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.

Three Ways To Delegate

Delegation is a vital skill for entrepreneurs to master. If you want to grow your business, you can’t just hire people and tell them to get on with it. You need a framework for delegation.

Derek Sivers tells an instructive story about the perils of delegation gone awry in Anything You Want, his autobiographical account of the founding of CDBaby. He delegated total responsibility for the creation of an employee bonus scheme at CDBaby to his own employees. He realised later that the resulting scheme was wiping out all profit in the business. When he amended the scheme, he faced a huge conflict with employees.

Although entrepreneurs agree about the importance of delegation, there are widely differing views on the best way to delegate. This article explains the three main approaches and outlines the pros and cons of each.

The "Operations Manual" Approach to Delegation

The Operations Manual approach to delegation is described in Michael Gerber’s book The E-Myth Revisited. This approach is geared towards the kinds of small businesses that Gerber spent many years advising. This method of delegation involves creating explicit and detailed instructions for work procedures that you expect your employees to follow. You tell them not just what you want done, but also how you want them to do it. Your instructions are codified in an operations manual or similar document.

In his book, Gerber describes an experience he had visiting a hotel where he noticed the great customer service. He asked the hotel manager how he had achieved this level of quality in service. The hotel manager showed him a detailed operations manual, which included well-defined procedures for all tasks, down to order in which the cleaning staff should clean each item in a room.

The idea behind this approach is to treat your business as if it were a franchise prototype. As the business owner, you try to get yourself out of the operational role as quickly as possible, in order to give yourself maximum freedom to grow the business and step away from it in future.

The operations manual approach works best with inexperienced employees who are willing to learn how things are done and to follow detailed instructions given to them. Since you want everyone to be working in line with your operations manual, you hire people willing to learn and follow your way of doing things. Experience in other ways of doing things could even be seen as a liability. Gerber recommends hiring inexperienced people in The E-Myth Revisited.

The advantage of the operations manual approach is that your business is highly scalable. The strategy of designing your business as if it were a franchise prototype makes it easy to increase production, doing more of the same.

The down side of this approach is that it can easily become outdated, because it is dependent on detailed prescriptions for all actions. Flexibility and adaptability are not built into a centralised system. You can codify all your procedures in an operations manual, but the business will grow and change. Innovation by staff members is deliberately stifled in this approach, which prevents you from benefiting from employee knowledge about what can be improved. Anyone adopting this approach has to implement feedback mechanisms to try to get some of that knowledge back into the centralised plan, such as asking staff for their suggestions as to how to improve procedures. But such feedback mechanisms tend to be cumbersome and bureaucratic.

You can try to mitigate the downside of this approach by involving employees as much as possible in the creation and updating of your procedures. I did this in my business by using a wiki-based operations manual, as I describe in my book Becoming An Entrepreneur. Everyone could edit any page in the manual and contribute to standardising the procedures. I found that with this adjustment, the operations manual approach to delegation worked very well with inexperienced employees. 

The ROWE Approach to Delegation

The Results Only Work Environment (or ROWE) is a totally different approach to delegation. This kind of delegation involves giving your employees clearly defined outcomes to reach, and leaving it to their discretion as to how they reach them. What really matters to the entrepreneur is the results of an employee’s work. The way that the employee achieves those results should be irrelevant to the entrepreneur (as long as they don’t do anything that is in conflict with the interests of the business or that creates any problems). Consequently, according to the ROWE approach, the best way to get things done is to provide very clear targets or business goals, and then leave your employees completely free to achieve those results in their own way.

If you accept the logic of this approach, you shouldn’t care what time your employees come to work, or whether they work from home. The only thing that the entrepreneur should concern themselves with is the employee’s productivity. What matters is the quality and quantity of completed work by each employee. If the employee does better work at home in their pyjamas, so be it.

Advocates of the ROWE approach also see a benefits to entrepreneur’s work from adopting this approach. This method of delegation forces the entrepreneur to provide very clear goals for the business. In the operations manual approach, it’s possible for an employer to get bogged down in telling staff what to do and lose sight of their own job—to provide vision for the business. ROWE forces the employer to think about what needs to be done rather than the minutiae of how to do it.

One of the aims of the ROWE approach to delegation is to incentivise employees to find more efficient ways of working. By giving employees the opportunity to benefit from efficiency gains, they are encouraged to seek out faster, easier ways of reaching their own targets. This reflects an underlying insight that employees are likely to be more aware than managers of potential efficiency gains in their own workflows, because they are the ones doing the work. The aim of ROWE is to encourage improvements to efficiency at the most distributed level possible.

Ricardo Semler is a famous proponent of this kind of approach.  He implemented ROWE principles throughout Semco, his corporation in Brazil. He has described his approach in two books Maverick and The Seven Day Weekend. The term ROWE was coined by Cali Ressler and Jody Thompson— two human resources executives who implemented these principles within the Best Buy corporation during the 2000s. They describe their journey in their book Why Work Sucks And How To Fix It. Jason Fried and David Heinemeier Hansson describe how they adopted a similar approach in their company Basecamp (formerly 37 Signals) in their book Rework.

The downside of the ROWE approach for the entrepreneur is that there is no clear mechanism to translate efficiency gains by individual employees into productivity gains for the business as a whole. Employees will always benefit from the greater flexibility. Increasing employee satisfaction certainly can benefit the business. However, more satisfied employees do not necessarily become more productive employees.

Efficiency gains can simply lead to employees finishing their work in less time and having more leisure time. This is exactly what Tim Ferriss suggests that employees do in his book, The Four Hour Work Week. He encourages employees to strive for the freedom to work at home so that they can take advantage of their own productivity gains to free up some of their employee time for personal projects. This means that all efficiency improvements are translated into higher effective wages for the employee. This higher wage might benefit to the business (by attracting better employees and improving retention) but it doesn’t necessarily lead to more productivity.

ROWE can only lead to greater productivity if employers are able to increase employee targets in line with increases in efficiency. This is going to be a difficult judgement call, since the employer gives up all detailed knowledge of working practices in a ROWE. It is interesting to note that Best Buy—which was the model example of a ROWE implementation—has since scrapped ROWE and gone back to previous working practices. 

The Outsourcing Approach to Delegation

The third approach to delegation is to avoid employer-employee relationships as far as possible and outsource work to external contractors instead. This model of delegation works by outlining your desired outcome and then negotiating with an external contractor for an agreed price, timescale, and other conditions, to achieve the outcome. 

In his book How I Found Freedom In An Unfree World, Harry Browne described his own implementation of this approach. He hated the bureaucracy involved with employing people, so he decided to arrange his business entirely using independent subcontractors.

Like the ROWE approach, the outsourcing model of delegation is focussed on outcomes and leaves it up to the person undertaking the work to identify the most efficient way of achieving the goal. This kind of delegation also incentivises the entrepreneur to create clear and explicit business goals.

Outsourcing has one significant advantage over the ROWE: with outsourcing there is a mechanism to translate efficiency gains by individual workers into productivity gains for the business as a whole. That mechanism is market competition. If the independent contractor does not pass on some of the efficiency gains to their customer in a lower price, then they run the risk of being uncompetitive relative to other subcontractors. In fact, this mechanism works for both sides, since it also means that the subcontractors will have to capture some gains in the form of profit in order for it to be worthwhile for them to innovate in the first place.

The cost basis of outsourcing is different from employing people. The entrepreneur gets to keep fixed costs as low as possible because he only employs people on a contract basis. He may have additional search and transaction costs when finding people to do the tasks (although the internet has reduced these costs significantly). The independent contractors may also be more expensive than employees because they need to charge more (since they don’t have the security of a fixed paycheque). However, the entrepreneur is also likely to get more skilled specialists by outsourcing, since he is not trying to fit a limited set of existing employees to a diverse range of tasks that need to get done.

If you accepted the logic of ROWE, then outsourcing is just a more consistent version of that approach. If you believe that people work better when they have autonomy, then why not work with people who have full autonomy (external contractors) and avoid hiring employees altogether? Hiring external contractors to achieve specific tasks is the ultimate version of ROWE.

I have had very positive experiences with independent contractors. I prefer the Harry Browne approach of relying on outsourcing instead of fixed employment contracts wherever possible.

Automation: An Alternative To Delegation?

Automation is one alternative to delegation that is becoming more feasible for many tasks. The act of delegation requires you, as delegator, to clearly identify your desired outcome. The Operations Manual approach also requires you to identify a detailed workflow for the work. Once you have clearly specified the task, you may be able to delegate it to a computer and avoid having to deal with human delegation altogether.

Automation is much easier now because there are so many applications available now to help with basic tasks. To take a simple historical example, typing on a typewriter used to be a slow and cumbersome process. Errors were not easy to correct and often involved restarting an entire page. Consequently, it made sense for any skilled professional to delegate typing tasks to an assistant. The professional would dictate a letter and give it to a secretary to type up. Very few people do this now, since word processors make the process of typing faster and easier than before. Even if you prefer to dictate a letter, personal computers can do a fairly good job of voice recognition and automate the transcription process for you. The job of typist has been effectively automated.

Over time, this kind of automation removes the need to delegate more and more simple tasks. This is the ultimate goal of the Operations Manual approach to delegation: specify the task so well that you can get a computer to do it automatically.

Choosing Your Approach to Delegation

If you need to delegate simple tasks to be done in exactly the way that you specify, it makes a lot of sense to adopt the Operations Manual approach to delegation. This approach will also likely inform your hiring strategy and you will tend to employ inexperienced, enthusiastic people at the start of their careers who are willing to learn your way of doing things. Consider automation as the final goal of this kind of delegation.

Alternatively, if you want to benefit from expertise that you don't have, it makes sense to delegate work to people in a way that gives them maximum autonomy. The ROWE concept is one way of implementing this approach. But if you accept the logic of the ROWE approach, then a more consistent implementation of the concept is simply to outsource work to external contractors, and avoid hiring employees altogether.