- 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.
- If you want to test yourself, click Practice Questions
or if you're ready to move on, just click Next Video.