Comparative advantage explains why people trade and what goods they should trade. To illustrate the concept of comparative advantage, we ask: Should Martha Stewart

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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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. 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 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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Show 2 Answers (Answer provided by Alex Tabarrok)
user's picture

Good question. Ultimately, wages are determined by productivity so wages are included in the model but implicitly. We go into this in more detail in our textbook. Here is the gist. Suppose computers cost $300 and shirts $100 then, using the pre-trade figures, if Mexico uses 24 units of labor to produce 1 computer and 6 shirts the total value of consumption is $900 and since workers in equilibrium all receive the same wage they each receive $37.50. You can do a similar calculation for the US - you should get $200.

You should also do these calculations using the after specialization (with trade) figures and you will find that wages in both countries increase because productivity increases.

So the model is actually quite deep as it also includes wages and the wage story is consistent with the story that focuses on output directly.Of course, the model doesn't include other factors like minimum wages or unions or lots of other things but that would obscure the point of the model.

Sir you said the similar calculation for US will get 200 dollar. I got 262.5 dollars. Where did I go wrong?

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Just looking at it from purely financial standpoint Martha Stewart is not better off doing her own ironing, however if we could calculate what implicit benefit that ironing her own shirt/clothes bring to her that be a good reason for her to continue ironing her shirt. As you defined at the beginning Comparative advantage is about one trying to maximize their well being through trading...so there in lies the solution: it depends on what Martha deems to be her well being... financial returns or that inner peace (most certainly doesn't add up to GDP) but may be the thing that keeps Martha going.

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Show 1 Answer (Answer provided by Ion Sterpan)
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In that case the concept of comparative advantage does not apply. The concept of comparative advantage only applies to objects which are "goods" for both countries (or processes which are "services"). This means objects which are desired, or for which there is some willingness to pay, for example if there is any positive fraction of a computer that Americans would pay for a Mexican shirt. A certain type of exorcism or ghost busting might be an example of a practice which is a service in country A but not in country B.

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