:01,189 but some individuals can be made worse off. 226 00:11:01,450 --> 00:11:02,802 And that should make perfect sense. 227 00:11:02,802 --> 00:11:06,343 After all, if A and B have been trading, 228 00:11:06,343 --> 00:11:08,190 and then because tariffs fall 229 00:11:08,190 --> 00:11:10,230 or because transportation costs fall, 230 00:11:10,230 --> 00:11:14,290 if A starts trading with C, then B may be worse off, 231 00:11:14,290 --> 00:11:17,760 even though A, B and C together have greater aggregate wealth. 232 00:11:17,760 --> 00:11:19,873 That's just a caution to keep in mind. 233 00:11:20,170 --> 00:11:21,810 Now here's the big picture. 234 00:11:21,810 --> 00:11:24,655 Comparative advantage -- it applies to people, 235 00:11:24,655 --> 00:11:26,308 to groups, to countries. 236 00:11:26,308 --> 00:11:29,344 It's sometimes called the law of association. 237 00:11:29,344 --> 00:11:31,273 And it's not only a beautiful theory -- 238 00:11:31,273 --> 00:11:34,033 it's a very positive and optimistic theory 239 00:11:34,033 --> 00:11:37,250 because it says that we all have something to gain from trade. 240 00:11:37,250 --> 00:11:42,210 It says by working together, we can increase total wealth. 241 00:11:43,208 --> 00:11:46,689 Moreover we can -- I like to phrase this in terms 242 00:11:46,689 --> 00:11:50,460 of a politically correct slogan: "Diversity is strength." 243 00:11:50,460 --> 00:11:52,556 You've probably heard that slogan before. 244 00:11:52,828 --> 00:11:55,440 What comparative advantage adds to this 245 00:11:55,440 --> 00:11:59,613 is that diversity is strength when combined with trade -- 246 00:11:59,613 --> 00:12:04,360 it's trade which turns diversity into strength. 247 00:12:04,360 --> 00:12:07,182 That's really the bottom line on comparative advantage. 248 00:12:07,182 --> 00:12:09,209 We'll be saying more in future videos. 249 00:12:09,209 --> 00:12:10,239 Thanks. 250 00:12:11,509 --> 00:12:12,779 - [Narrator] If you want to test yourself, 251 00:12:12,779 --> 00:12:14,343 click "Practice Questions." 252 00:12:15,163 --> 00:12:18,391 Or, if you're ready to move on, just click "Next Video."