[SQUEAKING]
[RUSTLING]
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JONATHAN GRUBER:
Today, we're going
to finish our
discussion of savings,
continue my nagging
on you guys about how
you should be saving money.
And then we're going
to move on and talk
about international trade.
So let's finish our
discussion of savings.
Now, savings turns out to be
a critically important element
of growth in the economy.
And we've now traced
through why that happens.
Our basic story is
as savings goes up,
that means that the
capital supply shifts out.
So the capital
supply curve shifts
outward as people save more.
That's an increase
in the capital supply
curve in the capital markets.
That means that
interest rates fall.
Because there's more
supply for given demand,
the price is going to fall.
The price of capital
is the interest rate.
So as people save more,
that's more supply
into capital markets.
It's increasing the pool from
which firms have to borrow.
For a given pool, firms
have to pay less money
to borrow from that.
If the interest rate
goes down, that means
the NPV of investment
goes up, because remember,
the net present
value of investments
is a negative function
of the interest rate.
The lower the interest
rate, the more firms
will say I might as well buy a
new machine, because the bank's
not paying anything.
That means that NPV
investment goes up,
which means investment goes up.
So the bottom line
is, the way we
get firms to invest
more and grow
the economy is by saving more.
We save more.
We increase capital supply.
That lowers the interest rate.
That raises the
NPV of investment,
which leads to more investment.
So that's the link by which
savings lead economic growth,
is that savings leads
firms to invest more.
Is that clear from
the sort of structure
we built in the last
couple lectures?
If it's not, just
go back through
and work through the math.
But you'll see we talked
about the capital market.
The interest rates, the price,
and the capital market--
last time we talked about
the lower the interest rate,
the higher the net present
value of any given investment.
That means firms
will invest more.
So that means a critical
public policy concern is
getting people to save enough.
Now, obviously, that varies
with economic conditions.
In a deep recession, we don't
naturally want as much savings
as when we're not in recession.
But in general, in the long run,
we will grow more as an economy
if we save more as a society.
And the US has an
incredible low savings rate.
Our savings rate in the US,
depending how you define it,
is maybe 3% to 5%.
In Europe, in Japan, it's
like 15-plus percent.
So we have a very
low savings rate.
And as a result, that has
led public policymakers
to try to think about tools they
can use to encourage savings.
And the major tool we
use in public policy
to encourage savings is the tax
subsidy to retirement savings.
The tax subsidy to
retirement savings
is the major tool that we use
to increase savings in the US.
Now, how does this work?
The basic logic
is the following--
When I put my money in the
bank and I earn interest,
that interest gets taxed.
Just like my labor
supply gets taxed,
my capital income gets taxed.
So when I put money in
the bank, I don't just
earn the interest rate.
We'll use our-- we don't care
about real interest rate.
[INAUDIBLE] earn interest rate.
I earn r times 1 minus tau,
where tau is the tax rate.
That's all I take home.
So the bank pays me 10%.
Say inflation is zero,
so nominal interest rates
are the same.
If the bank pays me 10%
and my tax rate's 50%,
I only take home 5% on that.
If we assume substitution
effects dominate--
which is a big assumption,
but typically one we make--
this means the taxation, by
lowering the return to savings,
will lead to less savings.
So by taxing people's savings,
we lead to less of it,
because we sort of assume
substitution effects dominate.
To offset this, we say,
well, I'll tell you what--
if you save for retirement,
we won't tax it.
So if you save it, and
you pull it out next year,
we're going to tax
it, but if you put it
in special accounts which we've
labeled as retirement savings,
we won't tax it.
So these have a number of forms.
One form is employer
sponsored pensions.
These are things
where your employer
takes some of your pay,
puts it aside in an account.
And when he does that,
you're not taxed on that pay.
So if MIT is going
to pay me $100,000,
and they pull $10,000 aside
and put it in a pension,
I'm only taxed on $90,000.
That $10,000 isn't taxed.
And likewise, the interest
that's earned on that
isn't taxed.
There's also 401(k)s.
A 401(k) is like a pension, but
where you control the money.
So when you get a job, you
might get offered a 401(k).
That's something where
some of your money
gets pulled out of your salary.
It doesn't get taxed, and
it gets saved instead,
and you control where it goes.
And then we also have
individual retirement accounts,
with the unfortunate name IRA.
It's not the Irish
Republican Army,
but individual retirement
accounts, which are similar
features, where you
could take your money
and save it on a tax-free basis.
Now here's the trick about
how all these things work, is
they're not actually tax free.
They are tax deferred.
And what do I mean by that?
What I mean by that is that
when you take the money out
eventually, it does get taxed.
So the way, say, your
401(k) would work--
you get a job at
whatever, Google.
Google offers you a 401(k).
You put money in it.
That money then accumulates.
And when you take it
out-- you put money in.
That money is not taxed
when you put it in,
but when you take
it out, it is taxed.
So it is eventually taxed.
So what good does that do you?
What good does that
do you if it's going
to get taxed eventually anyway?
Yeah.
AUDIENCE: If you don't
get taxed right now,
you get more money now, which
will then accumulate more money
through compound interest.
JONATHAN GRUBER: Right.
It takes advantage
of present value.
Remember, we talked
about this last time.
With present value, money in the
future is worth less than money
today.
By that same logic,
paying taxes in the future
costs you less than
paying taxes today,
because you have the money.
You can earn all
this interest on it,
and you have to pay taxes
on it off in the future.
So let's see an example of that.
Let's look at figure 18.1.
Let's say you have two types
of accounts, a regular account,
or an IRA account, which
is a tax-deferred account.
And let's say the
tax rate is 25%
and the interest rate is 10%.
And let's say you're just
going to put the money in--
to make life easy, imagine
put the money in for one year.
Imagine you're
retiring next year.
This is a super easy example.
You're retiring next year.
The question is, for
this last year of work,
should you put your money
in a tax-deferred account
or in a regular account?
If you put it in
a regular account,
you will take your $100 of
earnings to pay $25 of taxes
right away.
You only get to put $75 in.
On that $75, you'll earn $7.50.
And when you take the $7.50
out, you'll pay $1.88 in taxes.
So you pay $25 on your earnings.
You pay another $1.88 on
the interest you earned.
And you end up with $80.62.
Now let's say instead,
you set up an IRA.
There, you get to put
the whole $100 in.
That $100 earns $10.
And when you take out $110,
then you pay tax on it,
so you pay $27.50,
then, in the end.
But if you put it all together,
you end up with more money--
$82.50 rather than $80.62.
Why is that?
It's because you delayed
paying taxes by a year.
By paying taxes
one year later, you
got to earn the interest on
that money during the year.
Think of it this way--
if you pay taxes now,
the government gets
the money and they
get to earn interest on it.
If you pay taxes next
year, you keep the money
and you earn interest on it.
So it's much better
to pay taxes later,
and that's why these
accounts matter.
It's a simple example.
It's a simple example.
If you have a 30-year account,
if we kept the interest
rate at 10% and the
tax rate at 25%,
and did a 30-year
calculation, you
would have twice as much
money after 30 years,
if you put it in an IRA
rather than putting it
in a regular bank account.
So even though it
eventually gets taxed,
it's a big advantage.
It's a big advantage.
And that's why public policy
introduced these tools--
401(k)s, pensions, IRAs--
because they're trying
to encourage saving by
raising the return to saving.
And they hope that by
encouraging saving,
they'll get all this good
stuff coming out of it.
So that's why these
things come up.
So the first lesson is, just
like my continued nag on you,
is save early and save often.
Things like 401(k)s, by
putting your money away,
not only do you get the
compounding I talked about
before, but you also get the tax
benefit of paying taxes later
rather than sooner.
You get the compounding
on the money
and the compounding
on the taxes.
So these kinds of retirement
accounts, when you get your job
and you're thinking about why
would I worry about retirement,
worry about retirement.
There's a big advantage.
Then you ask, that's
fine, John, but when
I get my 401(k) paperwork,
I've got like a million things
I could invest in.
What I do with the money?
So let's talk for
a couple of minutes
about investment strategy, about
what you do with the money.
So let's think about
three different ways
you can invest your retirement
money, three class of options
a 401(k) will typically have.
They'll typically be a money
market fund, a bond fund,
and a stock fund.
And there will be various
combinations of these,
but these are the categories.
What do these mean?
Money market means the money is
invested in government bonds.
The money is invested in
what are called "Treasury
securities," government bonds.
These are things which are ultra
safe, as long as the US doesn't
default on its debt, which
we've never done in our history
and, the good Lord willing,
won't do in the near term.
Because the US doesn't default
on its debt, you get paid back.
These are super safe, the safest
place you can put your money.
But they pay a very
low interest rate.
Right now, they're
paying interest rates,
a typical government
bond fund right now
would be paying interest rate
of around maybe 2%, maybe
1% to 2%--
very low interest
rate, maybe up to 3%
now, but very, very low single
digits, but totally safe.
A bond fund invests your
money in corporate bonds.
Basically, this is making
loans to corporations.
Instead of loaning
money to the government,
you loan the money
to a corporation.
You're not actually
buying a bond in GM.
That's too hard.
So what these 401(k)
accounts do is they say,
we're going to buy
a bunch of bonds.
We're going to put
them together, and let
you own a small piece of
that entire set of bonds.
That's what a bond fund is.
So you own a small piece of
bunch of corporate bonds.
The difference is,
unlike the government,
corporations do go out
of business all the time.
So these are riskier.
These are riskier, but they
pay a higher interest rate.
Bond funds typically
paying 4% to 5% right now.
Then finally, the last thing
you can do with the money
is you can put in stocks.
You could literally
own corporate equity.
You could own a
piece of companies.
You could own a piece
of the companies,
and then what you get
is you get something,
it doesn't really matter.
With these two,
it only matters--
you get paid as long as the
government or the company
doesn't go out of business.
Here you get paid in proportion
to how well the company does.
If it does really well,
you make a lot of money.
Stock prices go up.
If it goes badly,
you lose money.
It goes bankrupt,
you lose everything.
So similar to these,
in the bankruptcy,
it costs you everything.
The difference is these,
either you get paid
or you go bankrupt.
Here, it's much more variable.
Things do well, you get more.
Things go badly, you get less.
So this is the
riskiest option of all,
but it also pays the
highest rate of return.
Traditionally, stock investments
pay a long rate of return
about 7% a year.
So what we see here when
we compare these is what
economists call the
"risk-return trade-off."
The riskier things
are, the higher
you earn by investing
in them, but the riskier
that earnings is.
The more [INAUDIBLE]
invest in them,
but the riskier
that earnings is.
That in other words, people
are willing to accept a lower
interest rate for
a safe investment
than they want for
a risky investment.
And we'll talk about, in
two lectures from now,
why that is, why people's
preferences are that way.
It's because people are
what we call "risk averse."
People don't like
risk, and we'll
talk about why that's
a natural way to be.
So basically, that is
your set of choices.
And what economists
recommend is that the key
in all of these investments
is to diversify.
The key recommendation
of economists
is diversification, that
you spread your money
across these options to get
the right balance of risk
and return.
So that basically, if
you're someone who--
now, how you balance depends
on your taste for risk.
For someone who
really hates risk,
you put most of your money here.
But it's silly to put all
your money in money markets,
because you're losing
a lot of return.
If you're someone
who's risk loving,
you might want to put most
of your money in stocks.
But still don't
put all your money
in stocks, because you
have a much higher risk.
You want some safety
behind you as well.
So an economist would
say you should diversify.
Now, that's a general.
I can't tell you what percentage
is the right percentages.
I can tell you to diversify.
But I can give you one
specific piece of advice--
that when you go
work for Company X,
the one thing you
do not want to do
is put your money in
the stock of Company X.
Why is that?
Why is the last
thing you want to do
when you go to work for Company
X to put a bunch of your money
in the stock of Company X?
Yeah.
AUDIENCE: [INAUDIBLE]
JONATHAN GRUBER:
No, this would be
through a 401(k) [INAUDIBLE].
It wouldn't be like that.
Yeah.
AUDIENCE: If you lose your job,
or if the company shuts down,
you can lose both your
job and the money.
JONATHAN GRUBER: That is the
maximally risky strategy,
because you are tying your
risk of your investments
to your risk of your salary.
That's the most risky
thing you can do.
So absolutely what you
would not want to do
is go work for
Google and say, good,
I'm going to put all my
retirement in Google stock.
You might think Googles
safe, but safer companies
than Google--
companies thought to be safer
than Google at some point
have gone bankrupt.
Google is bankrupt,
you're totally screwed.
You've lost all your
savings and your job,
so the last thing
you want do is that.
Yeah.
AUDIENCE: If you're in a
more corporate position,
and they gave you
bonds as promises.
JONATHAN GRUBER: Well, I mean,
certainly a lot of companies
give you stock options,
where you're sort of stuck
in the stock of that company.
And my lesson there
would be, that's
part of the conversation,
but as soon as it's best,
sell it and get out.
That doesn't mean
you shouldn't--
you should value-- it's
not saying stock options
in the company are worthless.
They're worth something.
It's just they're worth less
than if they just gave you
the cash, because
if you got the cash,
you'd go invest it
in somewhere that
wouldn't be tied to your job.
And this came to a head with
the example of Enron, which
is sort of before your time.
That's sort of when
you were young.
But basically, Enron
was an energy company
that got into some
really shady dealings
to try to essentially
prop up its stock price.
To make itself look valuable
it essentially created
shell companies that were the
same company it sold to them.
So it looked like it was
generating a lot of sales,
but it was just
selling to itself.
It was illegal activity.
But it caused their stock
price to go through the roof.
And Enron, in order to have
enough money in the company,
encouraged their employees to
invest all their retirement
savings at Enron.
Indeed, the Enron
401(k) said, we'll
give you extra money
in your account
if you invest your
money in Enron.
So most people at Enron had
their retirement savings
invested in Enron.
When the whole thing-- and Enron
was a very successful company,
in the Fortune 500,
doing quite well.
When the whole thing collapsed,
these people not only
lost their jobs, they
lost their entire savings.
That's the problem with
non-diversification.
And the ultimate form
of non-diversification
is to invest in the
company you're working for.
Have I scared you enough?
Any questions about that?
Now, let's move on.
That finishes our
discussion of savings.
Let's move on to a
totally new topic, which
we'll talk about this lecture
and the rest of next lecture,
which is international trade.
And let's start with what
is international trade
and why the ruckus?
This is the great
time to be teaching
on international trade,
probably the best,
most exciting time of any year
I've ever taught this topic.
It's front and center
in a way it hasn't been,
probably, in decades.
So what's the big deal?
Let's talk about
a simple example.
How many people have
ever given someone roses
for Valentine's Day?
Raise your hands.
MIT, man-- that's OK, when I
was your age, I hadn't either.
Now, here's the interesting
problem with Valentine's Day--
Valentine's Day
falls in the winter.
Roses don't grow outside
in the cold in the winter.
So what do you do?
For many years,
what we did was we
had hot houses where we grew--
basically were dedicated,
their reason for existing,
was essentially to grow
Valentine's Day roses.
So it's an industry around
growing these indoor roses
in the winter so that you
could have them available.
But what happened over
time is we realized
it was a lot cheaper to actually
by the roses in Colombia
or countries like
that, and fly them up,
than to actually
have them grown here.
So what happened
was all the roses
we get now in the winter
come from South America.
And we don't grow roses in
America anymore in the winter.
So is that a good
thing or a bad thing?
Well, on the one hand, roses
are a ton cheaper now than
when I was a kid.
So that's a good thing for
the romantics among us.
You can get a dozen
roses for 25 bucks.
It was like 80 bucks when
I was a kid or something.
It was crazy.
On the other hand,
a bunch of guys
who used to grow these
roses are out of jobs.
There was an industry devoted
to growing these roses
and these people
now have no job,
because they're
grown somewhere else.
So how do we think about--
this trade-off is sort of a
microcosm of the larger debate
around international trade.
The larger debate about
whether trade is good or bad
comes down to this rose example.
It sort of summarizes
that issue.
So now, when we think
about international trade,
we think about three concepts.
We think about
exports, which are
the amount of goods that
we sell to other countries,
and imports, which are the
amount of goods that we
buy from other countries.
So a country exports
to other countries.
It imports from other countries.
Currently, the US exports about
$1.6 trillion of goods a year.
That's trillion with a T. It
imports about $2.4 trillion
of goods a year, leaving us with
an $800 billion trade deficit.
You may have heard the President
mention this once or twice--
an $800 billion trade deficit.
So the question you want to ask
is, how big a problem is this
that we have a trade deficit?
And the answer economists
give is none problem.
No?
No Spinal Tap fans here?
OK, whatever.
So basically, let's explain
this in a simple example.
Imagine that you
have two Pikachus
and your friend has
two Jigglypuffs.
And you want to have a more
diverse set of Pokemon,
so you go to your
friend and you say,
I will trade you one
Pikachu for one Jigglypuff.
So you send your
friend a Pikachu.
He sends you a Jigglypuff.
You've just created a
massive Pikachu deficit.
Think about it-- you used
to have two Pikachus.
You sent one away.
You sent one away.
You didn't get any
Pikachus back, did you?
So you've created a huge
deficit of one Pikachu.
Is that bad?
No, you got a Jigglypuff.
You're happy.
You wanted to make the trade.
You made the trade.
Calling the trade deficit,
define trade deficit
in terms of-- if you
define trade deficit,
instead, in terms
of Jigglypuffs,
you've got a huge trade surplus.
You used to get no
Jigglypuffs, now you get one.
So basically, a trade
deficit, trade surplus,
is all about an
arbitrary definition.
The bottom line is America
then spends $800 billion more.
You're sending money
to other countries,
but we get $800 billion
year more stuff for it.
There's no bad or good.
It's just the way trade works.
So any time you've had a trade
in your life of anything,
with a friend or
whatever, you've
created a deficit and a surplus.
But that doesn't mean anyone
is worse off or better off.
Whether you're worse
off or better off
depends on the indicators of
the trade, depends on how much
each party values
what's going on.
So basically, if I
said, oh, good Lord,
if I had a headline like, "Good
Lord, Gruber Trades Pikachu
Deficit, Must End Trade
with Jigglypuff Land,"
we must shut down trade,
because good Lord,
we're creating this huge Pikachu
deficit, that would be bad.
Because I wanted to trade
my Pikachu for a Jigglypuff
I was happier.
That would be a bad
thing to shut that off.
And that, in a stupid
example, is why economists
like international trade.
It's the same reason we
like trade in general.
Think about this whole course--
the whole course is
a bit about trade.
It's about trading our
money for cookies and pizza,
about trading a firm's money
for workers and machines,
about trading my
time for a wage.
Life is all about trades.
International trade is just
another example of that.
Just because it's got this
bizarre label of a trade
deficit, we think
about it differently.
So that's sort of basically,
if you think about-- now
let's replace Pikachus
and Jigglypuffs
with the US and a poor country.
Instead of US
having two Pikachus,
the US has tons of money.
Instead of the poor country
having two Jigglypuffs,
the poor country has really
underpaid workers who
can make stuff really cheaply.
So I, in the US, say, wait--
I have a lot of money.
You've got a lot of sweaters.
I'm going to send you my
money and get your sweaters.
I'm better off because
I was happy to buy
those sweaters cheaply.
You're better off because
you can't eat sweaters.
You need money, so you
get some of my money.
We're both better off, but
I've created a trade deficit.
That is not
inherently a problem.
Now of course, the reality
is more complicated.
The reality is that when I send
the money to those countries
to buy the sweaters, and
I bring the sweaters in,
my consumers of sweaters
are much happier.
And I keep focusing on sweaters
because it's just amazing.
This sweater I just
got at Old Navy, $15.
Pretty nice, decent, it's
not cotton, whatever.
$15.
This would have been a
fortune when I was your age.
In those day's dollars,
it would've been $30,
and that would be
like $70 today.
Why?
China.
Because we used these to
make these in North Carolina,
now we make them in China.
So the good news is,
I went to Old Navy,
I got two pairs of pants, and
like four sweaters, like $100.
That's the good news.
The bad news is the guys in
North Carolina lost their jobs.
That's the bad news.
So there's a trade-off.
Now, I'm going to argue over
the next lecture and a half
that that trade-off is
worth it in aggregate,
but we can't ignore the
fact there's a trade-off.
Because that's what leads
to the very intense debates
around international trade,
is the fundamental tension
between the consumers
of goods that
are made cheaper by
international trade
and the producers
of goods that get
wiped out by
international trade.
So that's our setup.
That's our big picture.
Now I'm going to
dive in, and I'm
going to teach you the
nitty gritty of how
we think about this with models,
but that's the big picture
I wanted you to have in mind.
So let's dive into the models.
And to do the models, I
need to introduce a new tool
to you, which is the
Production Possibility
Frontier, the PPF, the
Production Possibility
Frontier.
What the PPF shows you is the
maximum combination of outputs
you can produce for any
given set of inputs.
So basically, let's
think about that.
Let's go to figure
18.2, because it's
easy to see this graphically.
Let's go to figure 18.2.
Let's think of you as a firm.
And you as a firm
produce two things--
problem set points
and exam points.
Sorry, it's all you're
good for at MIT here.
You produce problem set
points and exam points,
but you can produce either.
Those are the two
things you produce.
And to make life easy, let's say
given your innate intelligence,
the points are produced
as a function of time.
Literally the more time you
put in studying for an exam,
the better you do, the more time
you spend on the problem set,
the better you do.
And you have one scarce
input, which is time.
This production
possibility frontier
tells you if you devote
your scarce input
across different activities,
what will the result be
in terms of what's produced.
So what's this line saying
on the left-hand side?
It's saying, if I put all my
time into studying for exams,
I'll get 200 points on
exams and 0 on problem sets.
If I spend all my time
doing problem sets,
I'll got 200 points of
problem sets and 0 on exams,
and some combinations
in between.
That is a production
possibility frontier.
It shows the
combination of output
you get for any given
fixed level of inputs.
Now, what is wrong with
the graph on the left?
And why is the graph on the
right a probably more realistic
description of what your
actual production possibility
frontier looks like?
Yeah.
AUDIENCE: You know, if you can
get more points on the problem
set, and you know more, you're
probably more well prepared
for the exam.
JONATHAN GRUBER: Yeah.
It's wrong because in
fact, what this system
features is something we
call "economies of scope."
We talked about economies of
scale a number of lectures ago,
the notion that if you double
inputs, you double output.
This is economies
of scope, which
is that by producing more
than one thing at once,
you may get better at both.
By studying for an exam, you
get better at problem sets.
And by doing problem sets,
you do better on the exam.
So what that means is,
doing some of both leads
to a better outcome than doing
all of one or all the other.
You get a concave to
the origin production
possibility frontier.
A concave to the
origin production
possibility frontier
demonstrates
economies of scope.
Doing some of both
is better than
doing all of just one
and all the other.
And that makes
sense for you when
doing problem sets and exams.
It makes sense you'd be
better off doing some of both
than devoting all your attention
to just one and just the other.
So that is a production
possibility frontier.
Now, there can also be
dis-economies of scope.
Another great example
for MIT is that when
I was here as an undergrad,
I came in as a tennis player.
And I was on the tennis team.
Now tennis was only in
the fall and spring.
In the winter, they had squash.
So I thought I'd play squash.
Well, it turns out that
the key with tennis
is keeping your wrist firm,
and the key with squash
is keeping your wrist flexible.
And by playing squash, I
screwed up my tennis game,
and by playing tennis, I
screwed up my squash game.
So I had a dis-economy of scope.
I was worse off at both things
by playing both, rather than
just playing one or the other.
So there can be
economies of scope,
which is when doing both
things make you better at both,
and dis-economies of scope
when doing both things
make you worse at both.
And that's the nature of
the shape of production
possibilities frontier.
An economy of scope
is when doing both
makes you better off.
A dis-economy of scope is when
doing both makes you worse off.
Questions about that?
Now, I just introduced
that tool because that tool
is going to be the fundamental
modeling feature that
allows us to demonstrate
why international trade is
beneficial.
So now, we're going
to take that tool
and we're going to go and
talk about the concept
of comparative
advantage, which is
the core concept in
international trade economics.
This is the core of
how it all works.
Let's think of a particular
example to understand this.
Let's take the US and
Colombia and the rose market.
And as I said before, let's
say it's expensive for the US--
and the Valentine's
Day rose market.
It's expensive for the US to
grow Valentine's Day roses.
It's cheap in Colombia.
On the other hand, let's
compare roses to computers.
Roses are cheap to
produce in Colombia
and expensive in America.
Computers are the opposite.
We have giant factories,
and skilled labor,
and giant machines that can
quickly crank out computers.
In Colombia, they'd have to like
assemble the computer by hand.
So it's a lot cheaper to
produce a computer in the US
than it is in Colombia.
It's a lot cheaper to
produce a rose in Colombia
than it is in the US.
The way to think about
this is through the lens
of opportunity cost.
What we're saying is
the opportunity cost
of making a rose in terms of
computers is higher in the US,
In other words, the amount of
computers you have to give up
to make a rose is high in the
US, because computers are cheap
and roses are expensive.
The amount of roses
you have to give up
to make a computer in
Colombia is higher,
because roses are cheap and
computers are expensive.
So we say that Colombia has a
comparative advantage in roses.
It is relatively cheap-- in a
world of computers and roses,
it is relatively cheap
for them to produce roses
compared to computers.
The opportunity costs in terms
of forgone computers is lower.
Whereas the US has a comparative
advantage in computers.
It is comparatively cheaper
for us to produce computers.
So international trade
is all about what
you're relatively better at.
Now, let me emphasize
"relative" for a second.
This is an important concept.
The reason we don't
just say "advantage"
and we say "comparative
advantage" is it
doesn't actually matter
if you're better.
It matters if you're
relatively better.
Let me explain.
This is hard.
I would say of the main
economics concepts in the world
that we need people
to understand,
this is one of the top three
least understood concepts
in all the world in economics.
[INAUDIBLE] it's
like in our blood,
and we can't understand why
regular people can't understand
it.
It's because it's hard.
Let me give you an example.
Take me and LeBron
James, and imagine
there's two activities
in life, mowing the lawn
and playing basketball.
That's all life consists of.
Now, LeBron James is better than
me at both playing basketball
and mowing the lawn.
But he's much, much,
much, much, much,
much better than me at
basketball and only much
better than me at
mowing the lawn.
So LeBron James has an advantage
in everything, both activities,
but he only has a comparative
advantage in basketball.
He only has a comparative
advantage in basketball.
The comparative advantage
is about opportunity costs.
In other words, if LeBron
James mows his lawn,
the amount of basketball
he's giving up is ungodly.
It's crazy to have
to mow his lawn,
given how much basketball
he could've played.
If I mow my lawn, I'm not
giving up much basketball,
because I suck at basketball.
So I have a comparative
advantage in lawn mowing.
You say, you're not at lawn
mowing than LeBron James.
I'm not.
But I have a comparative
advantage in lawn mowing,
because the opportunity
cost to me is much lower.
The opportunity cost to LeBron
James of mowing his lawn
is high, because he could
be playing basketball.
The opportunity
cost to me is low,
because I can't play basketball.
Yeah.
AUDIENCE: [INAUDIBLE]
the only one
in the world that can mow lawns.
JONATHAN GRUBER: That's
a weird edge case.
I won't do that.
Then there'd be no reason for--
that makes trade things hard.
We can come back to that.
Now of course, the example
doesn't stop there.
Should I mow my lawn?
No, I should not mow
my lawn, because there
is someone who doesn't have
as much education as I, who
can't earn as much
money than I at work.
And they have a comparative
advantage in lawn mowing.
I have a comparative
advantage in office work.
So in fact, not
only should I mow--
do I have comparative advantage
over LeBron in lawn mowing,
but some less-educated guy
has a competitive edge over me
in lawn mowing.
So just as LeBron
would be better off
letting me mow his lawn
and I'm better off letting
him play basketball,
I'm better off
letting some less-educated guy
mow my lawn, and letting me go
sit in front of my
computer all day.
Comparative advantage
is all about what
you're relatively better at.
And the key insight
of international trade
is that in a world of
comparative advantage,
people should always specialize.
In a world of
comparative advantage,
people should always specialize.
You should do what
you're best at.
You should do what you're best
at because otherwise, it's
simply silly for LeBron to
spend any time mowing his lawn.
As much as my wife thinks I'm
just trying to get out of it,
it's simply silly for me to
spend any time mowing my lawn.
I have a comparative advantage
sitting on my computer
and doing that stuff,
so I should hire
someone else to mow my lawn.
So to actually see that,
let's go to figure 18.3.
This is a confusing
figure, so I'm
going to go through it slowly.
On the top, we have the US
production possibilities
frontier.
And to make life
easy, let's assume
that there's no
economies of scope
between roses and computers.
Makes sense there wouldn't be.
Let's assume there's no
economies or dis-economies
between roses and computers.
It's a linear production
possibility frontier.
So we're showing each graph as a
production possibility frontier
between roses and computers.
And we're assuming it's just
linear, which makes sense.
You don't make better computers
by making roses and vice versa.
On the top, we have the US.
Let's say that the US's
production possibility
frontier is the following--
given the resources
we have in the US,
we can produce 2,000 computers
or 1,000 boxes of roses, given
our resources, our
skill level, our capital
intensity, et cetera.
Now go to Colombia.
Say that Colombia, given
their skill level, resources,
the sunshine, the
beautiful weather--
any Colombians here?
Sounds perfect.
It's like 75 all the time.
They can make 2,000 roses
and 1,000 computers,
or 1,000 computers, or some
combination in between.
So the first thing I want
to make you guys understand
is why these are sensible
production possibility
frontiers for each country.
They're sensible production
possibility frontiers
because they basically show the
US has a comparative advantage
in computers.
That is, the trade-off
in terms of roses
foregone to make a computer is
lower in the US than Colombia.
And Colombia has a comparative
advantage in roses.
The trade-off in terms
of foregone computers
to make a rose is much lower
in Colombia than in the US.
So comparative advantage
is about opportunity cost.
Let me say it again--
the US has a
comparative advantage
in computers because
to make a computer,
we have to give up less
roses than Colombia does.
To make one computer, we
give up half a box of roses.
That's the slope of this line.
Colombia, to make
one computer, has
to give up two boxes of roses.
So we have a comparative
advantage in computers.
Yeah.
AUDIENCE: Would it
be possible to have
comparative advantage in both?
JONATHAN GRUBER: You cannot.
That's the term "comparative."
You can have an absolute-- in
this simple two by two model.
You can have
comparative advantage
in multiple things in life.
From the simple model, you can
have the absolute advantage
of both, but you can't have a
comparative advantage in both.
That's absolutely right.
In this model, with two
goods and two countries,
each country has a
comparative advantage
in one thing or the other.
Or there could be
weird edge cases,
but generally that's right.
So now, I did computers.
Now let's flip and do roses.
In roses, for the US to
produce a box of roses,
they have to give
up two computers.
For Colombia to
produce a box of roses,
they only give up
half a computer,
so they have a comparative
advantage in roses.
People understand the setup
here, these graphs on the left?
Yeah.
AUDIENCE: Does the
price of what you
can sell each unit for factor
into what you actually produce?
Because I can imagine
that yes, maybe you
can produce more roses--
JONATHAN GRUBER: But
they're worth less.
AUDIENCE: --more
easily, but they-- you
can't sell a rose as much
as you can [INAUDIBLE]
JONATHAN GRUBER: Right.
So for right now,
we're ignoring prices.
We'll come back to prices
later, but for right now,
we're ignoring the prices.
Right now, we're just sort of--
we're going to basically
have prices come in later,
but for right now,
we're doing prices.
So now, let's
imagine that tastes
are such that
consumers in the US
want 1,000 computers
and 500 boxes of roses.
That's point C US.
And consumers in Colombia
want 500 computers
and 1,000 box of roses.
I just made this up.
C US and C CO, I
just made up tastes.
I just said, let's just make it
a case where people in Colombia
like roses better, people in
America like computers better.
And imagine we do not
allow international trade.
This is the best case.
Actually, international trade
would be even more valuable
with a different assumption.
I've made assumptions which
make trade less valuable than it
would otherwise be.
I said look, Colombia produces
roses and people there
like roses.
American produce computers and
people there like computers,
but not totally.
Some US guy still
wants some roses.
Some Colombian guy still
wants some computers.
Now imagine we
don't allow trade.
What's the outcome?
Well, in the US,
we will produce--
like I said, we want 1,000
computers and 500 roses,
so we'll produce 1,000
computers and we'll
consume 1,000 computers.
So on the chart on
the right, you've
got production and consumption.
For the US, we'll
produce 1,000 computers,
consume 1,000 computers.
We have to consume
what we produce.
There is no trade.
And same with roses-- we'll
produce 500, consume 500.
Colombia's the flip.
So you end up in the world with
1,500 computers being produced
and consumed, and 1,500 roses
being produced and consumed.
Now, you might say that's silly,
computers cost more than roses.
We'll come back to prices.
For now, we're leaving
prices out of it.
The point is, given
the tastes I've
suggested with C US and C CO--
I just made those up--
given those tastes, we'll
end up in a situation where
every country just
consumes what they produce,
because there's no trade,
and the world as a whole
will produce 1,500 boxes
of roses, 1,500 computers.
Now let's say that
we allow trade.
What trade does is introduce
economies of scope.
Why?
Because trade allows
specialization.
Flip to the next figure.
The next figure is the
figure for the world.
Imagine the world
only wanted computers.
That's the point on the y-axis.
Then the US would produce
2,000, and Colombia
would produce 1,000.
We'd have 3,000.
Imagine the world only
wanted roses, the flip side.
We have 3,000.
But if the world wants
both, you get more.
Why?
Why is it outward bending
when you allow trade?
This is not a technological
change, change in technology.
All we've done is
take these two PPS
and combine them
and allow trade.
Why does that suddenly
introduce economies of scope?
Because what do
countries get to do
compared to what they
were doing before when
they couldn't trade?
What do they get to do now?
AUDIENCE: Specialize.
JONATHAN GRUBER: Specialize
the US specializes in--
and Colombia
specializes in roses.
By specializing,
we can make more,
because that's
what we're good at.
So by trading, we
allow specialization.
Without trading, we
can't specialize,
because some guys in
the US want roses.
We've got to make some roses.
But that's stupid.
We shouldn't make roses.
We should let
Colombia make roses.
If LeBron can't hire
anyone to mow his lawn,
he's going to mow his lawn.
That's stupid.
LeBron should hire someone
to mow his lawn and play
basketball all the time.
By allowing trade, we allow
people to specialize and take
advantage of their
comparative advantages.
Without trade, you
can't take advantage
of comparative advantage.
Without trade, it
doesn't matter if the US
is better at producing
computers or roses.
What's produced is just
determined by people's tastes.
But with trade,
you can specialize.
And that yields the outcome
we discussed in figure 18.5.
Figure 18.5 takes the previous
figure, 18.3, and adds trade.
So let me go through this.
The basic, the
blue, the PPFs are
the same on the left,
same PPFs as before.
And if you look at point CO
and C US [INAUDIBLE] before,
we could have 1,000 computers
and 500 roses in the US
or 1,000 roses and 500
computers in Colombia.
But now suppose we allow trade.
What happens now?
Well, what happens
now is the US goes
to producing only
computers and Colombia
goes to producing only roses.
Now let's assume, just
to make life easy,
let's just assume that people's
tastes are proportional.
So if there's more
computers and more roses,
they just want
proportionately more of each.
So the US, as
there's more of both,
wants two computers
for every rose.
And Colombia wants two
roses for every computer.
That's just their tastes.
What happens now is we shift
out to these new levels, C prime
US and C prime Colombia.
At the new levels, the US
produces 2,000 computers.
All they do is computers.
Colombia produces 2,000 roses.
The world as a whole
ends up with more.
Flip back two pages and look
at the table on the right.
The world as a whole
ended up with 1,500 roses
and 1,500 computers.
Now the world as a whole
ends up with 2,000 roses
and 2,000 computers.
What happened?
Nothing changed technologically,
same PPS here as before.
All the change is by trading.
We allowed people to exploit
their comparative advantage
through specialization.
Without trading, the US was
inefficiently producing roses
and Colombia was inefficiently
producing computers.
With trading, we've now
opened up the possibility
that they can specialize
in what they're good at.
And the world as a whole
ends up better off.
And look at both countries.
Both countries end up
with more consumption.
The US gets more computers,
so flip back and forth
between 18.3 and 18.5.
The US goes from 500
roses and 1,000 computers
to 750 roses and
1,250 computers.
Colombia goes from 1,000
roses and 500 computers
to 1,250 roses
and 750 computers.
Now, the split between
roses and computers
here is not determinate.
That's just made up.
I made up what tastes look like.
The point C and C prime,
that's just made up.
What you care about
is the bottom panel.
What you care about is fact
that the world as a whole
now has more roses and
more computers in it.
And that is the mechanics of
why international trade expands
our production
possibility frontier.
We have more goods
in the world once we
can trade, not because--
I mean, you still have the
same, where Pikachu and--
when I allow trade between
you and your friend,
that doesn't create
any more goods.
You each have two cards.
But in the real world,
it creates trade,
because the production
allows people to specialize.
And that's the beauty of trade.
We'll come back next time
and do a welfare analysis,
talking about why international
trade makes people better off.
