Another Look at Comparative Advantage
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0:10 - 0:11- [Alex] In our last video,
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0:11 - 0:14Don Boudreaux used
the simple example of Bob and Anne -
0:14 - 0:16to demonstrate
comparative advantage. -
0:17 - 0:18In the next two videos,
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0:18 - 0:20we'll dive deeper
into comparative advantage -
0:20 - 0:21and give you a homework question
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0:21 - 0:25to test how well you're doing
in understanding the concept. -
0:25 - 0:26Let's get going.
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0:30 - 0:33Comparative advantage
is a theory of trade. -
0:33 - 0:37It explains why people trade,
and which goods people should trade -
0:37 - 0:39if they want to maximize
their well-being. -
0:40 - 0:43It's actually useful to understand
comparative advantage -
0:43 - 0:45to begin with a false theory,
-
0:45 - 0:49a very plausible
but incorrect theory of trade -- -
0:49 - 0:51namely the theory
of absolute advantage. -
0:51 - 0:53So let's consider a simple model.
-
0:53 - 0:57Let's suppose that labor
is the only good used in production -
0:57 - 1:00and that we can produce
computers or shirts. -
1:00 - 1:04Now let's suppose that in Mexico
it takes 12 units of labor -
1:04 - 1:07to produce one computer.
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1:07 - 1:08Again, in Mexico,
-
1:08 - 1:12it takes two units of labor
to produce one shirt. -
1:12 - 1:14Now let's compare
with the United States. -
1:14 - 1:17To make it simple, we'll suppose
that in the United States -
1:17 - 1:20it takes just one unit of labor
to make one computer, -
1:20 - 1:24and one unit of labor
to create one shirt. -
1:24 - 1:29Now, from the absolute advantage
theory of trade -
1:29 - 1:31it may seem obvious
that there in fact -
1:31 - 1:33will be no trade here.
-
1:33 - 1:36It may seem obvious
that the United States -
1:36 - 1:40will outcompete Mexico
on all margins. -
1:40 - 1:42After all, the United States
in this example -
1:42 - 1:45is much more productive
at producing computers -
1:45 - 1:49and also more productive
at producing shirts than Mexico. -
1:50 - 1:51So this is a case
where we might think, -
1:51 - 1:54well the United States
is so much better -
1:54 - 1:56at producing
both computers and shirts, -
1:56 - 1:58that certainly there's no reason
-
1:58 - 2:02for the United States
to trade with Mexico, -
2:02 - 2:05its less productive neighbor.
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2:06 - 2:09That's the theory
of absolute advantage. -
2:09 - 2:12It's very plausible.
It's also very wrong. -
2:12 - 2:15To see why it's wrong,
let's take another simple example. -
2:15 - 2:18Here's a picture of Martha Stewart
ironing her shirt. -
2:18 - 2:21Now, let's stipulate
that Martha Stewart -
2:21 - 2:24has an absolute advantage
in ironing. -
2:24 - 2:27She has an advantage in ironing
just like the United States -
2:27 - 2:30had an advantage in producing
computers and shirts -
2:30 - 2:31in the previous example.
-
2:31 - 2:34In 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 -
2:44 - 2:46should Martha Stewart
iron her own shirts? -
2:47 - 2:50Of course the answer here is, no.
-
2:50 - 2:51Why not?
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2:51 - 2:54Well, every hour
which Martha Stewart spends -
2:54 - 2:58ironing her shirts is an hour
she's not spending -
2:58 - 3:01doing something else
which is even more valuable, -
3:01 - 3:03running her own business
for example -- -
3:03 - 3:06running her billion-dollar business.
-
3:06 - 3:08And in fact in a famous statement,
Martha Stewart -- -
3:08 - 3:10because she's very wise --
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3:10 - 3:13she said, "I don't always
do all of my own ironing, -
3:13 - 3:15even though I wish that I could."
-
3:16 - 3:19Let's take a little bit more detail
about why it doesn't make sense -
3:19 - 3:22for Martha Stewart
to iron her own shirts. -
3:23 - 3:25The most important point
to remember -
3:25 - 3:29is that the important cost
is opportunity cost. -
3:29 - 3:32So what is the opportunity cost
to Martha Stewart -
3:32 - 3:35of spending an hour
ironing her own shirts? -
3:35 - 3:38Well, it could be
thousands of dollars, at least. -
3:39 - 3:41Martha Stewart will be better off
-
3:41 - 3:45if she specializes in producing
her television show, -
3:45 - 3:47and then she trades
with someone else -
3:47 - 3:50who has a lower
opportunity cost of ironing. -
3:50 - 3:53It doesn't make sense
for Martha Stewart -
3:53 - 3:54to iron her own shirts
-
3:54 - 3:57because the cost of her doing so
-
3:57 - 4:01is devoting her time to something
where she's even more valuable -
4:01 - 4:03where she's even better,
-
4:03 - 4:05and that is producing
her own television show. -
4:06 - 4:09So Martha Stewart
has a comparative advantage -
4:09 - 4:13in running her business,
or to put it slightly differently -
4:13 - 4:16she has a comparative
disadvantage in ironing. -
4:16 - 4:20The cost to her of ironing
is very high -
4:20 - 4:24precisely because she is so much
more productive at other tasks. -
4:25 - 4:28So Martha Stewart
wants to specialize -
4:28 - 4:31in what she is most best at,
-
4:31 - 4:34in where she has
a comparative advantage. -
4:34 - 4:38Other people are almost as good
as her at ironing clothes, -
4:38 - 4:42but they're not as good as her
at producing her own TV show. -
4:43 - 4:46So that's why Martha Stewart
shouldn't iron her own shirts. -
4:46 - 4:49Let's go back now
to our previous example -
4:49 - 4:51of the United States and Mexico.
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4:52 - 4:55So the key to comparative advantage
is understanding opportunity cost. -
4:56 - 5:00So let's take this previous figure
we had from a previous slide -
5:00 - 5:03and turn it
into an opportunity cost figure. -
5:03 - 5:06So remember
what this top figure tells us -- -
5:06 - 5:08it tells us for example
that in Mexico -
5:08 - 5:11it takes 12 units of labor
to produce one computer, -
5:11 - 5:13and in Mexico it takes
two units of labor -
5:13 - 5:16to produce one shirt
and so forth. -
5:16 - 5:19Okay, for the United States,
it just takes one unit of labor -
5:19 - 5:21to produce
either a computer or a shirt. -
5:21 - 5:25Okay, now let's begin
with an easy case. -
5:25 - 5:30What's the opportunity cost of
one computer in the United States? -
5:31 - 5:34In other words, to produce
an additional computer -
5:34 - 5:37in the United States,
what would we have to give up? -
5:38 - 5:40Well, in order to get
that additional computer, -
5:40 - 5:42we'd have to take labor
from shirt production -
5:42 - 5:45and move it
into computer production. -
5:45 - 5:48In particular, we have to take
one unit of labor -
5:48 - 5:51from shirt production and move it
into computer production. -
5:52 - 5:56That would get us one more computer
at the cost of one shirt. -
5:56 - 5:58So the opportunity cost
-
5:58 - 6:01of one computer
in the United States is one shirt. -
6:02 - 6:04What is the opportunity cost
of a shirt? -
6:04 - 6:07Well, the opportunity cost
of a shirt, -
6:07 - 6:09what you're giving up
to produce an extra shirt, -
6:09 - 6:11is one computer.
-
6:11 - 6:14Okay, slightly harder case --
-
6:14 - 6:19what's the opportunity cost
of one computer in Mexico? -
6:19 - 6:23So in Mexico, in order to get
an additional computer, -
6:23 - 6:25you'd have to transfer labor
-
6:25 - 6:27from shirt production
into computer production. -
6:28 - 6:30But how many units of labor
do you need to transfer? -
6:30 - 6:33You need to transfer
12 units of labor. -
6:33 - 6:35In order to get one computer
-
6:35 - 6:37you're going to have
to take 12 units of labor -
6:37 - 6:39from shirt production.
-
6:39 - 6:41That means how many fewer shirts?
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6:42 - 6:44Since it takes two units of labor
to produce one shirt, -
6:44 - 6:47and you've got to move
12 units of labor, -
6:47 - 6:52it means that the opportunity cost
of one computer is six shirts. -
6:52 - 6:54If you need an additional computer,
-
6:54 - 6:57it's going to cost you
six fewer shirts -
6:57 - 6:59in order to get that computer.
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7:00 - 7:03Going the other way, in order
to get an additional shirt, -
7:03 - 7:07you're going to have to give up
one-sixth of a computer. -
7:07 - 7:10Okay, so now we have
our opportunity costs, -
7:10 - 7:11and now it's actually pretty simple
-
7:11 - 7:15because what the theory
of comparative advantage says -
7:15 - 7:19is that you should produce,
or you can produce at lowest cost. -
7:20 - 7:25So who here has the lowest cost
of producing a computer? -
7:26 - 7:28The lowest cost
of producing a computer -
7:28 - 7:29is the United States.
-
7:29 - 7:33The United States is
the low opportunity cost producer -
7:33 - 7:34of computers.
-
7:34 - 7:38Now, who is the low cost
producer of shirts? -
7:39 - 7:43Well, it's Mexico.
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7:43 - 7:46In Mexico, you're only giving up
one-sixth of a computer -
7:46 - 7:48to produce a shirt.
-
7:48 - 7:50In the United States,
you're giving up one computer -
7:50 - 7:51to produce a shirt.
-
7:51 - 7:54So you'd much rather
produce shirts in Mexico -
7:54 - 7:58where the opportunity cost is lower.
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7:58 - 8:01Okay, so what we're learning here
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8:01 - 8:05is that Mexico ought
to specialize in computers -
8:05 - 8:08because they're
the low cost producer of -- -
8:08 - 8:10excuse me, in shirts
-
8:10 - 8:12because they're
the low cost producer of shirts. -
8:12 - 8:16The United States ought
to specialize more towards computers -
8:16 - 8:19because they're
the low cost producer of computers. -
8:20 - 8:21Let's look in more detail.
-
8:22 - 8:24So I'm going to leave some
of the details to you actually -
8:24 - 8:26and some homework questions
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8:26 - 8:28which we'll go over
in a future video. -
8:28 - 8:32So question one -- let's suppose
that Mexico and the United States -
8:32 - 8:34each have 24 units of labor,
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8:34 - 8:36and that they each devote
12 units of labor -
8:36 - 8:38to producing computers
-
8:38 - 8:40and 12 units of labor
to producing shirts. -
8:41 - 8:44That will be our baseline scenario.
So the question is -- -
8:44 - 8:47What is total world production
in this scenario? -
8:47 - 8:49That's question one.
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8:49 - 8:50Question two.
-
8:50 - 8:54Suppose that Mexico
specializes in producing -
8:54 - 8:56what it produces
at lowest opportunity cost -- -
8:56 - 8:58we just saw that was shirts --
-
8:58 - 9:02and suppose that the U.S.
transfers two units of labor -
9:02 - 9:05from shirts to producing
what it produces -
9:05 - 9:08at lowest opportunity cost --
that's computers. -
9:08 - 9:11What then
is total world production? -
9:12 - 9:16Finally, can trade make
both countries better off? -
9:16 - 9:19And here what I'd like you to do
is give a concrete example -
9:19 - 9:23of how many units have to be traded
from where to where -
9:23 - 9:25in order to make
both countries better off, -
9:25 - 9:27if that in fact is possible.
-
9:27 - 9:29So to help you along a little bit --
-
9:29 - 9:31I know that was a mouthful --
-
9:31 - 9:34let's take a look at this
in terms of a diagram. -
9:35 - 9:37To help you along,
I want you to fill in these tables. -
9:38 - 9:39So our basic table
-
9:39 - 9:42from which you're going
to draw the information is up here. -
9:42 - 9:45If both countries have
24 units of labor, -
9:45 - 9:48half devoted to computers,
half to shirts, there's no trade, -
9:48 - 9:50so production is equal
to consumption -
9:50 - 9:54in this first example --
what is production going to be? -
9:54 - 9:57So Mexico, 12 units of labor
with computers, 12 shirts. -
9:57 - 9:59How many computers,
how many shirts? -
9:59 - 10:00Same for the United States.
-
10:00 - 10:02How many computers?
How many shirts? -
10:02 - 10:05What's total world production?
-
10:05 - 10:07Then suppose
we have specialization -- -
10:07 - 10:08what's production is going to be?
-
10:08 - 10:13So Mexico has zero units of labor
in computers, 24 in shirts. -
10:13 - 10:17United States has 14 units of labor
in computers, 10 in shirts. -
10:17 - 10:19What's production in each case?
-
10:19 - 10:21What is the total for the world?
-
10:21 - 10:24Then finally, can we --
-
10:24 - 10:26with production,
with specialization, -
10:26 - 10:28can we now find a way to have trade
-
10:28 - 10:31which makes both countries
better off? -
10:31 - 10:34And what's the exact,
or what's a exact price ratio -
10:34 - 10:36at which that trade will occur?
-
10:36 - 10:38We'll take that up
in a later video. -
10:38 - 10:41Let me just finally give you
some concluding comments -
10:41 - 10:43on comparative advantage.
-
10:43 - 10:45I want to conclude with a caution
-
10:45 - 10:48but also a big picture view
of comparative advantage. -
10:48 - 10:51In the two country/person examples
I've been working with -
10:51 - 10:53in order to explain the theory,
-
10:53 - 10:54everyone is made
better off by trade. -
10:55 - 10:59In larger examples, trade
will increase aggregate wealth, -
10:59 - 11:01but some individuals
can be made worse off. -
11:01 - 11:03And that should make perfect sense.
-
11:03 - 11:06After all, if A and B
have been trading, -
11:06 - 11:08and then because tariffs fall
-
11:08 - 11:10or because
transportation costs fall, -
11:10 - 11:14if A starts trading with C,
then B may be worse off, -
11:14 - 11:18even though A, B and C together
have greater aggregate wealth. -
11:18 - 11:20That's just a caution
to keep in mind. -
11:20 - 11:22Now here's the big picture.
-
11:22 - 11:25Comparative advantage --
it applies to people, -
11:25 - 11:26to groups, to countries.
-
11:26 - 11:29It's sometimes called
the law of association. -
11:29 - 11:31And it's not only
a beautiful theory -- -
11:31 - 11:34it's a very positive
and optimistic theory -
11:34 - 11:37because it says that we all have
something to gain from trade. -
11:37 - 11:42It says by working together,
we can increase total wealth. -
11:43 - 11:47Moreover we can --
I like to phrase this in terms -
11:47 - 11:50of a politically correct slogan:
"Diversity is strength." -
11:50 - 11:53You've probably heard
that slogan before. -
11:53 - 11:55What comparative advantage
adds to this -
11:55 - 12:00is that diversity is strength
when combined with trade -- -
12:00 - 12:04it's trade which turns diversity
into strength. -
12:04 - 12:07That's really the bottom line
on comparative advantage. -
12:07 - 12:09We'll be saying more
in future videos. -
12:09 - 12:10Thanks.
-
12:12 - 12:13- [Narrator] If you want
to test yourself, -
12:13 - 12:14click "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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