Hi. Today we're going to be dealing with one of the
deepest ideas in economics: comparative advantage.
Comparative advantage is the theory of trade.
It explains why people trade and which goods 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. Now let's suppose that in Mexico
it takes 12 units of labor to produce one computer
and again in Mexico it takes two units of labor to produce one shirt.
Now let's compare with the United States.
To make it simple, we'll suppose that 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 out-compete 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 the case where we might think, well, the United States
is 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?
And 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 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 cost
is opportunity cost. So what is the
opportunity cost of Martha Stewart of spending an hour ironing
her own shirts? Well, it could be thousands of dollars! At least!
Martha Stewart will 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,
where 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
most 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 her 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. And in particular, we'd 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.
Well what's 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, okay? 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.
And, 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
what 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.
So 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 a future video.
So question one: Let's suppose that Mexico and the United States each have
24 units of labor and that they each devote 12 units of labor to producing
computers and 12 units of labor to producing shirts. That will be our
baseline scenario. So 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 with shirts, and suppose that the US
transfers 2 units of labor from shirts to producing what it produces at lowest
opportunity cost, that's computers. What then, is total world production?
And finally, can trade make both countries better off? And here what I'd like you to
do is to 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 are 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 in 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 going to be? So Mexico has zero units of labor
in computers, 24 in shirts. The United States has 14 units of labor
in computers, 10 in shirts. What is production in each case?
What is the total for the world? And then finally, can we with production,
with specialization, can we now find a way to have trade which makes both countries
better off, and what's the exact, or what's a exact price ratio in 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 tariff fall, or
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.
It's sometimes called the Law of Association. And it's not only a beautiful
theory, it's a 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. Moreover, 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
is strength when combined with trade. It's trade which turns diversity into
strength. That's really the bottom line on comparative advantage. I'll be saying more
in future videos. Thanks.