Another Look at Comparative Advantage

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 a 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. 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 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, 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? 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 cost 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 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. 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 costs, 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, 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 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? And 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? And 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. 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. We'll be saying more in future videos. Thanks.