## Another Look at Comparative Advantage

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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
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In the next two videos,
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we'll dive deeper
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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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and which goods 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
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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
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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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Now 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
with the United States.
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To make it simple, we'll suppose
that 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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it may seem obvious
that there in fact
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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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well the United States
is 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
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its less productive neighbor.
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That's the theory
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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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in ironing.
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She has an advantage in ironing
just like the United States
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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
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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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for example --
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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 cost
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 will be better off
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if she specializes in producing
her television show,
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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
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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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where she's even better,
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and that is producing
her own television show.
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So Martha Stewart
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or to put it slightly differently
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she has a comparative
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The cost to her of ironing
is very high
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precisely because she is so much
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So Martha Stewart
wants to specialize
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in what she is most best at,
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in where she has
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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 her 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
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in the United States,
what would we have to give up?
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Well, in order to get
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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
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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
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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 costs,
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and now it's actually pretty simple
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because what the theory
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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, so 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 a future video.
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So question one -- let's suppose
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
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.
So the question is --
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What is total world production
in this scenario?
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That's question one.
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Question two.
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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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both countries better off?
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And 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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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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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, 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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And 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
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I want to conclude with a caution
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but also a big picture view
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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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will increase aggregate wealth,
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but some individuals
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And that should make perfect sense.
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After all, if A and B
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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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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
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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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is that diversity is strength
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into strength.
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That's really the bottom line
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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,
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click "Practice Questions."
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Or, if you're ready to move on,
just click "Next Video."
Title:
Description:

Comparative advantage explains why people trade and what goods they should trade. To illustrate the concept of comparative advantage, we ask: Should Martha Stewart iron her own shirts? Even if Martha Stewart has an absolute advantage in ironing shirts, her opportunity cost is simply too high! We’ll go over the concepts of absolute advantage and opportunity cost in depth using more examples, too.
Ready to test your knowledge? We introduce several homework questions in this video and we’ll cover the answers in another video in this section.
Microeconomics Course: http://mruniversity.com/courses/principles-economics-microeconomics

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Video Language:
English
Team:
Marginal Revolution University
Project:
Micro
Duration:
12:24
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