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I believe it picks the highest and it limits out at 720P. I know for a fact that it doesn't support 1080P or anything higher.

i have yourtube from cydia

and when i download a vid at the highest quality. the size of the video is not as big as when i download the video at the highest quality on my computer
which is 480p
 
i have yourtube from cydia

and when i download a vid at the highest quality. the size of the video is not as big as when i download the video at the highest quality on my computer
which is 480p

.flv and .mp4 are different files types and have different sizes.
 
The Apple Youtube app will limit quality over 3G. However, you can use the Google Youtube Webapp and click on the HD button to get high quality over 3G. Just remember this uses a LOT of data if you have a limit. Over WIFI, either app should be HD.
 
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