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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- [Alex] 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 Stewart
iron her own shirts?

Of course the answer here is, no.

Why not?

Well, every hour
which Martha Stewart 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 Stewart --

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 Stewart
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's 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 to 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 we'll go over
in the future video.

So question one -- let's suppose
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 baseline scenario.

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

That's question one.

Question two -- suppose that Mexico
specializes in producing

what it produces
at lowest opportunity cost --

we just saw that was shirts --

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

from shirts to producing
what it produces

at lowest opportunity cost --
that's computers.

What 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 suppose
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 case?

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 makes both countries
better off?

What's the exact,
or what's a exact price ratio

at which that trade will occur?

We'll take that up
in a later video.

Let me just finally give you
some concluding comments

on comparative advantage.

I want to conclude with a caution

but also a big picture view
of comparative advantage.

In the two country/person 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 worse off.

And that should make perfect sense.

After all, if A and B
have been trading,

and then because tariffs fall

or because
transportation costs fall,

if A starts trading with C,
then B may be 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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