Comparative Advantage Is Mind-Blowing

If you start a business, and if you are lucky, at some point someone will sit you down and tell you the most important lesson you have to learn. You must learn how to specialise. This means learning both how to focus on those tasks where you add most value, and how to delegate everything else. Stop trying to do everything.

Within the business, you must extract yourself from the day to day operations and focus on your responsibilities as the business owner. Within the market, you must stop competing in every way and focus on where you can add most value. This is an important piece of advice.

There is a concept from economics called comparative advantage that almost everyone thinks they understand, but most people misunderstand. When I studied economics, I thought I understood comparative advantage as soon as I learned about it, yet it took me years to realise just how amazing and significant its implications are.

Comparative advantage is the explanation of why trade is beneficial to both sides in any voluntary exchange. In the example of entrepreneurship, this concept explains why you must delegate or outsource tasks to other people effectively. You must trade with other people by purchasing their services for money, instead of you trying to be self-sufficient and doing everything yourself.

This theory proves logically why trade is always beneficial to both sides. But that is not all that it proves. It also shows why we all fundamentally rely on trading with each other for all the benefits of civilisation and economic development.

Most People Misunderstand Comparative Advantage

Most people who think they understand comparative advantage are mistaken. Most people think it means we should all find something that we can be the best at, specialise in that activity, and then trade with others who are the best in their respective fields. I'm the best at doing one thing and you are the best at doing another thing, so I should specialise in what I'm the best at and you should specialise in what you are the best at, and then we trade. That way, we both produce more, and through trade we both benefit more. So that's why trade is good.

In fact, that is not why trade works. That is not comparative advantage, it is absolute advantage, which is far less remarkable.

Comparative advantage is an amazing process whereby even if one person is the best at everything, it still makes sense to trade. Even if a Superman existed— someone who was the most skilled, most intelligent, and most physically adept at every single activity— he would still be better off if he specialised and traded with others. It would also benefit others to trade with him, even though none of them would not be as good as him at any activity.

This is counterintuitive: trade is beneficial even if you're not the best at anything and even if you are the best at everything.

Even Superman Benefits From Trade

Imagine that Superman and I get washed up on a desert island together. Superman is better at everything than me. Whereas it takes me four hours to gather some fruit, it only take Superman one hour. Whereas it takes me three hours to catch a fish, Superman can catch one in two hours.

So he's better at everything than me— he accomplishes any task faster than I can. But he will still be better off if he trades with me. If he specialises in the activity that he is comparatively much better at and I specialise in the activity that I’m least extremely bad at, compared to him.

In this example, Superman would benefit by relying on me to get his fish, in return for giving me some fruit. He could gather two portions of fruit and exchange one of them for a fish. I could gather two fish and swap one of them for some fruit. In this way, Superman would only need two hours for a meal of fruit and fish, instead of the three hours that he would have worked if he was self-sufficient. I would only need to work six hours for a meal, instead of the seven hours that I would have to work if I were self-sufficient.

So we both benefit from trading with each other compared to how we would have fared if we tried to do everything on our own. Superman benefits even though he can do everything better than me. I benefit from trading with Superman, even though I'm not as good as him at doing anything in particular.

Profound Implications

As an entrepreneur, this is why you have to specialise in activities where you add most value, and stop doing all the other things in your business that aren't the most important value-adding tasks.

As the owner of a small business, you can probably do many of the tasks in your business better than anyone else. You know your business better than anyone and you have the most experience of it, so you probably know how to do most things better than your employees or suppliers.

You could probably outperform most individual employees in completing a wide range of their tasks. When you notice that something is taking too long, the temptation is to step in and do it yourself, with the idea that “if you want something done properly you have to do it yourself”.

But it is madness for you to do such work yourself, because the overall outcome is so much better when you specialise on what you add most value doing. That way, you get to benefit of comparative advantage through the division of labour, with other people working together with you, focusing on the things that they are comparatively less bad at.

A profound implication of comparative advantage is that you don’t have to be the best at anything in order to make a positive contribution to a business, to society as a whole, and thereby to benefit yourself. You don't have to be the very best at anything, you just have to find ways that you can contribute by working together with others and focussing on what you are relatively good at.

Trade Is Indisputably Good

The concept of comparative advantage is logically indisputable. Its premises (e.g. we each have different skill levels) are so basic as to be self-evidently true. Once you understand the conclusion following from these premises, you realise that it must necessarily be true.

The insight has beautiful implications, because it shows that trade between individuals is not a war where the strong are just going to overpower and exploit the weak. The fact is that even the strong need the weak. Even those who are more skilled in every imaginable field are poorer when they try to be self-sufficient, compared to the benefits they gain by cooperating in trade with others.

We all need each other. We all benefit from trading and cooperating with each other. Trade is indisputably good, as a matter of basic logic.

Why We Love Each Other

Comparative advantage is the best explanation for why we love our fellow humans. Many philosophers have argued that humans are inherently social. They say that humans like each other, and therefore they co-operate and trade.

Only recently in human history have we come to understand that the truth is the other way around. We are better off together, and that is why we come to have affectionate feelings towards our fellow humans. Unfortunately, not all of us have yet come to understand that trade is positive, benign, and mutually beneficial.

Even grouches can come to appreciate their fellow humans, when they understand that they benefit themselves from voluntary exchange. Even a misanthrope can learn to be nice, interacting positively, and trade with others, because it is in his self interest.

I find the concept of comparative advantage mind-blowing, when I think through the implications. Everyone benefits from peaceful exchange, even those who are not the best that anything. We love each other because we are better off co-operating.

Are Empiricists Anti-Rational?

Stephen Hicks is a philosopher and author of “Explaining Postmodernism”. In a recent article, he answers the question “Is Austrian economics anti-empirical?” in the affirmative, stating “its roots and the tradition have been mostly anti-empirical.”

I commented on his FaceBook post that a better question would be “are empiricists anti-rational?” Professor Hicks responded:

“That's an interesting question, too, Jake. What makes it better?”

Here's my reply:

Thanks for your response. Empiricism is far more influential in economics than the Austrian School, so more deserving of scrutiny in my opinion. Popperian empiricism has been consciously adopted as the core philosophy of mainstream economics since Milton Friedman and others. The Austrian School’s emphasis on rational principles is a tiny holdout to this trend, and their rationalist approach is generally considered wacky and eccentric by the mainstream.

Empiricism’s victory has been so overwhelming that even the idea that some things can be known to be true or false based on reasoning from first principles is seen as “anti-empirical” (synonymous with bad). Yet one can hold that the answers to some questions about the world are knowable by reason alone, whilst other questions indeed can only be answered by checking empirical evidence. That’s the Austrian approach— not anti-empirical, just aware that reason shows us that some things can never be true. For example, when Mises demonstrated that central planning can never work in the socialist calculation debate, he did so by deductive argument from first principles, not by evidence.

Empiricism in economics is always vulnerable to radical skepticism, because empiricists hold that one can’t be sure of anything by reason alone (except, inconsistently, they are sure of that statement itself by reason alone). Will central planning work? Empiricism says the only way to know is to test it, and see if you can “falsify” it (and even then you are only provisionally accepting a hypothesis until the next test). 

Of course, Popper argued that you can be sure if a hypothesis is proven wrong, but any competent empiricist can always use “immunising stratagems” to protect a failed hypothesis (for example, that old chestnut “Russia wasn’t true Communism, it was Stalinism… so we need to try central planning again”). 

By the way, I hugely admire your book “Explaining Postmodernism” and I consider the continuation of the Enlightenment project a vital task for our times. My concern is that we’ve all assumed empiricism is the natural heir of the enlightenment (don’t we all want to be considered good empiricists?) but empiricism’s contradictions have undermined our ability to reason from first principles.

Professor Hicks responded:

Thanks for your explanation, Jake. Do you think the duality of empiricism versus principles can be overcome? That is, does empiricism have contradictions, or is is that we've not yet connected the basic empirical commitment to a good understanding of conceptualization, proposition-formation, and logic?

I appreciate the great questions. I’d love to hear your answer to them too. Here’s my take:
Empirical work is great, but empiricism as a philosophy is self-contradictory. Even committed empiricists rely on principles that aren’t dependent on sense data all the time. As Hume pointed out, you can’t derive a single causal relationship from the senses because all sense data ever shows is one thing happening, then another thing happening. Without rational principles, the evidence of the senses is meaningless. Empiricism always piggybacks on the deeper principles of reason.

Of course, it is vain to assume one could solve all questions with pure reason. But it does not follow that all questions about the real world can be answered with evidence from the senses. There are a-priori synthetic truths about the world, like the principle of causality and the laws of logic. I presume there is some kind of evolutionary explanation for how we acquired such rational principles, but ultimately how we got them doesn’t make a difference to the fact that they are true and useful. These principles are the ultimate foundation of rationality and failing to accept a-priori synthetic truths is a good definition for irrationality.

The Enlightenment philosophers lost their way when they assumed that empiricism could be the source of all truth. It led them away from developing rational ethics and towards utilitarianism, positive law, and relativism. When logic, causality, and other rational principles were assumed to be mere conventions, the Enlightenment lost it’s objective footing. That was a mistake we need to correct.

I think the task for continuing the Enlightenment project is to clean up rationalism. Rationalism doesn’t have to deny the existence of empirical questions, but empiricism as a philosophy must deny the existence of a-priori synthetic truths (which always leads to self-contradiction).