Another Look at Comparative Advantage
-
0:10 - 0:14- In our last video Don Boudreaux
used the simple example of Bob and Anne to -
0:14 - 0:19demonstrate comparative advantage. In the
next two videos we'll dive deeper into -
0:19 - 0:22comparative advantage, and give you a
homework question to test how well you're -
0:22 - 0:26doing in understanding the concept.
Let's get going. -
0:30 - 0:34- Comparative advantage is the
theory of trade. It explains why people -
0:34 - 0:40trade, and which good people should trade
if they want to maximize their well being. -
0:40 - 0:45It's actually useful to understand
comparative advantage to begin with a -
0:45 - 0:49false theory. Every plausible but
incorrect theory of trade namely the -
0:49 - 0:54theory of absolute advantage. So let's
consider a simple model. Let's supposed -
0:54 - 0:58that labor is the only good use in
production and that we can produce -
0:58 - 1:04computers or shirts. Let's supposed that
in Mexico it takes 12 units of labor to -
1:05 - 1:08produce one computer. Again in Mexico,
-
1:08 - 1:12it takes two units of labor
to produce one shirt. -
1:12 - 1:15Now let's compare it with the United
States. To make it simple, we'll suppose -
1:15 - 1:20in the United States it takes just one
unit of labor to make one computer, and -
1:21 - 1:28one unit of labor to create one shirt.
Now, from the absolute advantage theory of -
1:28 - 1:33trade, it should-- it may seem obvious
that there in fact will be no trade here. -
1:33 - 1:39It may seem obvious that the United
States will out compete Mexico on all -
1:39 - 1:44margins. After all, the United States in
this example is much more productive at -
1:44 - 1:48producing computers and also more
productive at producing shirts than -
1:49 - 1:53Mexico. So this is a case where we might
think with the United States is so much -
1:53 - 1:58better at producing both computers and
shirts that certainly there's no reason -
1:59 - 2:06for the United States to trade with
Mexico, it's less productive neighbor. -
2:06 - 2:12That's the theory of absolute advantage,
it's very plausible, it's also very wrong. -
2:12 - 2:16To see why it's wrong, let's take another
simple example. Here's a picture of Martha -
2:16 - 2:21Stewart ironing her shirt. Now, let's
stipulate that Martha Stewart has an -
2:22 - 2:26absolute advantage in ironing. She has an
advantage in ironing just like the United -
2:26 - 2:30States had an advantage in producing
computers and shirts in the previous -
2:31 - 2:34example. In other words, we'll stipulate
that Martha Stewart -
2:34 - 2:39can iron a shirt better and in
less time than anyone else. -
2:39 - 2:43So if Martha Stewart has an
absolute advantage in ironing -
2:43 - 2:50should Martha Stuart iron her own
shirts? Of course the answer here is, no. -
2:50 - 2:56Why not? Well every hour which Martha
Stuart Spends ironing her shirts is an -
2:56 - 3:01hour she's not spending doing something
else which is even more valuable, running -
3:02 - 3:07her own business for example. Running her
billion dollar business, and in fact in a -
3:07 - 3:12famous statement, Martha Stuart because
she's very wise she said, "I don't always -
3:12 - 3:16do all of my own ironing, even though I
wish that I could." Let's take a little -
3:17 - 3:21bit more detail about why it doesn't make
sense for Martha Stuart to iron her own -
3:21 - 3:27shirts. The most important point to
remember is that the important cause is -
3:27 - 3:32opportunity cost. So what is the
opportunity cost of Martha Stewart of -
3:33 - 3:37spending an hour ironing her own shirts?
Well, it could be thousands of dollars, at -
3:38 - 3:44least. Martha Stewart would be better off
if she specializes in producing her -
3:44 - 3:49television show, and then she trade with
someone else who has a lower opportunity -
3:49 - 3:54cost of ironing. It doesn't make sense for
Martha Stewart to iron her own shirts -
3:55 - 3:59because the cost of her doing so is
devoting her time to something where she's -
3:59 - 4:05even more valuable or she even better and
that is producing her own television show. -
4:05 - 4:11So Martha Stewart has a comparative
advantage in running her business, or to -
4:11 - 4:16put it slightly differently she has a
comparative disadvantage in ironing. The -
4:16 - 4:22cost of her of ironing is very high
precisely because she is so much more -
4:22 - 4:29productive at other tasks. So Martha
Stewart wants to specialized in what she -
4:29 - 4:35is most best at in where she has a
comparative advantage. Other people who -
4:35 - 4:41are almost as good as her at ironing
clothes but they're not as good as her at -
4:41 - 4:44producing her own TV show. So that's why
Martha Stewart shouldn't -
4:44 - 4:46iron her own shirts.
-
4:47 - 4:52Let's go back now to our previous example
of the United States and Mexico. So the -
4:52 - 4:56key to comparative advantage is
understanding opportunity cost. So let's -
4:56 - 5:01take this previous figure we had from a
previous slide and turn it into an -
5:01 - 5:06opportunity cost figure. So remember what
this top figure tells us, it tells us for -
5:06 - 5:11example that in Mexico it takes 12 units
of labor to produce one computer, and in -
5:11 - 5:16Mexico it takes two units of labor to
produce one shirt and so forth. Okay, for -
5:16 - 5:19the United States, it just takes one unit
of labor to produce either -
5:19 - 5:21a computer or a shirt.
-
5:21 - 5:27Okay, now let's begin with an easy case.
What's the opportunity cost of one -
5:28 - 5:34computer in the United States? In other
words, to produce an additional computer -
5:34 - 5:39in the United States, what would we have
to give up? Well, in order to get that -
5:39 - 5:43additional computer, we'd have to take
labor from shirt production and move it -
5:43 - 5:48into computer production. In particular,
we have to take one unit of labor from -
5:48 - 5:53shirt production and move it into computer
production. That would get us one more -
5:53 - 5:59computer at the cost of one shirt. So the
opportunity cost of one computer in the -
5:59 - 6:04United States is one shirt.
What is the opportunity cost of a shirt? -
6:05 - 6:08Well, the opportunity cost of a shirt,
what you're giving up to produce an extra -
6:08 - 6:16shirt is one computer. Okay, slightly
harder case, what's the opportunity cost -
6:16 - 6:23of one computer in Mexico? So in Mexico,
in order to get an additional computer, -
6:23 - 6:28you'd have to transfer labor from shirt
production into computer production. But -
6:28 - 6:32how many units of labor you need to
transfer? You need to transfer 12 units of -
6:32 - 6:37labor in order to get one computer, you're
going to have to take 12 units of labor -
6:37 - 6:43from shirt production. That means how many
fewer shirts? Since it takes two units of -
6:43 - 6:48labor to produce one shirt, and you've got
to move 12 units of labor. It means that -
6:48 - 6:54the opportunity cost of one computer is
six shirts. If you need an additional -
6:54 - 7:00computer, it's going to cost you six fewer
shirts in order to get that computer. -
7:00 - 7:04Going the other way, in order to get an
additional shirt, you're going to have to -
7:04 - 7:10give up one-sixth of a computer. Okay, so
now we have our opportunity cost, and now -
7:10 - 7:15it's actually pretty simple because what
the theory of comparative advantage says -
7:15 - 7:21is that you should produce, or you can
produce at lowest cost. So who here has -
7:21 - 7:28the lowest cost of producing a computer?
The lowest cost of producing a computer is -
7:28 - 7:33the United States. The United States is
the low opportunity cost producer of -
7:33 - 7:43computers. Now, who is the low cost
producer of shirts? Well, it's Mexico. In -
7:43 - 7:48Mexico, you're only giving up one-sixth of
a computer to produce a shirt. In the -
7:48 - 7:52United States, you're giving up one
computer to produce a shirt. So you'd much -
7:52 - 7:59rather produce shirts in Mexico where the
opportunity cost is lower. Okay, what -
7:59 - 8:05we're learning here is that Mexico ought
to specialize in computers because they're -
8:06 - 8:11the low cost producer of-- excuse me, in
shirts because they're the low cost -
8:11 - 8:14producer of shirts. The United States
ought to specialize more -
8:14 - 8:20towards computers because they're the low
cost producer of computers. Let's look in -
8:20 - 8:24more detail. So I'm going to leave some of
the details to you actually and some -
8:24 - 8:28homework questions which will go over in
the future video. -
8:28 - 8:32So question one, let's supposed in Mexico
and in the United States each have 24 -
8:32 - 8:38units of labor, and that each devote 12
units of labor to producing computers and -
8:38 - 8:4312 units of labor to producing shirts.
That will be our base line scenario. -
8:43 - 8:47The question is, "What is total world
production in this scenario?" -
8:47 - 8:49That's question one.
-
8:49 - 8:55Question two, supposed that Mexico
specializes in producing what it produces -
8:55 - 8:59at lowest opportunity cost, we just saw
that was shirts and supposed that the U.S. -
8:59 - 9:05transfers two units of labor from shirts
to producing what it produces at lowest -
9:05 - 9:12opportunity cost, that's computers. What
it then is total world production? -
9:12 - 9:17Finally, can trade make both countries
better off? Here what I'd like you to do -
9:17 - 9:23is give a concrete example of how many
units have to be traded from where to -
9:23 - 9:27where in order to make both countries
better off, if that in fact is possible. -
9:28 - 9:32So to help you along a little bit, I know
that was a mouthful. Let's take a look at -
9:32 - 9:38this in terms of a diagram. To help you
along, I want you to fill in these tables. -
9:38 - 9:43So our basic table from which you're going
to draw the information is up here. If -
9:43 - 9:47both countries have 24 units of labor,
half devoted to computers, half to shirts. -
9:47 - 9:52There's no trade so production is equal to
consumption in this first example. What is -
9:52 - 9:54production going to be?
-
9:54 - 9:58So Mexico, 12 units of labor with
computers, 12 shirts. How many computers, -
9:58 - 10:00how many shirts? Same for the United
States. -
10:00 - 10:05How many computers? How many shirts?
What's total world production? Then -
10:05 - 10:09supposed we have specialization, what's
production is going to be? So Mexico has -
10:09 - 10:14zero units of labor in computers, 24 in
shirts. United States has 14 units of -
10:15 - 10:19labor in computers, 10 in shirts. What's
production in each cases? What is the -
10:19 - 10:25total for the world? Then finally, can
we-- with production, with specialization, -
10:25 - 10:31can we now find a way to have trade which
make both countries better off? What's the -
10:32 - 10:36exact-- or what a exact price ratio with
that trade will occur. -
10:36 - 10:40We'll take that up in an later video. Let
me just finally give you some concluding -
10:41 - 10:42comments on comparative advantage.
-
10:43 - 10:47I want to conclude with the caution but
also a big picture of view of comparative -
10:47 - 10:51advantage. In the two country first in
examples, I've been working with in order -
10:51 - 10:56to explain the theory. Everyone is made
better off by trade. In larger examples, -
10:56 - 11:01trade will increase aggregate wealth, but
some individuals can be made where it's -
11:01 - 11:06off. That should make perfect sense after
all. If A and B have been trading, and -
11:06 - 11:11then because terrace cost fall or because
transportation cost fall. If A starts -
11:11 - 11:16trading with C, then B maybe worse off,
even though A, B and C together have -
11:16 - 11:20greater aggregate wealth. That's just a
caution to keep in mind. -
11:20 - 11:25Now here's the big picture. Comparative
advantage, it applies to people, to -
11:25 - 11:30groups, to countries, and sometimes called
the law of association. It's not only a -
11:30 - 11:35beautiful theory. It's very positive and
optimistic theory because it says that we -
11:35 - 11:41all have something to gain from trade. It
says by working together, we can increase -
11:41 - 11:47total wealth. More over we can-- I like to
phrase this in terms of a politically -
11:48 - 11:53correct slogan. "Diversity is strength",
you've probably heard that slogan before. -
11:53 - 11:58What comparative advantage adds to this is
that diversity and strength when combined -
11:58 - 12:04with trade, its trade which turns
diversity into strength. -
12:04 - 12:07That's really the bottom line on
comparative advantage. -
12:07 - 12:10We'll be saying more in future videos.
Thanks. -
12:12 - 12:14- If you want to test
yourself, click Practice Questions -
12:15 - 12:18or if you're ready to move on,
just click Next Video.
- Title:
- Another Look at Comparative Advantage
- 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-microeconomicsAsk a question about the video: http://mruniversity.com/courses/principles-economics-microeconomics/comparative-advantage-definition-opportunity-cost#QandA
Next video: http://mruniversity.com/courses/principles-economics-microeconomics/comparative-advantage-trade-homework
- Video Language:
- English
- Team:
- Marginal Revolution University
- Project:
- Micro
- Duration:
- 12:24
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