Another Look at Comparative Advantage

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.
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- In our last video, Don Boudreaux
used the simple example of Bob and Anne to

demonstrate comparative advantage. In the
next two videos, we'll dive deeper into

comparative advantage and give you a
homework question to test how well you're

doing in understanding the concept.
Let's get going.

- Comparative advantage is the
theory of trade. It explains why people

trade, and which good people should trade
if they want to maximize their well being.

It's actually useful to understand
comparative advantage to begin with a

false theory: a very plausible but
incorrect theory of trade, namely the

theory of absolute advantage. So let's
consider a simple model. Let's suppose

that labor is the only good used in
production and that we can produce

computers or shirts. Let's suppose that
in Mexico it takes 12 units of labor to

produce one computer. Again in Mexico,

it takes two units of labor
to produce one shirt.

Now let's compare it with the United
States. To make it simple, we'll suppose

in the United States it takes just one
unit of labor to make one computer, and

one unit of labor to create one shirt.
Now, from the absolute advantage theory of

trade, it should-- it may seem obvious
that there in fact will-- be no trade here.

It may seem obvious that the United
States will outcompete Mexico on all

margins. After all, the United States in
this example is much more productive at

producing computers and also more
productive at producing shirts than

Mexico. So this is a case where we might
think, with the United States so much

better at producing both computers and
shirts, that certainly there's no reason

for the United States to trade with
Mexico, its less productive neighbor.

That's the theory of absolute advantage.
It's very plausible; it's also very wrong.

To see why it's wrong, let's take another
simple example. Here's a picture of Martha

Stewart ironing her shirt. Now, let's
stipulate that Martha Stewart has an

absolute advantage in ironing. She has an
advantage in ironing just like the United

States had an advantage in producing
computers and shirts in the previous

example. In other words, we'll stipulate
that Martha Stewart

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

So if Martha Stewart has an
absolute advantage in ironing

should Martha Stuart iron her own
shirts? Of course the answer here is, no.

Why not? Well, every hour which Martha
Stuart Spends ironing her shirts is an

hour she's not spending doing something
else which is even more valuable, running

her own business for example, running her
billion dollar business. And in fact in a

famous statement, Martha Stuart because
she's very wise she said, "I don't always

do all of my own ironing, even though I
wish that I could." Let's take a little

bit more detail about why it doesn't make
sense for Martha Stuart to iron her own

shirts. The most important point to
remember is that the important cause is

opportunity cost. So what is the
opportunity cost to Martha Stewart of

spending an hour ironing her own shirts?
Well, it could be thousands of dollars, at

least. Martha Stewart would be better off
if she specializes in producing her

television show, and then she trades with
someone else who has a lower opportunity

cost of ironing. It doesn't make sense for
Martha Stewart to iron her own shirts

because the cost of her doing so is
devoting her time to something where she's

even more valuable or she even better and
that is producing her own television show.

So Martha Stewart has a comparative
advantage in running her business, or to

put it slightly differently she has a
comparative disadvantage in ironing. The

cost of her of ironing is very high
precisely because she is so much more

productive at other tasks. So Martha
Stewart wants to specialize in what she

is best at, in where she has a
comparative advantage. Other people

are almost as good as her at ironing
clothes, but they're not as good as her at

producing their own TV show. So that's why
Martha Stewart shouldn't

iron her own shirts.

Let's go back now to our previous example
of the United States and Mexico. So the

key to comparative advantage is
understanding opportunity cost. So let's

take this previous figure we had from a
previous slide and turn it into an

opportunity cost figure. So remember what
this top figure tells us: it tells us for

example that in Mexico it takes 12 units
of labor to produce one computer, and in

Mexico it takes two units of labor to
produce one shirt and so forth. Okay, for

the United States, it just takes one unit
of labor to produce either

a computer or a shirt.

Okay, now let's begin with an easy case.
What's the opportunity cost of one

computer in the United States? In other
words, to produce an additional computer

in the United States, what would we have
to give up? Well, in order to get that

additional computer, we'd have to take
labor from shirt production and move it

into computer production. In particular,
we have to take one unit of labor from

shirt production and move it into computer
production. That would get us one more

computer at the cost of one shirt. So the
opportunity cost of one computer in the

United States is one shirt.
What is the opportunity cost of a shirt?

Well, the opportunity cost of a shirt,
what you're giving up to produce an extra

shirt, is one computer. Okay, slightly
harder case, what's the opportunity cost

of one computer in Mexico? So in Mexico,
in order to get an additional computer,

you'd have to transfer labor from shirt
production into computer production. But

how many units of labor do you need to
transfer? You need to transfer 12 units of

labor in order to get one computer. You're
going to have to take 12 units of labor

from shirt production. That means how many
fewer shirts? Since it takes two units of

labor to produce one shirt, and you've got
to move 12 units of labor. It means that

the opportunity cost of one computer is
six shirts. If you need an additional

computer, it's going to cost you six fewer
shirts in order to get that computer.

Going the other way, in order to get an
additional shirt, you're going to have to

give up one-sixth of a computer. Okay, so
now we have our opportunity cost, and now

it's actually pretty simple because what
the theory of comparative advantage says

is that you should produce, or you can
produce at lowest cost. So who here has

the lowest cost of producing a computer?
The lowest cost of producing a computer is

the United States. The United States is
the low opportunity cost producer of

computers. Now, who is the low cost
producer of shirts? Well, it's Mexico. In

Mexico, you're only giving up one-sixth of
a computer to produce a shirt. In the

United States, you're giving up one
computer to produce a shirt. So you'd much

rather produce shirts in Mexico where the
opportunity cost is lower. Okay, what

we're learning here is that Mexico ought
to specialize in computers because they're

the low cost producer of-- excuse me, in
shirts because they're the low cost

producer of shirts. The United States
ought to specialize more

towards computers because they're the low
cost producer of computers. Let's look in

more detail. So I'm going to leave some of
the details to you actually and some

homework questions which will go over in
the future video.

So question one, let's supposed in Mexico
and in the United States each have 24

units of labor, and that each devote 12
units of labor to producing computers and

12 units of labor to producing shirts.
That will be our base line scenario.

The question is, "What is total world
production in this scenario?"

That's question one.

Question two, supposed that Mexico
specializes in producing what it produces

at lowest opportunity cost, we just saw
that was shirts and supposed that the U.S.

transfers two units of labor from shirts
to producing what it produces at lowest

opportunity cost, that's computers. What
it then is total world production?

Finally, can trade make both countries
better off? Here what I'd like you to do

is give a concrete example of how many
units have to be traded from where to

where in order to make both countries
better off, if that in fact is possible.

So to help you along a little bit, I know
that was a mouthful. Let's take a look at

this in terms of a diagram. To help you
along, I want you to fill in these tables.

So our basic table from which you're going
to draw the information is up here. If

both countries have 24 units of labor,
half devoted to computers, half to shirts.

There's no trade so production is equal to
consumption in this first example. What is

production going to be?

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

how many shirts? Same for the United
States.

How many computers? How many shirts?
What's total world production? Then

supposed we have specialization, what's
production is going to be? So Mexico has

zero units of labor in computers, 24 in
shirts. United States has 14 units of

labor in computers, 10 in shirts. What's
production in each cases? What is the

total for the world? Then finally, can
we-- with production, with specialization,

can we now find a way to have trade which
make both countries better off? What's the

exact-- or what a exact price ratio with
that trade will occur.

We'll take that up in an later video. Let
me just finally give you some concluding

comments on comparative advantage.

I want to conclude with the caution but
also a big picture of view of comparative

advantage. In the two country first in
examples, I've been working with in order

to explain the theory. Everyone is made
better off by trade. In larger examples,

trade will increase aggregate wealth, but
some individuals can be made where it's

off. That should make perfect sense after
all. If A and B have been trading, and

then because terrace cost fall or because
transportation cost fall. If A starts

trading with C, then B maybe worse off,
even though A, B and C together have

greater aggregate wealth. That's just a
caution to keep in mind.

Now here's the big picture. Comparative
advantage, it applies to people, to

groups, to countries, and sometimes called
the law of association. It's not only a

beautiful theory. It's very positive and
optimistic theory because it says that we

all have something to gain from trade. It
says by working together, we can increase

total wealth. More over we can-- I like to
phrase this in terms of a politically

correct slogan. "Diversity is strength",
you've probably heard that slogan before.

What comparative advantage adds to this is
that diversity and strength when combined

with trade, its trade which turns
diversity into strength.

That's really the bottom line on
comparative advantage.

We'll be saying more in future videos.
Thanks.

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yourself, click Practice Questions

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