Professional Documents
Culture Documents
com
How people like US get really smart
1
Behavior Models! 9
Availability ! 9
Habit! 11
Human Action! 13
Negotiation! 14
Operant Conditioning! 15
Pain - Pleasure ! 16
Pavlovian Conditioning! 17
PLAGGES - 7 Sins! 18
Reader or Listener?! 19
Science of Achievement! 20
Deprival Syndrome ! 23
Incentive-Cause Bias! 25
Liking! 26
Reciprocation! 27
Scarcity ! 28
2
Social Proof! 29
Deduction or Induction?! 35
Disconfirming Evidence ! 36
Game Theory ! 37
Getting to Why ! 39
Ideas! 40
Incentives ! 42
Information! 43
Invert! 44
Marginal Thinking! 45
Metaphors! 46
Opportunity Costs! 48
Probabilistic Thinking! 49
Reductionism! 52
Scientific Method! 53
Spend - Conserve! 54
Systems Thinking! 56
The Argument! 57
3
Unintended Consequences ! 59
80:20 Rule! 61
Business Models! 62
Arbitrage! 62
Brand! 63
Business Model! 64
Core Competency! 66
Cost Leader! 68
Culture! 69
Disruptive Innovation! 70
Entrepreneurship! 71
GRICS (Retailers)! 72
Management Fanaticism! 74
Network Effect! 76
Porterʼs 5-forces! 77
Pricing Ability! 78
Protective Moat! 79
Scale ! 80
Specialization! 82
Standardization! 83
4
Surf a Wave! 84
Technology ! 85
Business Metrics! 87
Intrinsic Value! 88
Mr. Market! 90
Reversion-to-mean! 91
Scandal! 92
Nature of Goods! 95
Maslowʼs Triangle! 96
Total Utility! 97
Value ! 98
Decision Models! 99
Margin of Safety! 99
Pr O A C T! 100
5
The Agency Problem! 102
Trade-offs! 103
Extrapolation! 110
Groupthink! 112
Ideology ! 113
Over-optimism! 116
Statistics! 118
Bubbles! 122
6
Comparative Advantage! 124
Equilibrium! 128
Externalities! 129
Markets! 130
Bottlenecks ! 139
Evolution! 142
Momentum! 145
7
Power Law! 147
Reflexivity! 148
Thermodynamics! 153
8
Behavior Models
Availability
A Behavior Changer
Think Starbucks, where being everywhere links to the creatures of habit principle,
reducing the need to try other coffee establishments; and consider how people
have adapted their behavior to take advantage of Starbucks’ many locations -
social gatherings, business meetings, study areas etc.
9
Fool Yourself Tendency
Cognitive Dissonance: When feelings and facts are in opposition, people will find,
or invent, a way to reconcile them.
"The first rule is not to fool yourself, and you are the easiest person to fool."
People have a general bias toward spinning their reality in positive ways and ignoring
uncomfortable facts. It takes a real jolt to make them see that everything is not O.K.
[Experts] refer to such optimism in the face of countervailing facts as delusional optimism.
Jack Welch was infamous for popping the unduly optimistic bubbles of his people, and one
of his dicta was that managers must ‘face reality [and] see things as they are… not the way
they wished it would be.’
10
Habit
My Burger Habit
Humans have a tendency to habituate to any unpleasant stimulus, from pain and
sorrow to a persistent car alarm.
This is no easy task. Consumer studies and historical experience suggest that Coke drinkers
are fiercely attached to their Cokes.
11
The tendency for people to stay with the status quo has produced the
‘default’ behavior option. Thaler and Sunstein describe this idea in
‘Nudge’.
For lots of reasons, people have a more general tendency to stick with their current situation.
This phenomenon... dubbed the ‘status quo bias’, has been demonstrated in numerous
situations. Most teachers know that students tend to sit in the same seats in class, even
without a seating chart. Status quo bias is easily exploited (Examples include never-changing
asset allocations in 401(k) plans; automatic renewals of subscriptions on credit cards etc.).
One of the causes of status quo bias is a lack of attention. Many people adopt what we will
call the ‘yeah, whatever’ heuristic. A good illustration is the carryover effect in television
viewing.
The combination of loss aversion with mindless choosing implies that if an option is
designated as the ‘default’, it will attract a large market share. Default options thus act as
powerful nudges. In many contexts defaults have some extra nudging power because
consumers may feel, rightly or wrongly, that default options come with an implicit
endorsement from the default setter, be it the employer, government, or TV scheduler.
12
Human Action
! Acting man is eager to substitute a more satisfactory state of affairs for a less
satisfactory one. His mind imagines conditions which suit him better, and his action aims at
bringing about this desired state. The incentive that impels a man to act is always some
uneasiness. A man perfectly content with the state of his affairs would have no incentive to
change things. He would have neither wishes nor desires; he would be perfectly happy. He
would not act; he would simply live free from care.
! But to make a man act, uneasiness and the image of a more satisfactory state alone
are not sufficient. A third condition is required: the expectation that purposeful behavior has
the power to remove or at least to alleviate the felt uneasiness. In the absence of this
condition no action is feasible.
! Action is not simply giving preference. Man also shows preference in situations in
which things and events are unavoidable or are believed to be so. Thus a man may prefer
sunshine to rain and may wish that the sun would dispel the clouds. He who only wishes and
hopes does not interfere actively with the course of events and with the shaping of his own
destiny. But acting man chooses, determines, and tries to reach an end. Of two things both
of which he cannot have together he selects one and gives up the other. Action therefore
always involves both taking and renunciation.
13
Negotiation
Roger Fisher & William Ury outline their methods for principled negotiation
in 'Getting To Yes':
... in contrast to positional bargaining, the principled negotiation method of focusing on basic
interests, mutually satisfying options, and fair standards typically results in a wise agreement.
The method permits you to reach a gradual consensus on a joint decision efficiently without
all the transactional costs of digging in to positions only to have to dig yourself out of them.
BATNA: What is your BATNA - your Best Alternative To a Negotiated Agreement? That is the
standard against which any proposed agreement should be measured. That is the only
standard which can protect you both from accepting terms that are too unfavorable and from
rejecting terms it would be in your interest to accept.
14
Operant Conditioning
The behavior is said to be strengthened by its consequences, and for that reason the
consequences themselves are called 'reinforcers'.
The probability of behavior depends upon the kind or frequency of reinforcement in similar
situations in the past.
The things which make us happy are the things which reinforce us, but it is the things, not
the feelings, which must be identified and used in prediction, control, and interpretation.
B.F. Skinner, on the other hand, thought that preferences were essentially learned. So, a
Skinnerian might say that we want the fancy car because we have learned from society that
fancy cars are desirable, and the maker of the car has taught us to want it by exposing us to
alluring marketing messages.
15
Pain - Pleasure
Pain or Pleasure?
The sovereign masters that determine what people will do are not pleasure and
pain, but fallible memories of pleasure and pain.
Real pleasure is derived from experiences over physical goods, pastimes over
knick-knacks, and doing over having.
What is this force that is controlling you even now and will continue to do so for the rest of
your life? PAIN and PLEASURE! Everything you and I do, we do either out of our need to
avoid pain or our desire to gain pleasure.
! 'If you are distressed by anything external, the pain is not due to the thing
itself but to your own estimate of it; and this you have the power to revoke at any
moment.' - Marcus Aurelius
The truth is that we can learn to condition our minds, bodies, and emotions to link pain or
pleasure to whatever we choose. By changing what we link pain and pleasure to, we will
instantly change our behaviors.
16
Pavlovian Conditioning
! Pavlov's most famous experiment showed that dogs tend to salivate before food is
actually delivered to their mouths. This result led him to a long series of experiments in which
he manipulated the stimuli occurring before the presentation of food. He thereby established
the basic laws for the establishment and extinction of what he called 'conditional reflexes',
later mistranslated from the original Russian as 'conditioned reflexes'.
! In Pavlovian conditioning, powerful effects come from mere association. The neural
system of Pavlov's dog causes it to salivate at the bell it can't eat. And the brain of man
yearns for the type of beverage held by the pretty woman he can't have. And so... we must
use every sort of decent, honorable Pavlovian conditioning we can think of. For as long as
we are in business, our beverage and its promotion must be associated in consumer minds
with all things consumers like or admire.
! Such extensive Pavlovian conditioning will cost a lot of money, particularly for
advertising. We will spend big money as far ahead as we can imagine. But the money will be
effectively spent. As we expand fast in our new-beverage market, our competitors will face
gross disadvantages of scale in buying advertising to create the Pavlovian conditioning they
need.
! Moreover, Pavlovian effects from mere association will help us choose the flavor,
texture, and color of our new beverage. Considering Pavlovian effects, we will have wisely
chosen the exotic and expensive-sounding name 'Coca-Cola', instead of a pedestrian name
like 'Glotz's Sugared, Caffeinated Water'. For similar Pavlovian reasons, it will be wise to have
our beverage look pretty much like wine instead of sugared water. And so, we will artificially
color our beverage if it comes out clear. And we will carbonate our water, making our product
seem like champagne, or some other expensive beverage.
17
PLAGGES - 7 Sins
! What the theory of natural selection says, rather, is that people's minds were designed
to maximize fitness in the environment in which those minds evolved... the 'ancestral
environment'... the question, properly put, is always whether a trait would be in the 'genetic
interest' of someone in the [ancestral environment]. Only traits that would have propelled the
genes responsible for them through the generations in our ancestral social environment
should, in theory, be part of human nature today.
! ... there are recurring themes among contemporary hunter-gatherer societies, and
they suggest that some features probably stayed fairly constant during much of the evolution
of the human mind. For example: people grew up near close kin in small villages where
everyone knew everyone else and strangers didn't show up very often.
! ... whatever the ancestral environment was like, it wasn't much like the environment
we're in now. We aren't designed to stand on crowded subway platforms, or to live in
suburbs next door to people we never talk to, or to get hired or fired...
18
Reader or Listener?
! The explanation: Eisenhower apparently did not know himself that he was a
reader and not a listener. When he was Commander-in-Chief in Europe, his aides made
sure that every question from the press was handed in, in writing, at least half an hour before
the conference began. And then Eisenhower was in total command.
! [on the other hand] Roosevelt knew himself to be so much of a listener that he
insisted that everything first be read out loud to him - only then did he look at anything in
writing.
19
Science of Achievement
The science of taking ideas, and dreams, and making them happen is generally considered
as:
1. Setting a goal.
2. Creating a written plan to reach the goal within a certain timeframe.
3. Taking action by implementing the plan.
4. Getting feedback from actions - negative and
positive - and making changes, if necessary.
The thoughts you think, the images you hold, the feelings you experience trigger words and
actions consistent with them.
Every attitude, behavior, value, opinion, belief and fear you have today has been learned.
Therefore, if there are elements of your self-concept that do not serve your purposes, you
can unlearn them.
20
Behavior - Influence Models
Authority
! The strength of this tendency to obey legitimate authorities comes from systematic
socialization practices designed to instill in members of society the perception that such
obedience constitutes correct conduct. In addition, it is frequently adaptive to obey the
dictates of genuine authorities because such individuals usually possess high levels of
knowledge, wisdom, and power. For these reasons, deference to authorities can occur in a
mindless fashion as a kind of decision-making shortcut.
! The worrisome possibility arises, then, that when a physician makes a clear error, no
one lower in the hierarchy will think to question it - precisely because, once a legitimate
authority has given an order, subordinates stop thinking in the situation and start reacting.
Mix this kind of click, whirr response into a complex hospital environment and mistakes are
inevitable. Indeed, a study by the U.S. Health Care Financing Administration shows that, for
patient medication alone, the average hospital has a 12 percent daily error rate.
21
Commitment & Consistency
! Indeed, we all fool ourselves from time to time in order to keep our thoughts and
beliefs consistent with what we have already done or decided.
! For instance, suppose you wanted to increase the number of people in your area who
would agree to go door-to-door collecting donations for your favorite charity. You would be
wise to study the approach taken by social psychologist Steven J. Sherman. He simply
called a sample of Bloomington, Indiana, residents as part of a survey he was taking and
asked them to predict what they would say if asked to spend three hours collecting money
for the American Cancer Society. Of course, not wanting to seem uncharitable to the survey-
taker or to themselves, many of these people said that they would volunteer. The
consequence of this subtle commitment procedure was a 700 percent increase in volunteers
when, a few days later, a representative of the American Cancer Society did call and ask for
neighborhood canvassers.
! ...he did something that fits perfectly with the commitment/consistency principle you
talk about. He told his receptionists to stop saying, "Please call us if you change your plans,"
and to start asking, "Will you please call us if you change your plans," and to wait for a
response. His no-show rate immediately dropped from 30 percent to 10 percent.
! In all, it seems that active commitments give us the kind of information we use to
shape self-image, which then shapes future actions, which solidify the new self-image.
! Commitments are most effective when they are active, public, effortful, and viewed as
internally motivated (not coerced).
22
Deprival Syndrome
! A man ordinarily reacts with irrational intensity to even a small loss, or threatened loss,
of property, love, friendship, dominated territory, opportunity, status, or any valued thing.
'Why Smart People Make Big Money Mistakes and How to Correct Them',
by Gary Belsky & Thomas Gilovich:
Behavioral economists describe the takeaway idea as the 'endowment effect'. Businesses
understand this effect - once you take a product home and use it, there's a strong chance
that the endowment effect will kick in; whatever value you might have placed on, say, a
stereo at a store will likely be increased once it sits in your den for a few weeks.
23
Framing the Issue
Necessary or Welfare?
'If you would persuade, appeal to interest and not to reason' - Ben Franklin
I learned through this episode that from the moment a President presents an important
proposal to the nation, he has to spend time painting a picture of it his way. Otherwise,
his opponents will color it their way and put him on the defensive. Our opponents went right
to work casting our plan as a tax increase - a grave distortion in relation to the majority of
taxpayers, who saw no increase in their income taxes and a gas tax estimated at only $36 a
year for an average family of four.
We, on the other hand, spent little time explaining how few people were affected by the tax
increase or, more important, painting our own picture of the program as a restoration of fiscal
discipline to create jobs, increase standards of living, and promote economic growth.
24
Incentive-Cause Bias
! Widespread incentive-caused bias requires that one should often distrust, or take with
a grain of salt, the advice of one's professional advisor, even if he is an engineer. The general
antidotes here are: 1) fear professional advice when it is especially good for the advisor; 2)
learn and use the basic elements of your advisor's trade as you deal with your advisor; and
3) double check, disbelieve, or replace much of what you're told, to the degree that seems
appropriate after objective thought.
25
Liking
Easy to Like
! "It's gotten to the point now where I hate to be invited to Tupperware parties. I've got
all the containers I need; and if I wanted any more, I could buy another brand cheaper in the
store. But when a friend calls up, I feel like I have to go. And when I get there, I feel like I have
to buy something. What can I do? It's for one of my friends."
26
Reciprocation
Just Reciprocating
! I know of no better illustration of the way reciprocal obligations can reach long and
powerfully into the future than the perplexing story of $5,000 of relief aid that was exchanged
between Mexico and Ethiopia. In 1985, Ethiopia could justly lay claim to the greatest suffering
and privation in the world. Under these circumstances, I would not have been surprised to
learn of a $5,000 relief donation from Mexico... I remember my feeling of amazement,
though, when a brief newspaper item I was reading insisted that the aid had gone in the
opposite direction.
27
Scarcity
! The scarcity principle is most likely to hold true under two optimizing conditions. First,
scarce items are heightened in value when they are newly scarce. That is, we value those
things that have become recently restricted more than those that were restricted all along.
Second, we are most attracted to scarce resources when we compete with others for them.
! People seem to be more motivated by the thought of losing something than by the
thought of gaining something of equal value. For instance, college students experienced
much stronger emotions when asked to imagine losses as opposed to gains in their romantic
relationships or in their grade point averages. Especially under conditions of risk and
uncertainty, the threat of potential loss plays a powerful role in human decision making.
28
Social Proof
29
Big Thinking Models
As Simple As Possible
The process requires asking why, why and why until one can go no further -
essentially trying to reduce to a more fundamental body of knowledge.
When you explain a ‘why’ you have to be in some kind of framework where you allow
something to be true, otherwise you are perpetually asking ‘why?’
Learn by trying to understand simple things in terms of other ideas – always honestly and
directly. What keeps clouds up, why do colors appear on oily water, etc. Look about you and
think of what you see there.
It was my father who got me into this business of having to imagine things all the time.
Things like, if a Martian landed wouldn’t they ask: ‘Why does everyone go to sleep every
night?’
For example, Aunt Minnie is in hospital. Why - Because she slipped on the ice and broke her
hip. That satisfies people. But it wouldn’t satisfy someone who came from another planet.
30
Occam's Razor provides another approach to the 'as simple as possible' approach.
William of Occam, a 14th century philosopher, said, 'Non sunt entia multiplicanda
oracter necessitatem,' which translates to, 'Hypotheses should not be multiplied
without reason.' In other words, look for the simplest answer possible.
In 'The Nature of Science', James Trefil, the author, explains it this way:
For example, suppose that someone sees a bright and unexpected light in the night sky, a
UFO. One explanation is that this person has seen the lights of a spacecraft piloted by
extraterrestrials.
But there are many other, simpler explanations for lights in the sky - airplanes, the planet
Venus (the number one explanation for 'UFOs'), weather balloons, and so on. Each of these
explanations requires a relatively small number of hypotheses.
31
Big Picture Math
Using elementary math to quickly appraise a situation. Here, the idea is to use
numbers to evaluate the big idea in the argument, to see whether or not it makes
sense.
Compounding has only half-jokingly been referred to as the eighth wonder of the
world.
The rule of '72' provides a handy calculation tool. If $10,000 were invested in an
account yielding 7%, it would double about every 10 years (72 divided by 7 equals
10, the doubling period).
[For example]... the bedrock underlying the economy, namely, the pattern of family formation
and population structure that had emerged in the United States between 1937 and 1943.
32
Whilst there isn’t a formula set for Big Picture Math, the following examples
highlight the methodology of looking for the big part of the argument.
Alfred Rappaport and Michael Mauboussin get to the heart of the rollout
success of McDonald’s in ‘Expectations Investing’:
The world's leading fast food purveyor, McDonald's, is an illustration of how fixed-capital
investment efficiency can add value. Through standardization, global sourcing, and
purchasing power, McDonald's trimmed its average U.S. unit development costs significantly
in the early 1990s. Notably, expected sales and operating profit margins from these units did
not diminish. The improved efficiency translated directly into higher cash flows and
shareholder value.
33
The last example of math reasoning is taken from a ‘Heard on the Street’
article in the Wall Street Journal:
Washington's "cash for clunkers" isn't just a way of getting you to buy a car you didn't know
you wanted. The administration also touts its green credentials.
Assume 250,000 vehicles are exchanged, with the new ones getting 9.6 miles more per
gallon. Based on each driving 12,000 miles a year, that equates to almost 200 million gallons
of fuel saved every day. Sounds big, but the U.S. burns that much every 22 seconds.
Every gallon of gasoline burned emits about 19 pounds of carbon dioxide. Say the old cars
would have been driven another five years without the clunkers subsidy. The implied saving is
about 3.5 million tons of carbon dioxide. Even apportioning only half of the $1 billion cost of
the subsidy to carbon reduction works out at $144 a ton - about seven times what carbon
permits trade for in Europe. As a cost-effective green initiative, "clunkers" emit a fair amount
of hot air.
34
Deduction or Induction?
Latin roots of the two words mean: ‘leading from’ and ‘leading in’. Deduction
forms the basis of classical logic, while induction is the foundation of scientific
method.
‘If all cows are ruminants, and Bossy is a cow, it follows that Bossy chews
her cud.’
Induction begins with the particular and moves to the universal (a generalization
that accounts for other examples of the same category or class). It relies on
observation and experimentation.
‘In the case of Bossy, it can be demonstrated that she digests by rumination;
if all the other cows we observe do likewise, we can declare, if not a certainty
then a high probability, that cud chewing is a distinguishing feature of all
cows.’
35
Disconfirming Evidence
A Disconfirming Figure
The tendency to rationalize preconceived ideas and not look for disconfirming
evidence.
Most of us favor confirming evidence even when the search for confirming evidence has
clearly become unhelpful. Confirming evidence gives us a mental reward. Every shred says:
'You're on the right track... You're doing a good job.'
Disconfirming evidence, on the other hand, says: 'Your idea wasn't as good as you thought.'
In short, confirmation feels good and disconfirmation feels (at least momentarily) painful. Thus
people tend to neglect evidence that might undermine their ideas.
! Moral: Have the discipline to seek information that might disconfirm your opinions. If
you look for it and can't find it, then you have reason to be confident. One way to look for it is
to generate an alternative hypothesis and test both.
The human understanding when it has once adopted an opinion draws all things
else to support and agree with it. And though there be a greater number and
weight of instances to be found on the other side, yet these it either neglects and
despises, or else by some distinction sets aside and rejects, in order that by this
great and pernicious predetermination the authority of its former conclusion may
remain inviolate. - Francis Bacon
36
Game Theory
A framework for studying situations in which decisions are influenced by the
choices of others.
Consider, for example a new company that wishes to enter a market segment
against the industry leader. How should the new company set its prices? Should it
go in with its original pricing scheme, or does it go in lower judging that the
leader will lower prices to drive out the new entrant?
Lower Maintain
Lower 0 0
A B
0 1
New Company
Maintain 1 1
C D
0 1
Box A: If both the new company and leader adopt lower prices, they both lose
(score = 0) as profits are lower
all around.
Box B: If the new company goes lower price, but the leader maintains, then the
new company is likely to gain market share (score = 1).
Box C: If the new company maintains its price, but the leader opts for a low price
strategy then the new company is unlikely to get a foothold in the leader’s
market.
Box D: If they both maintain pricing, they will both be better off as profits are
maximized.
From this basic analysis the best and worst joint scenarios are clear. However, for
the leader the best choice is the least worst option. Since it is already the leader if
it chooses the lower price strategy, it may win (Box C) or at the worst (Box A) it
will prevent the new company from gaining an advantage.
37
From 'The Moral Animal', by Robert Wright:
Game theorists, then, may want to follow a few simple rules when applying their tools to
human [behavior]. First, the object of the game should be to maximize genetic proliferation.
Second, the context of the game should mirror reality in the ancestral environment, an
environment roughly like a hunter-gatherer society. Third, once the optimal strategy has been
found, the experiment isn't over. The final step - the payoff - is to figure out what feelings
would lead human beings to pursue that strategy. Those feelings, in theory, should be part of
human nature; they should have evolved through generations and generations of the
evolutionary game.
!
'Thinking Strategically', by Avinash Dixit and Barry Nalebuff:
Everyone’s best choice depends on what others are going to do, whether it’s going to war or
maneuvering in a traffic jam. These situations, in which people’s choices depend on the
behavior or the choices of other people, are the ones that usually don’t permit any simple
summation. Rather we have to look at the system of interaction.
A player has a Dominant Strategy when he has one course of action that outperforms all
others no matter what the other players do.
(Prisoner’s Dilemma – players follow their dominant strategy but the outcome is jointly worse)
When leading it may be better to copy those against whom you are competing in order to
guarantee staying ahead. Sometimes moving first can be a disadvantage.
Credibility
1.! Establish and use a reputation (threats/promises must be credible)
2.! Write contracts
3.! Burn bridges behind you
4.! Employ mandated negotiating agents
Slippery Slope
Continual small steps and lack of focus on overall package can start one on slippery slope
and then one cannot back out: Auctions; trade arguments; military arguments.
38
Getting to Why
In 'The New Rational Manager', Charles Kepner and Benjamin Tregoe,
outline their approach to solving problems. Their framework targets the
gap - deviation - between expected and actual outcomes.
IS IS NOT
WHAT WHAT
What object or group of objects are you having What object(s) could you be having trouble with
trouble with? but are not?
What is wrong with the object or objects - (Defect/ What else could be wrong with the object/s but is
Fault)? not?
WHERE WHAT
Where is the object when the defect is noticed Where could the defective object be observed but
(Geographic Location)? is not?
Where is the defect/fault located on the object? Where could the defect/fault be located on the
object but is not?
WHEN WHEN
When was the defect/fault first noticed (Date & When could the defect/fault have been first
Time)? noticed but was not?
When has the defect/fault been noticed since When could the defect/fault have been noticed
(Pattern)? since but was not?
When in the life cycle of the object was the When in the life cycle could the defect/fault have
defect/fault first noticed? been noticed but was not?
EXTENT/SIZE EXTENT/SIZE
How many defective objects are there? How many defective objects could there be, but
What is the size of the defect/fault on the object? are not?
How many defects/faults are on any one object? What could the size of the defect/fault be, but is
What is the trend? not?
How many defects/faults could there be but are
not?
What could the trend be, but is not?
The analysis can then start by asking what, if anything, is distinctive about the 'is'
from the 'is not' for each parameter.
Since people tend to think 'what is' rather than 'what is not', the Kepner Tregoe
approach helps target the 'what is not' deficiency.
39
Ideas
A Good Idea?
An idea is nothing more nor less than a new combination of old elements. The second
important principle involved is that the capacity to bring old elements into new combinations
depends largely on the ability to see relationships.
1. Gather new material. The materials which must be gathered are of two kinds: they are
specific and they are general. In advertising, the specific materials are those relating to the
product and the people to whom you propose to sell it. General materials come from being
intensely curious about all manner of things. Extensive browsing produces this general data
bank.
3. Then really work these materials over in your mind. Trying first to fit one way and then
looking from another angle, or trying to combine in a different way. Mindset: To be constantly
pre-occupied (with its brooding quality) with the possibilities of new combinations.
4. Then incubate, by letting the conscious mind think about something completely different.
This will aid the synthesis process.
5. Once the ‘eureka’ moment has arrived and the idea given birth, review it in the cold light of
day so that it can take its final shape and form, helping to overcome those last minute
doubts as to its usefulness.
40
In 'why not?' the authors Barry Nalebuff and Ian Ayres describe four tools
for generating good ideas:
Since Croesus was the supremely rich king of Lydia (modern day Turkey), the question is
what would you do if money wasn't an issue?
If money was not a problem, you would use your own private plane to jet around the world.
So how, more realistically, can you get your own jet? Enter the business model that is now
known as fractional jet ownership - first conceived by NetJets.
In addition to watching what consumers do well, it is also useful to pay attention to what they
do wrong. In other words, how do the incentives cause them to behave in the 'wrong' way?
Busy highways full of no passenger cars, at peak hours, have led many states to introduce
car pool lanes in an attempt to provide the correct incentive. Perhaps tolls could be used,
based on the number of passengers (the greater the number, the lower the toll), to reinforce
this incentive.
You've come up with a great solution. What other problems does it solve?
The idea of self-checkout at the supermarket has now been adapted to self-checkin airline
counters, automated library checkouts and self-service post office kiosks.
In South Africa, as most other places, the utility provides electricity and then bills you for the
amount used. You consume and then pay. But what if you pay first and then consume? This
was the scheme devised by Eskom, the electricity utility, as it provided electricity to crowded
black townships. Consumers bought prepaid electricity cards and inserted them into their
meters to 'turn-on the lights'.
41
Incentives
Say No More
Consider the total utility of the given incentive when predicting behavior.
And it was always screwed up. They could never get it done on time. They tried everything -
moral suasion, threats, you name it. And nothing worked.
Finally, somebody get the idea to pay all these people not so much an hour, but so much a
shift - and when it's all done, they can go home. Well, their problems cleared up overnight.
42
Information
Is it important?
If it's not important then it can be discarded.
But if it is important, is it knowable?
'In Seeking Wisdom', the author Peter Bevelin quotes Warren Buffett:
There are two questions you ask yourself as you look at the decision you'll make.
A) is it knowable?
B) is it important?
If it is not knowable, as you know there are all kinds of things that are important but not
knowable, we forget about those. And if it's unimportant, whether it's knowable or not, it
won't make any difference. We don't care. But there are enough things that are knowable
and important that we focus on those things. And everything else, we forget about.
43
Invert
! In every business deal or transaction, identify the worst thing that can
possibly go wrong, and then make sure it doesn't happen - John Paul Getty
! That is not what most people do with their initial assumption. They try and confirm it.
It's an automatic tendency in psychology - often called 'first-conclusion bias'. But it's only a
tendency. You can train yourself away from the tendency to a substantial degree. You just
constantly take your own assumptions and try to disprove them.
44
Marginal Thinking
Rational people can make better decisions by thinking at the margin. For
example:
Although the average cost of flying a passenger may be $500, the marginal cost
is merely the extra bag of peanuts and a drink. As long as the marginal passenger
pays more than the marginal cost, selling him a ticket is profitable.
Economic analysis is basically marginal analysis. Marginal means additional. Economic theory
is marginal analysis because it assumes that decisions are always reached by weighing
additional costs against additional benefits. Nothing matters in decision making except
marginal costs and marginal benefits.
45
Metaphors
It’s often difficult to tell whether similarities between a familiar and an unfamiliar
problem are deep or superficial. People facing choices can improve their odds of
using analogies well by following these 4 steps:
Translate, decide
& adapt
Application
46
The method is illustrated as follows:
Candidate Solution: The bank reviewed every single account and applied a cost
to it based on customer transactions per year, for a 3-year period. It then decided
to transfer all the small accounts of its least profitable customers to an internet
only account. Some of these customers decided to close their accounts. The
majority, however, remained. After six months an independent branch survey
showed a high degree of satisfaction among business and high-value checking
customers.
Target Problem: The international airline has been slipping recently and business
customers, its most profitable passengers, have been complaining.
The airline has decided to adapt the local bank strategy. It already knows that
business class passengers generate the bulk of its profits, whilst economy
passengers are barely profitable. The airline reviews all the costs associated with
its economy passengers and decides that extra baggage and on-board drinks
represent significant 'hidden' costs.
Your Solution: The airline will therefore reduce its baggage allowance for
economy passengers, and will further ask them to pay for on-board drinks. The
additional income will be used to improve food and beverage service in business
class.
47
Opportunity Costs
The cost of any action is the value of the opportunity forgone by taking that
action.Resources have other opportunities for their employment. Hence to acquire
them one must 'crowd out' the next best application. Only actions have costs.
One must do something to incur the cost. And costs are always to someone.
! Now let us take another look. The crowd is at least right in its first conclusion. This
little act of vandalism will in the first instance mean more business for some glazier. The
glazier will be no more unhappy to learn of the incident than an undertaker to learn of a
death. But the shopkeeper will be out $250 that he was planning to spend for a new suit.
Because he has had to replace a window, he will have to go without the suit (or some
equivalent need or luxury). Instead of having a window and $250 he now has merely a
window. Or, as he was planning to buy the suit that very afternoon, instead of having both a
window and a suit he must be content with the window and no suit. If we think of him as a
part of the community, the community has lost a new suit that might otherwise have come
into being, and is just that much poorer.
" The glazier’s gain of business, in short, is merely the tailor’s loss of business. No new
“employment” has been added. The people in the crowd were thinking only of two parties to
the transaction, the baker and the glazier. They had forgotten the potential third party
involved, the tailor. They forgot him precisely because he will not now enter the scene. They
will see the new window in the next day or two. They will never see the extra suit, precisely
because it will never be made. They see only what is immediately visible to the eye.
48
Probabilistic Thinking
For me, probabilistic thinking has long been a highly conscious process. I imagine the mind
as a virtual legal pad, with the factors involved in a decision gathered, weighed, and totaled
up. To describe probabilistic thinking this way does not, however, mean that it can be
reduced to a mathematical formula, with the best decision jumping automatically off a legal
pad. Sound decisions are based on identifying relevant variables and attaching probabilities
to each of them. That’s an analytic process but also involves subjective judgements. The
ultimate decision then reflects all of this input, but also instinct, experience, and ‘feel’. All the
time bearing in mind that reality is always more complex than concepts and models.
A true probabilistic view of life quickly leads to the recognition that almost all significant
issues are enormously complex and demand that one delve into those complexities to
identify the relevant considerations and the inevitable trade-offs. With an enormous number
of competing considerations, the key to reaching the best possible decision is to identify all
of them and decide what odds and import to attach to each.
49
A widely used tool for probabilistic thinking is decision tree analysis.
For example, consider a company that wishes to conduct a 10,000 piece test
marketing campaign and must decide between mail and email. The company
obtains pricing from its vendor for both options - $4,000 for mail campaign and
$1,500 for email.
The company then asks its vendor what the average, best case and worst case
orders would be in each case.
The vendor is confident of its mail figures due to a large body of prior experience
and the nature of delivery (physical address); and therefore informs the company
that the average rate is 3%, best case would be 8% and worst case 0.25%.
The vendor feels that email is much more unpredictable due to spam filters and
the quality of the email list; and therefore informs the company that the average
order rate is 1%, best case would be 10% and worst case 0.25%.
50
In 'Take The Risk', Dr. Ben Carson illustrates his approach to probabilistic
thinking:
" Being successful is simply a matter of making good choices by using our incredibly
sophisticated brains. We all have the means to analyze risks and decide which are worth
taking and which should be avoided. That’s a simple but powerful prescription for life, love
and success.
! With respect to the best/worst analysis, when wrestling with an important decision,
ask yourself these four questions:
51
Reductionism
From 'An Introduction to General Systems Thinking', by Gerald Weinberg.
Reductionism - Getting Your Hands Around It.
… it is his chosen task to understand the simplifying assumptions of a science… those
‘objects of interest’ and ‘well-defined conditions’ that delimit its domain of application and
magnify its power of prediction.
Think out alternative conceivable answers. Phrase them so that a reasonable amount of
evidence makes a clear-cut choice possible. If too many conceptual difficulties are
encountered, back off. Search for another question. When you finally hit a soft spot, search
for the model system – say a controlled emission in particle physics or a fast breeding
organism in genetics – on which decisive experiments can be most easily conducted.
Become thoroughly familiar with the system; love the details. Design the experiment, so that
no matter what the result, the answer to the question will be convincing. Use the result to
press on to new questions, new systems.
In 'More Than You Know', author Michael Mauboussin, explains the limits
to reductionism:
! Reductionism is the cornerstone of discovery in the Newtonian world, the basis for
much of science's breathtaking advance in the seventeenth through nineteenth centuries. As
scientist John Holland explains, 'The idea is that you could understand the world, all of
nature, by examining smaller and smaller pieces of it. When assembled, the small pieces
would explain the whole.' In many systems reductionism works brilliantly.
! But reductionism has its limits. In systems that rely on complex interactions of many
components, the whole system often has properties and characteristics that are distinct from
the aggregation of the underlying components. Since the whole of the system emerges from
the interaction of the components, we cannot understand the whole simply by looking at the
parts. Reductionism fails.
! When a system has low complexity and we can define interactions linearly,
reductionism is very useful. Many engineered systems fit this bill.
52
Scientific Method
" Or, put another way, ‘The exception proves that the rule is wrong.’ That is the principle
of science. If there is an exception to any rule, and if it can be proved by observation, that
rule is wrong.
! So the more specific the rule, the more powerful it is, the more liable it is to
exceptions, and the more interesting and valuable it is to check.
" The method is ‘Try it and see’… and accumulate the information and so on. And so
the question ‘If I do it what will happen?’ is a typically scientific question.
53
Spend - Conserve
Abundant Information
Economists have traditionally focused on scarcity. Abundances tend to end in a near zero
price and thus escape economics altogether. As the price declines and their role in the
economy becomes more vast and vital, their role in economic analyses diminishes. When
they are ubiquitous, like air and water, they are invisible... 'externalities'.
Every economic era has a defining abundance, a critical resource or technology that is
expanding in production and plummeting in price so rapidly that it appears virtually free when
compared to an array of competing critical resources for which it can be substituted. These
abundances come to define the very character of their age, whether an age of 'steam' or 'oil'
or an age of 'information'.
54
During the pre-industrial era in America, the scarcity was horsepower and the abundance
was land. In the industrial age, horsepower - physical force, translated eventually into watts,
or kilowatt-hours - abounded while land grew relatively scarce. Between 1660 and 1950, the
cost of an effective kilowatt-hour dropped from thousands of dollars to some seven cents.
We splurged on cheap horsepower - to clear farmland, to refine ores, to manufacture goods
etc.
Over the last 30 years... transistors became asymptotically costless. On a computer memory
chip the price of a transistor, with support circuits, dropped from some seven dollars to a few
millionths of a cent.
An era's defining abundances relieve its critical scarcities. We use transistors to compensate
for a shortage of human servants and... broadband communications capacity.
But abundances can also create new scarcities. The plethora of cheap fuel created a dearth
of roads and a need for pollution controls. The more recent glut of transistors led to a
shortage of the very communications capacity it was meant to enhance.
'...in an information-rich world, the wealth of information means a dearth of something else: a
scarcity of whatever it is that information consumes. What information consumes is rather
obvious: it consumes the attention of its recipients. Hence a wealth of information creates a
poverty of attention and a need to allocate that attention efficiently among the
overabundance of information sources that might consume it.'
55
Systems Thinking
A Systematic Thinker
Randomness
One suggestive phrase is that statistical mechanics deals with ‘unorganized complexity’ -
that is, systems that are complex, but yet sufficiently random in their behavior so that they
are sufficiently regular to be studied statistically.
Stability
When we speak of stability, we are speaking of two things: a set of acceptable behaviors of
the system and a set of expected behaviors of the environment.
Principle of Invariance
We understand change only by observing what remains invariant, and permanence only by
what is transformed.
Count-to-Three Principle
If you cannot think of three ways of abusing a tool, you do not understand how to use it.
56
The Argument
Letʼs Debate
In 'Asking the Right Questions', the authors Neil Browne and Stuart
Keeley, lay out a framework for critical thinking:
57
Consider the following paragraph:
! The quality of education at this university is not declining. In my interviews, I found that
an overwhelming majority of the students and instructors responded that they saw no decline
in the quality of education here.
! The 'quality of education' is obviously the key point, but does it refer to grade point
average, the starting salary of graduating students, a third party ranking etc.
Keep asking, 'How do you get from the reason to the conclusion?' Ask, 'If the reason is true,
what else must be true for the conclusion to follow?' And, to help answer that question, you
will find it helpful to ask, 'Supposing the reason(s) were true, is there any way in which the
conclusion nevertheless could be false?'
58
Unintended Consequences
Not So Fast
The question caught me off guard. However, as I thought about it, it became clear that the
situation I described would lead to other economic consequences, which I then began to
consider and to spell out. "And then what will happen after that?" Professor Smithies
asked.
As I analyzed how the further economic reactions to the policy would unfold, I began to
realize that these reactions would lead to consequences much less desirable than those at
the first stage, and then I began to waver somewhat. "And then what will happen?"
Smithies persisted.
By now I was beginning to see that the economic reverberations of the policy I advocated
were likely to be pretty disastrous - and, in fact, much worse than the initial situation that it
was designed to improve.
59
Warren Buffett gives an example of this analysis (Originally in Outstanding
Investor Digest, but quoted from 'Seeking Wisdom', by Peter Bevelin):
!
The key thing in economics, whenever someone makes an assertion to you, is to always ask,
"And then what?" Actually, it's not such a bad idea to ask it about everything. But you should
always ask, "And then what?"
So when you read that the merchandise trade deficit is $9 billion, what else does that mean?
It means that somehow we must also have traded $9 billion of capital assets - (future) claims
on our production - and given them to somebody else in the world. So they have to invest.
They don't have a choice. And when somebody says, "Won't it be terrible if the Japanese
sell all of their government bonds?" Well, they can't without getting another American asset
in exchange. There's simply no other way to do it. They could sell it to the French, but then
the French have the same problem.
So trace through the transactions on the circle whenever you talk about any
specific action in economics.
60
80:20 Rule
Considering the 80/20 idea forces one to look for the biggest issue, or the
point of greatest leverage. This is illustrated in the following approach by
Bill Gates:
1. Determine a Goal
2. Find the ‘highest-leverage approach’
3. Discover the ideal technology for that approach
4. In the meantime, make the smartest application of the technology that you already have.
61
Business Models
Arbitrage
A process for identifying market inefficiencies. The classic idea is that of buying
an item in one place and selling it in another. For example buying gold in London
at $900 and selling it in New York at $910. But the mis-pricing mindset can apply
just as well in business. Outsourcing, for example, is the buying of labor in one
location for sale in another.
Since World War I the definition of arbitrage - or “risk arbitrage,” as it is now sometimes
called - has expanded to include the pursuit of profits from an announced corporate event
such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender,
etc. In most cases the arbitrageur expects to profit regardless of the behavior of the stock
market. The major risk he usually faces instead is that the announced event won’t happen.
Some offbeat opportunities occasionally arise in the arbitrage field. I participated in one of
these when I was 24 and working in New York for Graham-Newman Corp. Rockwood & Co.,
a Brooklyn based chocolate products company of limited profitability, had adopted LIFO
inventory valuation in 1941 when cocoa was selling for 50 cents per pound. In 1954 a
temporary shortage of cocoa caused the price to soar to over 60 cents. Consequently
Rockwood wished to unload its valuable inventory - quickly, before the price dropped. But if
the cocoa had simply been sold off, the company would have owed close to a 50% tax on
the proceeds.
The 1954 Tax Code came to the rescue. It contained an arcane provision that eliminated the
tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a
plan reducing the scope of a corporation’s business. Rockwood decided to terminate one of
its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean
inventory was attributable to that activity. Accordingly, the company offered to repurchase its
stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for
each share. For several weeks I busily bought shares, sold beans, and made periodic stops
at Schroeder Trust to exchange stock certificates for warehouse receipts. The profits were
good and my only expense was subway tokens.
62
Brand
Difficult to Reproduce
! Popular brands aren't always profitable brands. If a brand doesn't entice consumers
to pay more, it may not create a competitive advantage.
63
Business Model
The emphasis of defining and thinking about the business from the
customer's perspective is further highlighted in 'Marketing Myopia', by
Theodore Levitt, a Harvard Business Review article.
! Always ask where the competition might come from; and examine substitutable
products. The customer group often never articulates their greatest unsatisfied need.
" Do not focus on the product, rather keep focusing on the people who consume it (or
don’t consume it) and their changing needs and desires, remembering that the consumer
always buys to accomplish something.
! If you weren't already in this business would you enter it today? If not, what are you
going to do about it?
64
money. The characters must be precisely delineated, their motivations must be plausible, and
the plot must turn on an insight about value.
! Underpinning every successful organization - whether the people who run that
organization know it or not - is a business model that any sensible person can understand
after the fact. We see who the characters are, why they will behave as they do, and the
underlying economic logic that drives the plot and makes a self-sustaining system of the
whole.
! It's just so unproductive! If you want to win, when it comes to strategy, ponder less
and do more.
" First, come up with a big ‘aha’ for you business - a smart, realistic, relatively fast way
to gain sustainable competitive advantage.
! Look, what is strategy but resource allocation? When you strip away all the noise,
that's what it comes down to. Strategy means making clear-cut choices about how to
compete. You cannot be everything to everybody, no matter what the size of your business
or how deep its pockets.
65
Core Competency
Tests of causal relationships: Stating the observed problem; the root cause suspected; the
change proposed; the countermeasure’s actual effect on performance. Understand how the
process works – and perhaps more importantly how the process was studied and improved.
So, it may be that Toyota's proprietary learning curve is its thinking and
implementation culture, and high quality is the result?
Similarly, we might ask what is about Honda that has led to its core competency
in engines? Or why does Virgin seem to be further along the learning curve of
setting up successful entrepreneurial businesses?
66
The idea of a 'core competency' in a company is outlined in 'Competing
for the Future' by Gary Hamal and C.K. Prahalad:
! A competence is a bundle of skills and technologies rather than a single discrete skill
or technology... [it] represents the sum of learning. Thus, a core competence is very unlikely
to reside in its entirety in a single individual or small team.
! What is visible to the customers is the benefit, not the technical nuances, of the
competence that underlies that benefit. Questions to answer include: What is the customer
actually paying for? Why is the customer willing to pay more or less for one product or
service than another?
! For example, while SKF, the world's leading manufacturer of roller bearings, might be
tempted to define its core competence as bearings, such a definition would be unnecessarily
limiting in terms of providing access to new markets. The company's growth need not be
totally dependent on finding new uses for roller bearings because, when SKF moves away
from a product-based view of its competencies to a skill-based view, new opportunities
quickly emerge. SKF has competencies in anti-friction (understanding how different materials
work together to either generate or reduce friction), in precision engineering (it is one of a very
few European companies that can machine hard metals to incredibly tight tolerances), and in
making perfectly spherical devices.
To better consider potential competencies, one can think in terms of physical and
social (methods for organizing people) technology classifications:
67
Cost Leader
Since there can only be one cost leader, this is a powerful position for any
company to hold. As the product tends to commodity status, with price becoming
the major issue for the buyer, the competitive position of the cost leader
improves. There are several areas to look for a cost advantage - cost of goods
sold, cost of funds, distribution, research and development, marketing reach etc.
But does the company have the discipline to maintain its relentless focus on cost
leadership? Will it keep its simple low-cost message in the future? Or could the
company drift?
68
Culture
A superstar manager will likely provide exceptional company performance only
whilst at the helm, but the underlying attributes of a company's culture should be
more enduring.
! Conversely, our CEOs' scorecards for success are not whether they obtain my job,
but instead are the long-term performances of their businesses. Their decisions flow from a
here-today, here-forever mindset. I think our rare and hard-to-replicate managerial structure
gives Berkshire a real advantage.
69
Disruptive Innovation
! Disruptive technologies bring to a market a very different value proposition than had
been available previously. Disruptive technologies typically enable new markets to emerge.
And products that seriously underperform today, relative to customer expectations
[functionality, reliability, convenience, price] in mainstream markets, may become directly
performance-competitive tomorrow.
70
Entrepreneurship
Incongruities.
Think ‘what is it at the moment’ and ‘what should it be’. The gap between these two is the
opportunity. For example, people are seeking more leisure pursuits yet cinema audiences are
going down. Why? Be ready to challenge the most basic industry assumptions.
Process Need.
Look hard for the ‘weak link’ within a self-contained process. You should be struck by the
realization of ‘there should be a better way’.
Industry/Market Changes.
See the value migrating within the industry, by spotting commoditization or changing
technologies or society changes. For example, from computer hardware to software, from
big steel mills to mini-mills or from public to private medicine.
Demographics.
Are the demographics of your market changing? Clearly the population of Japan is aging,
what opportunities does this create? The young urban population of many middle-eastern
countries provides different opportunities.
Mood/Perception.
Take advantage of changing tastes within society. Timing is crucial, as those who move too
early on a change often meet with disaster. Some recent changes include wildlife
conservation, healthy eating, women in the workplace and holidays abroad.
New Knowledge.
The advent of a new technology or new knowledge can create opportunities. This need not
be in your direct market in order to affect you. Technology/knowledge scanning across
industry segments can be useful.
71
GRICS (Retailers)
Nelson Peltz (Fortune Magazine Article): His lieutenants prepare detailed comparisons
on margins, the percentage of sales spent on marketing, ‘deals and allowances’ paid to
retailers, and growth in overhead versus sales. They worship free cash flow, and believe it’s
more efficient to revitalize a great brand than to try to build one from scratch. He also loves
exploring what grabs the public taste – "I try to figure out the marketing puzzle."
72
Key Factors for Success
Or a firm may simply be very good across a wide range of operating variables.
The first of those key factors is a relatively simple matter: the purchase of forest land. But his
second point required further explanation. Accordingly, my next question was: "What variable
or variables do you control in order to maximize the yield from a given tract?"
He replied: "The rate of tree growth is the key variable. As a rule, two factors promote
growth: the amount of sunshine and the amount of water. Our company doesn't have many
forests with enough of both."
73
Management Fanaticism
A Fanatical JOB
As I mentioned, I found out early that one of my talents is remembering numbers. I can't
recall names and a lot of other things as well as I would like to. But numbers just stick with
me, and always have.
That's why I come in every Saturday morning usually around two or three [am], and go
through all the weekly numbers. I steal a march on everybody else for the Saturday morning
meeting. I can go through those sheets and look at a store, and even though I haven't been
74
there in a while, I can remind myself of something about it, the manager maybe, and then I
can remember later that they are doing this much business this week and that their wage
cost is such and such. I do this with each store every Saturday morning. It usually takes
about three hours, but when I'm done I have as good a feel for what's going on in the
company as anybody here - maybe better on some days.
This I vow... WE ARE GOING TO HAVE A SUPER MARKET TIRE STORE IN EVERY TOWN
THAT WE HAVE A LES SCHWAB TIRE CENTER.
I hate to use threats, it’s against my policy entirely, but you can visualize what is going to
happen in your town if you don’t RUN A SUPER MARKET TIRE STORE, because I’m going
to have it regardless of cost, hurt feelings. A Super Market tire store has tires displayed, a
clean showroom, tires waxed, appealing appearance... hell, you know by now what a Super
Market tire store should look like. If you don’t take a trip to Hermiston, it could be the most
important day of your life.
I sincerely hope I have made myself very clear. I Love You, But I Love a Super Market Tire
Store Even More.
! ! ! !
! ! ! ! ! ! ! Les
75
Network Effect
♥ Ur Network
The Network effect results from positive feedback, where success begets success
and economies of scale undermine the competition. The effect can be observed
with Ebay, Microsoft, or even the largest local newspaper. Once Ebay had
established itself as the site to visit in order to sell things, this attracted even
more sellers as they realized it had the largest audience. So why bother to list on
another site? The process snowballs and provides a barrier to competition.
Microsoft has network economies with both the Windows operating system and
Microsoft Office. In addition, complementary products provide an important
reinforcement to the network. For example, a video game producer will obviously
want to develop the program for Windows and if the game is a hit, this provides
the end-user with another benefit from the Windows platform.
This powerful network effect was encapsulated by Bob Metcalf, the inventor, of
Ethernet. He stated that if there are n people in a network, and the value of the
network to each of them is proportional to the number of other users, then the
total value of the network (to all the users) is
proportional to n*(n-1) = n2 - n.
If the value of a network to single user is $1 for each other user on the network,
then a network of size 10 has a total value of roughly $100.
In contrast, a network of size 100 has a total value of roughly $10,000. A tenfold
increase in the size of the network leads to a hundredfold increase in its value.
76
Porter’s 5-forces
A widely used model for diagnosing industry structure, developed by Prof.
Michael Porter.
Issues to Consider:
Economies of Scale
Proprietary Product Differences (Trademarks, Patents)
Brand Identity
Switching Costs
Capital Requirements
Access to Distribution
Absolute Costs Advantages
Proprietary Learning Curve
Access to Necessary Inputs
Regulations
Decision Makers' Incentives
Industry Headwinds or Tailwinds
Bankruptcy Laws
Is Competition Rational?
77
Pricing Ability
A company that can raise prices, relatively easily, is likely to have some kind of
enduring competitive advantage.
The ideal investment contains hidden pricing power - examples include retailers
renewing leases in a recessionary environment; operators with a ‘back-catalogue’
that can be exploited through new technologies; and companies with an under-
exploited brand.
78
Protective Moat
Hard to Replicate
That doesn't necessarily mean the profit will be more this year than it was last year because it
won't be sometimes. However, if the moat is widened every year, the business will do very
well. When we see a moat that's tenuous in any way - it's just too risky. We don't know how
to evaluate that. And, therefore, we leave it alone. We think that all of our businesses - or
virtually all of our businesses - have pretty darned good moats. And we think the managers
are widening them.
The idea of the moat is further discussed in 'The Warren Buffet CEO:
Secrets From the Berkshire Hathaway Managers', by Robert Miles:
Build the brand, build the brand and build the brand. Invest, as much as possible, in the
customer relationship. Focus on building for the long term, even if that means taking short-
term hits. Plan ahead. Search for ways to keep building the competitive advantage –
distribution, manufacturing, branding, acquisitions etc. Dominate, profitably, the markets you
are in. It’s not necessary to do extraordinary things to make extraordinary profits. It is
necessary to do the basics extraordinarily well.
79
Scale
In 'The Little Book That Builds Wealth', author Pat Dorsey, discusses
another scale advantage:
! Although building and operating the delivery network is an expensive proposition for a
base level of service, the incremental profit on each item that the truck fleet delivers is
enormous. Think about it - once the fixed costs are covered, delivering an extra item that is
on a delivery route is extremely profitable because the variable cost of making an extra stop
is almost nothing.
! Now imagine that you need to try to compete with a company that has an established
distribution network. It has likely covered its fixed costs and is making large incremental
profits as it delivers more stuff, while you'll need to take on large losses for a time until (if) you
gain enough scale to become profitable.
But scale can also work against you as discussed in 'Six Degrees, The
Science of A Connected Age', by Duncan Watts:
! In slowly changing environments in which generic products appeal to large numbers
of consumers and the range of competing choices is limited, economies of scale are optimal.
But in [a] rapidly globalizing world... with uncertain economic and political forecasts... and
with increasingly heterogeneous tastes of consumers... uncertainty, ambiguity, and rapid
change favor flexibility and adaptability over sheer scale.
80
Scale advantage is also constrained to particular niches as explained in
'Competition Demystified', by Bruce Greenwald and Judd Kahn:
! ...pure size is not the same thing as economies of scale, which arise when the
dominant firm in a market can spread the fixed costs of being in that market across a greater
number of units than its rivals. It is the share of the relevant market, rather than size per se,
that creates economies of scale.
! The relevant market is the area - geographic or otherwise - in which the fixed costs
stay fixed. In the case of a retail company, distribution infrastructure, advertising
expenditures, and store supervision expenses are largely fixed for each metropolitan area or
other regional cluster. If sales are added outside the territory, fixed costs rise and economies
of scale diminish.
" The same conditions apply when the relevant geography is a product line rather than
a physical region. Research and development costs, including the start-up costs of new
production lines and product management overhead, are fixed costs associated with specific
product lines. Though IBM’s total sales dwarf those of Intel, its research and development
expenses are spread over a far greater range of products. In CPU development and
production, which has its own particular technologies, Intel enjoys the benefits of economies
of scale.
" The superior efficiencies Wal-Mart achieved in these three functions - inbound
logistics, advertising, and executive supervision - taken together, gave the company an
operating margin advantage of 4-5 percent of net sales. Wal-Mart’s total advantage was only
around 3 percent. Because the lower prices it charged pushed up Wal-Mart’s purchases, in
percentage terms, various operating savings could account for more than the entire
difference in margins.
" The superior efficiencies in these three functions were due to local economies of
scale. The relevant localities are the areas in which Wal-Mart and its competitors had their
stores, their warehouses, their advertising campaigns, and their managers. It made no
difference that Kmart’s total sales were three times those of Wal-Mart in these years
(1984-85).
81
Specialization
The concept of Adam Smith's pin factory, as described in 'The Wealth of
Nations':
! To take an example, therefore, from a very trifling manufacture; but one in which the
division of labour has been very often taken notice of, the trade of the pin-maker; a workman
not educated to this business (which the division of labour has rendered a distinct trade), nor
acquainted with the use of the machinery employed in it (to the invention of which the same
division of labour has probably given occasion), could scarce, perhaps, with his utmost
industry, make one pin in a day, and certainly could not make make twenty. But in the way in
which this business is now carried on, not only the whole work is a peculiar trade, but it is
divided into a number of branches, of which the greater part are likewise peculiar trades. One
man draws out the wire, another straights it, a third cuts it, a fourth points it... I have seen a
small manufactory of this kind where ten men only were employed... But though they were
very poor, and therefore but indifferently accommodated with the necessary machinery, they
could, when they exerted themselves, make among them about [forty-eight thousand] pins in
a day.
! In every other art and manufacture, the effects of the division of labour are similar to
what they are in this very trifling one; though, in many of them, the labour can neither be so
much subdivided, nor reduced to so great a simplicity of operation. The division of labour,
however, so far as it can be introduced, occasions, in every art, a proportionate increase of
the productive powers of labour.
82
Standardization
The following ideas are more fully developed in 'Lean Thinking' and 'The
Machine That Changed the World', by James Womack and Daniel Jones.
Eliminate Muda
Muda is the Japanese term for waste. Specifically any human activity which absorbs
resources but creates no value: mistakes which require rectification, production of items no
one wants so that inventories and remaindered goods pile up, processing steps which aren't
actually needed, movement of employees and transport of goods from one place to another
without any purpose, groups of people in a downstream activity standing around waiting
because an upstream activity has not delivered on time, and goods and services which don't
meet the needs of the customer.
Design Pull
Letting the customer 'pull' the product to them. This means order then manufacture, as
opposed to the 'push' system that has manufacture, inventory and then sale.
The Process
Applicable for both manufacturing and service industries.
1.! Place linked processes near one another
2.! Standardize procedures
3.! Eliminate loop-backs
4.! Setting a common tempo
5.! Balancing loads
6.! Segregating complexity
7. Posting performance results - including customer focused metrics.
83
Surf a Wave
The idea of a large business force that developed, which a company was
able to ride. The metaphor is explained in 'Poor Charlie's Almanack', by
Charles Munger:
! There's a tire store chain in the Northwest that has slowly succeeded over the last fifty
years, the Les Schwab tire store chain. It started competing with the stores that were owned
by the big tire companies that made all the tires, the Goodyears and so forth. And, of course,
the manufacturers favored their own stores. Their 'tied stores' had a big cost advantage.
Later, Les Schwab rose in competition with the huge price discounters like Costco and
Sam's Club and before that Sears, Roebuck and so forth. And yet, here is Schwab now, with
hundreds of millions of dollars in sales. How did he do it? Well, let's think about it with some
microeconomic fluency.
! Is there some wave that Schwab could have caught? The minute you ask the
question, the answer pops in. The Japanese had a zero position in tires, and they got big. So
this guy must have ridden that wave some in the early times. So, he had to get a wave in
Japanese tire invasion, the Japanese being as successful as they were. And then a talented
fanatic had to get a hell of a lot of things right and keep them right with clever systems.
84
Technology
Technology’s doubled edged sword is described by Charles Munger in
'Poor Charlie's Almanack':
! The great lesson in microeconomics is to discriminate between when technology is
going to help you and when it's going to kill you. And most people do not get this straight in
their heads. But a fellow like Buffett does.
! For example, when we were in the textile business, which is a terrible commodity
business, we were making low-end textiles, which are a real commodity product. And one
day, the people came to Warren and said, 'They've invented a new loom that we think will do
twice as much work as our old ones.' And Warren said, 'Gee, I hope this doesn't work -
because if it does, I'm going to close the mill.' And he meant it.
! What was he thinking? He was thinking, 'It's a lousy business. We're earning
substandard returns and keeping it open just to be nice to the elderly workers. But we're not
going to put huge amounts of new capital into a lousy business.'
! And he knew that the huge productivity increases that would come from a better
machine introduced into the production of a commodity product would all go to the benefit of
the buyers of the textiles. Nothing was going to stick to our ribs as owners.
! That's such an obvious concept - that there are all kinds of wonderful new inventions
that give you nothing as owners except the opportunity to spend a lot more money in a
business that's still going to be lousy. The money still won't come to you. All of the
advantages from great improvements are going to flow through to the customers.
! Conversely, if you own the only newspaper in Oshkosh and they were to invent more
efficient ways of composing the whole newspaper, then when you got rid of the old
technology and get new, fancy computers and so forth, all of the savings would come right
through to the bottom line.
The need for continuing technology investment just to stand still is a component
of maintenance capital expenditures. As technologies progress, the major trends
seem to be -
increasing efficiency
increasing capacity
increasing compactness
increasing accuracy
increasing size range
increasing complexity
85
Business - Financial Models
Bob-around Earnings
Since most companies do not have an enduring competitive, investors have to get
a picture of normalized earning power. For these companies growth that
consumes additional capital may not add economic value.
! Now change the assumption and posit that the $1 million represents 'normal earning
power' and that earnings will bob around this figure cyclically. A 'bob-around' pattern is
indeed the lot of most businesses, whose income stream grows only if their owners are
willing to commit more capital (usually in the form of retained earnings). Under our revised
assumption, $1 million of earnings, discounted by the same 10%, translates to a $10 million
valuation. Thus a seemingly modest shift in assumptions reduce the property's valuation to
10 times after-tax earnings.
! Dollars are dollars whether they are derived from the operation of media properties or
of steel mills. What in the past caused buyers to value a dollar of earnings from media far
higher than a dollar from steel was that the earnings of a media property were expected to
constantly grow (without the business requiring much additional capital), whereas steel
earnings clearly fall in the bob-around category. Now, however, expectations for media have
moved toward the bob-around model.
86
Business Metrics
Logisticsʼ Benchmark
Setting and measuring the appropriate metrics to drive the company forward -
profitably.
Benchmarking within the industry, and outside of it, in order to obtain
productivity information.
" In such businesses, milestone measures such as hiring a key executive, winning early
customers, and meeting budget targets may be more appropriate. Second, financial
measures are often lagging indicators of the market’s feedback. Other, more operational
measures, such as customer satisfaction, assembly time, sales per square foot, employee
turnover, and rework time, when added to financial data, may provide a more complete, real-
time picture...
87
Intrinsic Value
Whatʼs It Worth?
It is not sufficient to know what the past earnings have averaged, or even that they disclose a
definite line of growth or decline. There must be plausible grounds for believing that this
average or this trend is a dependable guide to the future. Experience has shown only too
forcibly that in many instances this is far from true.
The essential point is that security analysis does not seek to determine exactly what is the
intrinsic value of a given security. It needs only to establish either that the value is adequate -
e.g., to protect a bond or to justify a stock purchase - or else that the value is
considerably higher or considerably lower than the market price. For such purposes an
indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely
simile, it is quite possible to decide by inspection that a woman is old enough to vote without
knowing her age or that a man is heavier than he should be without knowing his exact
weight.
... figures alone are not sufficient; they may be completely vitiated by qualitative
considerations of an opposite import. A security may make a satisfactory statistical showing,
but doubt as to the future or distrust of the management may properly impel its rejection.
Again, the analyst is likely to attach prime importance to the qualitative element of stability,
because its presence means that conclusions based on past results are not so likely to be
upset by unexpected developments. It is also true that he will be far more confident in his
selection of an issue if he can buttress an adequate quantitative exhibit with unusually
favorable qualitative factors.
88
From 'Valuation, Measuring and Managing the Value of Companies', by T.
Copeland, T. Koller & J. Murrin:
The value of operations equals the discounted value of expected future free cash flow. Free
cash flow is equal to the after-tax operating earnings of the company, plus non-cash
charges, less investments in operating working capital, property, plant and equipment, and
other assets.
This is the discounted cash flow model, where factors of inherent stability allow
one to use past and current data as a guide to future business prospects. The
major problem occurs when there's a secular change, where the fundamental
economics of the business, or the industry, are changing.
The Austrian School of Economics, however, states that the value of an asset is
determined solely by the quality of plans for its use.
89
Mr. Market
! If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily
communication determine your view of the value of a $1,000 interest in the enterprise?
! You may be happy to sell out to him when he quotes you a ridiculously high price, and
equally happy to buy from him when his price is low. But the rest of the time you will be wiser
to form your own ideas of the value of your holdings, based on full reports from the company
about its operations and financial position.
90
Reversion-to-mean
There is a strong tendency in many areas of the financial market, due to the
action of economic forces, for results to revert to their long-term mean.
If a certain company, or industry, earns large profits for a period of time, then
more companies, or capital, will enter and the increased competition will likely
drive the exceptional profits down to a lower level. If a certain commodity goes
up in price, producers will be encouraged to produce, or find, more and the extra
supply will drive the price down.
The Dow's historical return on equity has been around 11% and book value
growth in the order of 5%. Will the future be significantly better, or worse?
The $24 real estate investment by the Dutch to buy the island of Manhattan
would today, by some estimates, be roughly equivalent to $3 trillion. Over 378
years, that's about a seven percent annual compound rate of return.
The history of the automotive industry explains why Mercedes does not have a profitable
franchise. In the late 1960s, the luxury car market in general and Daimler in particular enjoyed
abnormally high profits. Seeking to benefit from this situation, other European luxury car
makers, such as BMW, Jaguar, Rover, Citroen, and Peugeot, all expanded aggressively.
In the 1980s, the Japanese car makers - first Acura (Honda), then Lexus (Toyota), and finally
Infiniti (Nissan) - all entered the market. The results turned out exactly as theory predicts;
more competition meant a substantial erosion of profit margins. They shrunk for Mercedes in
Europe and for Lincoln and Cadillac in the United States. Globalization of the luxury car
market proved to be profitability’s foe. Both in theory and in practice, product differentiation
and a strong brand are not the same as a profitable franchise.
91
Scandal
Warren Buffett has used this model for American Express (salad oil scandal),
GEICO and more recently USG (asbestos litigation). Essentially, there is a big, one-
time mess of some kind, but the enduring competitive advantage of the
underlying business is still in tact.
! GEICO may appear to be an exception, having been turned around from the very
edge of bankruptcy in 1976. It certainly is true that managerial brilliance was needed...
! But it is also true that the fundamental business advantage that GEICO had enjoyed -
an advantage that previously had produced staggering success - was still intact within the
company, although submerged in a sea of financial and operating troubles.
" GEICO’s problems at that time put it in a position analogous to that of American
Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies,
temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional
underlying economics. The GEICO and American Express situations, extraordinary business
franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should
be distinguished from the true ‘turnaround’ situation in which the managers expect - and
need - to pull off a corporate Pygmalion.
92
The Magic Formula
It Really Is Magic
Return on capital is measured by calculating the ratio of pre-tax operating earnings (EBIT) to
tangible capital employed (Net Working Capital + Net Fixed Assets).
Earnings yield is measured by calculating the ratio of pre-tax operating earnings (EBIT) to
enterprise value (market value of equity + net interest-bearing debt).
We need to plug in estimates for earnings in a normal year (i.e. when nothing extraordinary or
unusual is happening within the company, its industry, or the overall economy). Earnings
could have been higher than normal due to extraordinarily favorable conditions that may not
be repeated in most years. Alternatively there may have been a temporary problem with the
company’s operations.
Then we want both a high earnings yield and a high return on capital - based on normal
earnings. In addition, we need to assess how confident we were in our estimates and make
a judgment on whether those earnings are likely to grow in the future (as well as whether
there was an honest management team that would reinvest those profits wisely).
93
Business - Goods’ Models
Diminishing Utility
People will progressively place a lower value to each additional unit of something
that they have in increasing abundance.
! Once Bernoulli has established his basic thesis that people ascribe different values to
risk, he introduces a pivotal idea: '[The] utility resulting from any small increase in wealth will
be inversely proportionate to the quantity of goods previously possessed.'
! The hypothesis that utility is inversely related to the quantity of goods previously
possessed is one of the great intellectual leaps in the history of ideas. In less than one full
printed page, Bernoulli converts the process of calculating probabilities into a procedure for
introducing subjective considerations into decisions that have uncertain outcomes.
94
Nature of Goods
A Complementary Good
95
Maslow’s Triangle
Self – Actualization
(Truth, justice, wisdom & meaning)
Esteem Wants
(Self-respect, achievement, attention, recognition,
reputation, knowledge &
aesthetics)
Social Needs
(Friendship, group belonging, giving & receiving love)
Safety Needs
(Free from the threat of physical & emotional harm)
Physiological Needs
(Air/water/food/sleep)
For any business, consider whether its product/service acts as a painkiller or as a vitamin
tablet.
96
Total Utility
A Utility Vehicle
Everyone tries to maximize his utility, i.e. get most bang for buck. This may
include money, time, physical effort, social reward, pleasure reward, satisfaction
reward etc.
" [I developed the idea of] satisficing - searching for ‘good enough’ actions rather than
optimal ones. [Indeed] natural selection only predicts that survivors will be fit enough, that is,
fitter than their losing competitors; it postulates satisficing, not optimizing.
" How do human beings reason when the conditions for rationality postulated by
neoclassical economics are not met? The central concept is bounded rationality, a label for
the computational constraints on human thinking. When people don’t know how to optimize,
they may very well be able to satisfice, to find good enough solutions. And good enough
solutions can often be found by heuristic search through the maze of possibilities.
97
Value
A Great Value
1. Goods have only imputed value. It is the importance of satisfactions of needs that gives a
good value.
2. Satisfactions, and therefore goods, have differing levels of importance – [Basically
according to Maslow’s Triangle].
3. The value of a good is equal to the least important of the satisfactions assured by the
whole available quantity.
4. Consumers desire less of that good they already have.
98
Decision Models
Margin of Safety
" " "
A Small Margin
! Securities of this type can be found in reasonable abundance, as a result of the stock
market's obsession with companies considered to have unusually good prospects of growth.
Because of this emphasis on the growth factor, quite a number of enterprises that are long-
established, well financed, important in their industries and presumably destined to stay in
business and make profits indefinitely in the future, but that have no speculative or growth
appeal, tend to be discriminated against by the stock market - especially in years of
subnormal profits - and to sell for considerably less than the business would be worth to a
private owner.
! We incline strongly to the belief that this last criterion - a price far less than the value
to a private owner - will constitute a sound touchstone for the discovery of true investment
opportunities in common stocks.
99
Pr O A C T
The correct mindset when approaching a problem is essential. a negative one will
unnecessarily exclude a lot of options. Deal sensibly with uncertainties. Take account of your
risk-taking attitude. Plan ahead for decisions linked over time.
100
Process v Outcome
Good Judgement
You just made a great decision, but was the outcome due to...
Review the decision making process, as that is the thing which can be controlled.
Often the outcome is out of our hands.
At Goldman, our decisions were driven much more by analysis. We always tried to think of
everything that could possibly go wrong with a deal and then tried to evaluate how much
weight to accord to such risks in our analysis.
Someone who had been to business school would have recognized the charts I made on my
yellow pad as expected-value tables, used to calculate the anticipated outcome of a
transaction. After a while, organizing my analysis according to these tables became second
nature and I’d do them in my head. But I still constantly scribbled notes and numbers on a
legal pad - a lifelong habit with me.
101
The Agency Problem
My Brokerʼs Yacht
! In response to the answers, the professor next gave every student an undesirable
grade except for one student who was graded at the top by a wide margin. What was the
winning answer?
! It was very short and roughly as follows: 'The business field and this particular
business, in its particular location, present crucial problems that are so difficult that unworldly
old ladies can not wisely try to solve them through hired help. Given the difficulties and
unavoidable agency costs, the old ladies should promptly sell the shoe factory, probably to
the nearest competitor who would enjoy the greatest marginal-utility advantage.
102
Trade-offs
Decisions require trading off one goal against another. Classic trade-offs include
guns or butter, efficiency or equity, work or leisure, spending or saving etc.
Because people face trade-offs, making decisions requires comparing the costs
and benefits of alternative courses of action.
When there are no painful trade-offs to consider, then there are idle, wasted
resources, those that yield no value in return for what they cost. However, trade-
offs can be moving targets, shifting and changing, often with great speed.
! The left-hand line represents the scale of a lawyer's possible ethical standards, from 1
to 5 (1 being least ethical, 5 being most); the right-hand line stands for the possible range for
tactics, up to the hardball maneuvers - say, badgering a rape victim about her sexual history
- represented by 'T-5'.
Tactics and ethics form, in his view, the pivotal trade-off facing any criminal lawyer, and
therefore any client in search of a lawyer.
103
Your Circle of Competence
104
Decision - Common Mistakes’ Models
Anchor Effect
The anchor effect is commonly observed in real estate and the stock market.
Consider how many people tend to negotiate around the listed price of a house,
or cling to the original price of a stock purchase as a benchmark, when neither
price may have been established on an objective basis.
Amos Tversky and Daniel Kahneman, for example, asked participants in one study to
estimate the percentage of African nations in the United Nations. First, a wheel of fortune -
numbered 1 through 100 - was spun in the presence of the experimental participants, who
were subsequently asked whether their answer was higher or lower than the number that
had just been spun on the wheel. Amazingly, given that the number was so obviously a
matter of chance, the participants' answers were strongly influenced by the wheel's location.
'For example,' wrote Kahneman and Tversky, 'the median estimates of the percentages of
African countries in the United Nations were 25 and 45 for groups that received 10 and 65,
respectively, as starting points.'
105
Bayes Theorem
The conditional probability of the event A given that the event B has occurred is
described by Bayes Theorem (first developed by the English Reverend Thomas
Bayes):
= Pr (B \ A) * Pr (A)
Pr (B \ A) * Pr (A) + Pr (B \ not A) * Pr (not A)
!
You feel ill at night and stumble into the bathroom, grab one of three bottles in the dark and
take a pill. An hour later you feel really ghastly, and you remember that one of the bottles
contains poison and the other two aspirin.
Your handy medical text says that 80% of people who take the poison will show the same
symptoms as you are showing, and that 5% of people taking aspirin will have them.
What is the probability that you took the poison given that you have got the symptoms? i.e.
what is Pr (A \ B)
Thus Pr(A \ B) = {0.8 * 1/3} divided by {0.8 * 1/3 + 0.05 * 2/3} = 0.89
106
Contrast Principle
Contrasting Principles
! In the same way, the larger-then-smaller request procedure uses the contrast principle
to make the smaller request look even smaller by comparison with the larger one. If I want
you to lend me $5, I can make the request seem smaller than it is by first asking you to lend
me $10. One of the beauties of this tactic is that, by first requesting $10 and then retreating
to $5, I will have simultaneously engaged the force of both the reciprocity rule and the
contrast principle. Not only will my $5 request be viewed as a concession to be reciprocated,
it will also look like a smaller request than if I had just asked for $5 straightaway.
107
Correlation or Causation
'Asking The Right Questions', by Neil Browne and Stuart Keeley discusses
this problem:
!
We have an inherent tendency to 'see' events that are associated, or that 'go together', as
events that cause one another. That is, we conclude that because characteristic X (e.g.,
amount of TV viewing) is associated with characteristic Y (e.g., performance in school), that X
therefore causes Y.
1. States with low speed limits tend to have a lower rate of highway death than states with
higher speed limits; thus, low speed limits deter highway death.
2. Absence of a father in the home occurs at a higher rate with juvenile delinquents than with
non-delinquents; thus, father absence is a cause of juvenile delinquency.
When we think this way, we are, however, often very wrong. Why? Usually, because multiple
hypotheses can explain why X and Y 'go together'.
108
Doubt Avoidance
No Doubt
109
Extrapolation
People have a tendency to take the most recent, or the most easily available
information and project the 'trend' into the future in a linear fashion -
extrapolation.
110
False Mental Accounting
Letʼs Spend It
From 'Why Smart People Make Big Money Mistakes and How to Correct
Them', by Gary Belsky & Thomas Gilovich:
! This idea, developed and championed by the University of Chicago's Richard Thaler,
underlies one of the most common and costly money mistakes - the tendency to value some
dollars less than others and thus to waste them. More formally, mental accounting refers to
the inclination to categorize and treat money differently depending on where it comes from,
where it is kept, or how it is spent.
! The notion of mental accounts is anathema to traditional economics, which holds that
wealth in general, and money in particular, should be 'fungible'. Fungibility, at its essence,
means that $100 in roulette winnings, $100 in salary, and a $100 tax refund should have the
same significance and value to you, since each [dollar could buy the same thing].
! ... the easiest-to-explain instance of mental accounting's harmful effects is the
different value people place on earned income as opposed to gift income. That is, we'll
spend $50 from Mom with less thought than $50 we've earned on the job.
! Imagine that you go to a store to buy a lamp, which sells for $100. At the store you
discover that the same lamp is on sale for $75 at a branch of the store five blocks away. Do
you go to the other branch to get the lower price?
! Now imagine that you go to the same store to buy a dining room set, which sells for
$1,775. At the store you discover that you can buy the same table and chairs for $1,750 at a
branch of the store five blocks away. Do you go to the other branch to get the lower price?
! Credit card dollars are cheapened because there is seemingly no loss at the moment
of purchase, at least on a visceral level. Think of it this way: If you have $100 cash in your
pocket and you pay $50 for a toaster, you experience the purchase as cutting your pocket
money in half. If you charge that toaster, though, you don't experience the same loss of
buying power that emptying your wallet of $50 brings.
111
Groupthink
Groupthink
Gentlemen, I take it we are all in complete agreement on the decision here... Then I propose
we postpone further discussion of this matter until our next meeting to give ourselves time to
develop disagreement and perhaps gain some understanding of what the decision is all
about. - Alfred P. Sloan, Jr.
In 'Thinking and Deciding', by Jonathan Baron, the major errors that can
arise from Groupthink are highlighted -
The Group overestimates its abilities
! Because there is an illusion of invulnerability
! Due to a belief in the inherent morality of the group
The behavior of a group may be completely different from the traits of the individuals
comprising the group.
By contrast, when good thinking occurs in groups, there is a commitment of the group to a
friendly (and sometimes not so friendly) interchange of arguments pro and con, not to a
decision already tentatively made. Loyalty to the group is defined in terms of loyalty to the
process of making the best decision, not loyalty to a decision already made.
112
Ideology
A Matching Ideology
A tendency to ignore facts and dismiss analyses that do not conform to a political
viewpoint.
113
Information Bias
There is a strong tendency to overweigh the first piece of information that one
comes across (recency bias). A further bias is the tendency to overweigh
information because we are familiar with the source - Home Bias - or worse still,
because we like the source (liking tendency).
In conjunction with this bias, are the ones that overweigh information that is easily available,
or that is extra-vivid.
! The great algorithm to remember in dealing with this tendency is simple: An idea or a
fact is not worth more merely because it is easily available to you.
114
Nassim Nicholas Taleb, in 'Fooled by Randomness' illustrates another
information bias - survivorship:
! The mistake of ignoring the survivorship bias is chronic, even (or perhaps especially)
among professionals. How? Because we are trained to take advantage of the information
that is lying in front of our eyes, ignoring information that we do not see.
! ... we tend to mistake one realization among all possible random histories as the most
representative one, forgetting that there may be others. In a nut-shell, the survivorship bias
implies that the highest performing realization will be the most visible. Why? Because the
losers do not show up.
[The author later goes on to quote from a paper analyzing trading strategies]
" Suppose that, over time, investors have experimented with technical trading rules
drawn from a very wide universe - in principle thousands of parameterizations of a variety of
types of rules. As time progresses, the rules that happen to perform well historically receive
more attention and are considered ‘serious contenders’ by the investment community, while
unsuccessful trading rules are more likely to be forgotten... If enough trading rules are
considered over time, some rules are bound by pure luck, even in a very large sample, to
produce superior performance even if they do not genuinely possess predictive power over
asset returns. Of course, inference based solely on the subset of surviving trading rules may
be misleading in this context since it does not account for the full set of initial trading rules,
most of which are unlikely to have underperformed.
115
Over-optimism
From 'Why Smart People Make Big Money Mistakes and How to Correct
Them', by Gary Belsky & Thomas Gilovich:
! The core idea... is not particularly uplifting: You're probably not as smart as you think
you are. Overconfidence is pervasive, even among people who presumably have good
reason to think highly of themselves.
! ... what research psychologists have discovered about overconfidence is that most
people - those with healthy egos and those in the basement of self-esteem - consistently
overrate their abilities, knowledge, and skill, at whatever level they might place them.
! To quote Odean and Barber: 'We argue that the well-documented tendency for
human beings to be overconfident can best explain the high trading levels and the resulting
poor performance of individual investors. Our central message is that trading is hazardous to
your wealth.'
116
Overweighting Numbers
Not everything that can be counted counts, and not everything that counts can be counted.
- Albert Einstein
A widely used management phrase is 'if you can measure it you can manage it'.
There is, however, a tendency to attach too little importance to things that cannot
be measured.
In part this can be attributed to the 'man with a hammer syndrome' - if the only
tool that a man has is a hammer, then every problem will look like a nail. So, for
example, an individual with great proficiency in numbers will tend to bias an
analysis towards data and its subsequent manipulation. And numbers may not be
the heart of the issue.
! You see that again and again - that people have some information they can count well
and they have other information much harder to count. So they make the decision based
only on what they can count well. And they ignore much more important information because
its quality in terms of numeracy is less - even though it's very important in terms of reaching
the right cognitive result.
117
Statistics
A series of numbers can be represented by the mean (average), the mode (most
frequent) and the median (middle number).
The mean is the most commonly used everyday statistic, but sometimes the
median provides greater insight. For example, the median house price is a
better gauge than the average price as the nature of housing stock units across
the whole economy tends to remain the same and therefore the middle number
better represents the state of housing.
118
Economic Models
Animal Spirits
The state of confidence, as they term it, is a matter to which practical men always pay the
closest and most anxious attention. But economists have not analyzed it carefully and have
been content, as a rule, to discuss it in general terms.
Even apart from the instability due to speculation, there is the instability due to the
characteristic of human nature that a large proportion of our positive activities depend on
spontaneous optimism rather than on a mathematical expectation, whether moral or
hedonistic or economic. Most, probably, of our decisions to do something positive, the full
consequences of which will be drawn out over many days to come, can only be taken as a
result of animal spirits - of a spontaneous urge to action rather than in action, and not as the
outcome of a weighted average of quantitative benefits multiplied by quantitative
probabilities.
119
... individual initiative will only be adequate when reasonable calculation is supplemented and
supported by animal spirits, so that the thought of ultimate loss which often overtakes
pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts
aside the expectation of death.
In estimating the prospects of investment, we must have regard, therefore, to the nerves and
hysteria and even the digestions and reactions to the weather of those upon whose
spontaneous activity it largely depends.
We are merely reminding ourselves that human decisions affecting the future, whether
personal or political or economic, cannot depend on strict mathematical expectation, since
the basis for making such calculations does not exist; and that it is our innate urge to activity
which makes the wheels go round, our rational selves choosing between the alternatives as
best we are able, calculating where we can, but often falling back for our motive on whim or
sentiment or chance.
The idea is further developed and its impact on the broader economy
discussed by George A. Akerlof and Robert J. Shiller in 'Animal Spirits:
How Human Psychology Drives the Economy, and Why It Matters for
Global Capitalism ' -
... there have been no principles in conventional economic theories regarding animal spirits.
Conventional economic theories exclude the changing thought patterns and modes of doing
business that bring on the crisis.
They even exclude the loss of trust and confidence. They exclude the sense of fairness that
inhibits the wage and price flexibility that could possibly stabilize an economy. They exclude
the role of corruption and the sale of bad products in booms, and the role of their revelation
when the bubbles burst. They also exclude the role of stories that interpret the economy.
All of these exclusions from conventional explanations of how the economy behaves were
responsible for the suspension of disbelief that led out to the [2007 to 2009] crisis.
120
Asymmetric Information
Itʼs a Lemon
When one party to a transaction has more relevant information than the other. For
example: The insurance deductible is a tool for teasing out private information.
This was the fundamental insight of 2001 Nobel laureate George Akerlof... his paper entitled
'The Market for Lemons' used the used-car market to make its central point.
Any individual selling a used car knows more about its quality than someone looking to buy
it. Thus, used-car buyers anticipate hidden problems and demand a discount. But once
there is a discount built into the market, owners of high-quality cars become even less likely
to sell them - which guarantees the market will be full of lemons.
121
Bubbles
A Bubble Prayer
The recurring nature of market extremes provide some examples - Japanese real
estate and stocks in the 1980s; the internet mania of 1999 & 2000; and more
recently global property markets.
! A model developed by Hyman Minsky... [he] believed that pro-cyclical increases in the
supply of credit in good times and the decline in the supply of credit in less buoyant
economic times led to fragility in financial arrangements and increased the likelihood of
financial crisis.
! The boom in the Minsky model is fueled by an expansion of credit. Minsky argued that
the growth of bank credit has been very unstable; at times the banks as lenders have
become more euphoric and have lent freely and then at other times they have become
extremely cautious and let the borrowers 'swing in the wind'.
! Minsky argued that the events that lead to a crisis start with a 'displacement', some
exogenous, outside shock to the macroeconomic system. If the shock was sufficiently large
and pervasive, the economic outlook and the anticipated profit opportunities would improve
in at least one important sector of the economy. Business firms and individuals would borrow
to take advantage of the increase in the anticipated profits associated with a wide range of
investments. The rate of economic growth would accelerate and in turn there might be a
122
feedback to even greater optimism. It's 'Japan as Number One' or the 'East Asian Miracle'
or 'The New American Economy' - a new sense of more profound optimism about the
economic environment.
! Minsky noted that 'euphoria' might develop at this stage. Investors buy goods and
securities to profit from the capital gains associated with the anticipated increases in the
prices of these goods and securities. The authorities recognize that something exceptional is
happening in the economy and while they are mindful of earlier manias, 'this time it's
different', and they have extensive explanations for the difference.
! A follow-the-leader process develops as firms and households see that others are
profiting from speculative purchases [and the envy principle goes to work]. More and more
firms and households that previously had been aloof from these speculative ventures begin
to participate in the scramble for high rates of return. Making money never seemed easier.
! If the eagerness of the outsiders to buy is stronger than the eagerness of the insiders
to sell, the prices of the assets or securities continue to increase. In contrast if the sellers
become more eager than the buyers, then the prices will decline.
! As the buyers become less eager and the sellers become more eager an uneasy
period of 'financial distress' follows...
! As the decline in prices continues, more and more investors realize that prices are
unlikely to increase and that they should sell before prices decline further; in some cases this
realization occurs gradually and in others suddenly. The race out of real or long-term financial
securities and into money may turn into a stampede.
! The specific signal that precipitates the crisis may be the failure of a bank or of a firm,
the revelation of a swindle... or a sharp fall in price.
Magazine covers are a useful money-management tool because they indicate the
point in time when public awareness of a financial subject has reached maximum
saturation – and by extension, the point in time when prices within the subject
market are likely to be at, or near, a major extreme.
123
Comparative Advantage
The same concept applies to nations and the trade between them. For example, a
rich developed country may want to sell computers to a less developed country,
which in turn may want to sell it fruit. Of course it may be that the developed
country could allocate resources and grow its own fruit, but by doing so it will
likely take resources from even more productive activities.
This is the reason why, in general, trade makes everyone better off. Trade allows
individuals and countries to specialize in what they do best and thus be more
productive by leveraging their comparative advantage.
124
Creative Destruction
Creatively Destroying
It is natural to think that if customers don't complain, they are satisfied. But thinking this way
can lull us into complacency and make us vulnerable to creative destruction. Customers
seldom know what they will value until they see it. This essential insight is fundamental to
success.
125
Andy Grove in 'Only the Paranoid Survive’, describes creative destruction
as a recurring set of strategic inflection points:
So how do you know whether a change signals a strategic inflection point? Ask these
questions to attempt to distinguish signal from noise.
Is your key competitor about to change? When the answer to this question stops being as
crystal clear as it used to be and some of your people direct the silver bullet to competitors
who didn't merit this kind of attention previously, it's time to sit and pay special attention.
When the importance of your competitors shifts, it is often a sign that something significant is
going on.
In an analogous fashion, you should ask, is your key complementor about to change?
My point is that you can't judge the significance of strategic inflection points by the quality of
the first version. You need to draw on your own experience. Perhaps you remember your
reaction to the first PC you ever saw. It probably didn't strike you as a revolutionary device.
So it is with the Internet [Note: this was written in 1996]. Now, as you stare at your computer
screen that is connected to the Internet, waiting for a World Wide Web page to slowly
materialize, let your imagination flow a bit. What might this experience be like if transmission
speed doubled? Or better yet, if it were improved by "10 X"? What might the content
look like if professional editors rather than amateurs create it, not as a sideline but as their
main occupation? You might extrapolate the evolution of this phenomenon by remembering
how rapidly PCs evolved and improved.
As you consider this or any new device, your answer may be that, even if it were "10 X"
better, it would not interest you as a consumer. Even if a company actually supplied it, it
wouldn't change the silver bullet test and it wouldn't rearrange your complementors. Life
would go on as before, just with one more gadget.
But if your instincts suggest that a "10 X" improvement could make this capability exciting or
threatening, you may very well be looking at the beginning of what is going to be a strategic
inflection point. Consequently, you must discipline yourself to think things through and
separate the quality of the early versions from the longer-term potential and significance of a
new product or technology.
126
Diminishing Returns
After grabbing the low hanging fruit, things tend to get more difficult. Capital, in
particular, is subject to diminishing returns. As the amount of capital rises, the
return from additional units tends to fall.
The principle applies equally to other factors - for example, one more production
employee in a small manufacturing company will have a different impact to one
more production employee at Toyota.
Berkshire's past record can't be duplicated or even approached. Our base of assets and
earnings is now far too large for us to make outsized gains in the future.
! ! ! ! ! ! ! ! ! ! - Warren Buffett
127
Equilibrium
Perfect Equilibrium
! It can be applied to any system, from a planet circling its star to the population of fish
in a tropical lake. In mechanics, a system is in equilibrium if all the forces on it balance,
canceling one another out. If you are sitting in a chair and reading this book, for example, the
downward force of gravity on your body is being canceled by the upward force exerted on
you by the chair. You neither fall nor rise - you are in equilibrium.
! Consider, for example, the relation between predator and prey in an ecosystem. The
numbers of predator and prey will come to an equilibrium - so many foxes for so many
rabbits, for example. If for some reason the equilibrium number of prey is disturbed (e.g., by
rabbits having a successful breeding season) then the number of predators will increase and
drive the rabbit population down again. Although these aren't physical forces, they are still
forces, in a broader sense of the term, operating in the ecosystem to drive it back toward
equilibrium following a disturbance.
128
Externalities
A Negative Externality
Sometimes our actions do not have costs. These actions can affect others and yet
we do not suffer any consequences. A good example of just such a negative
externality would be pollution - the pollution from a car, or even noise pollution
from loud music.
The inability to charge for externalities (positive and negative) may be a problem
and is therefore an opportunity for better resource allocation.
129
Markets
Market failures can result from scarcity power, missing information and externalities, among
other things. At these times government interventions can sometimes improve market
outcomes.
In short, the reason that markets work so well comes down to what evolutionary theorists
refer to as Orgel's Second Rule, which says, 'Evolution is cleverer than you are'. Even a
highly rational, intelligent, benevolent Big Man would not be able to beat an evolutionary
algorithm in finding peaks in the economic fitness landscape. Markets win over command
and control, not because of their efficiency at resource allocation in equilibrium, but because
of their effectiveness at innovation in disequilibrium.
130
Moral Hazard
Describes a situation where one party does not bear the true costs associated
with its actions, and is therefore likely to behave in a reckless fashion.
Moral Hazard issues can occur at any level - for example, government insurance
subsidies allowing homeowners to build near vulnerable coastlines; a teenager's
car insurance incorporated under the parent's accident free policy etc.
! The other kind of moral hazard, the kind that affects creditors and investors, was a
more serious concern: insulation from loss can sow the seeds of future crises. Part of the
issue in Thailand had clearly been excessive and undisciplined investment from the
developed world. 'Rescuing' these investors, especially in a relatively small economy like
Thailand's, could encourage lenders and investors to give insufficient weight to risk in pursuit
of higher yield in other developing countries and undermine the discipline of the market-
based system. In supporting an IMF rescue program, we would be interfering with the free
play of market forces. As a result, investors would escape some of the burden of problems
they had helped create.
131
Price Discrimination
132
Property Rights
Our Fish
! As the years pass, the population of the town grows, and so does the number of
sheep grazing on the Town Common. With a growing number of sheep and a fixed amount
of land, the land starts to lose its ability to replenish itself. Eventually, the land is grazed so
heavily that it becomes barren. With no grass left on the Town Common... the town's once
prosperous wool industry disappears.
! What causes the tragedy? The reason is that social and private incentives differ.
Avoiding the destruction of the grazing land depends on the collective action of the
shepherds. If the shepherds acted together, they could reduce the sheep population to a size
that the Town Common can support. Yet no single family has an incentive to reduce the size
of its own flock because each flock represents only a small part of the problem.
! This lesson has been known for thousands of years. The ancient Greek philosopher
Aristotle pointed out the problem with common resources: 'What is common to many is
taken lest care of, for all men have greater regard for what is their own than for what they
possess in common with others.'
133
Public/Private Goods
A Public Good
Public Goods are available to everyone and people cannot easily be prevented
from using them. Examples include clean air and the protection of the Military.
Using a Public Good does not hinder, or diminish, another's access to that good.
Public Goods can have the problem of the Free Rider - a person who receives the
benefit of a good but avoids paying for it.
134
Sunk Costs
! It will not be $1.90 - or $1.80, if we assume your first bite consumed about ten cents'
worth of tuna lasagna. That cost is history. The cost of leaving the lasagna on your plate will
be the value of whatever opportunity you forgo by doing so. Do you have a dog that would
enjoy pasta with tuna? If so, the cost of leaving the lasagna is the opportunity you forgo (by
not asking for a doggie bag) to see your dog's eyes light up and its tail wag.
! The price you paid is what economists dismiss as a sunk cost. Sunk costs are
irrelevant to economic decisions. Bygones are bygones. The proper stance for making cost
calculations is not looking back to the past, but forward to the future.
! Of course, we must be certain that a cost is really sunk, or fully sunk, before we
decide to regard it as irrelevant to decision making.
135
Switching Costs
136
Transaction Costs
Every exchange incurs some kind of transaction cost. Consider electronic share
trading, which has sharply lowered the cost of buying and selling shares, both in
terms of commissions and the spread between bid and offer.
But money may not be the only consideration. Time is also a component in a
transaction. The large range of products under one roof in a supermarket is a
convenience for many people as it reduces the time transaction costs associated
with buying groceries and household essentials.
On a macro level, transaction costs can play an even bigger role: The time to set
up a business corporation; to prepare and file taxes; the costs in resolving
business contract disputes etc.
Highest Lowest
137
System Models
Back-up/Redundancy
! Small interactions over time slowly accumulate into a critical state - where the degree
of instability increases. A small event may then trigger a dramatic change like an earthquake.
A web of cracks over time may increase vibrations that cause an accident. The underlying
process may be simple and easy to understand but still remain unpredictable.
138
Bottlenecks
A system comprises a set of dependent events and therefore one must think cause and
effect - 'If the hypothesis is right then logically another fact must also exist?'
Measures
Throughput is the rate at which the system generates money through sales.
Inventory is all the money that the system has invested in purchasing things which it intends
to sell.
Operational expense is all the money the system spends in order to turn inventory into
throughput.
139
Complex Adaptive Systems
Natural Complexity
The system is dynamic, the whole is greater than the sum of its parts, and
solutions can't be imposed; rather they arise from the circumstances -
emergence.
The system has a history, and the past is integrated with the present; the
elements evolve with one another and with the environment; and evolution is
irreversible.
140
In ‘The Origin of Wealth’, Eric Beinhocker contrasts the ‘complex’ view of
economics with traditional economic approach :
141
Evolution
The Explanation?
If some individuals have a trait that allows them to better compete in a given
environment, then they are more likely to survive into adulthood and produce
offspring. And the offspring are likely to carry the same trait. The organism acts,
and has evolved, to further the interests of its genes.
142
Success by mutual cooperation is explained in 'Darwin's Blind Spot', by
Frank Ryan.
!
Besides the law of mutual struggle there is in Nature the law of mutual aid, which, for the
progressive evolution of the species, is far more important than the law of mutual contest.
The intimate cooperation between wholly different life forms - plants and fungi - is not only an
amazing biological phenomenon but also a vitally important factor in the diversity of plant life
on Earth.
This evolutionary force that derives from the interaction of different species is Symbiogenesis
- the creative force is not natural selection but the act of symbiotic union.
Changes in species over time, arising from multifactorial forces that often include symbiotic
mechanisms. This does not mean that symbiosis is the sole mechanism of evolutionary
change, any more than Darwinian gradualism is.
Once the symbiosis is established, each partner is likely to show resistance to further
selection pressures because individual change could upset the equilibrium of the symbiotic
whole.
Evolution can perform its tricks not just in the ‘substrate’ of DNA, but in any system that has
the right information-processing and information-storage characteristics. In short, evolution’s
simple recipe of ‘differentiate, select, and amplify’ is a type of computer program - a program
for creating novelty, knowledge, and growth. Because evolution is a form of information
processing, it can do its order-creating work in realms ranging from computer software to the
mind, to human culture, and to the economy.
143
Feedback Loops
Feedback loops at the systemic level can be positive, or negative. The system is
likely to continually adjust to the loop, but may reach a critical state - a tipping
point - and then fundamentally change (consider the metaphor of a spring
stretched to deformity).
144
Momentum
When two pool balls heading toward each other on a straight line collide, several things
happen. The balls rebound from each other, they flex slightly during the impact, and some of
their kinetic energy is converted to heat. But whatever else happens, we know that the total
momentum of the system will be zero. If we see one ball moving off at a given speed in a
given direction after the collision, we can say with certainty that the other is moving at the
same speed in exactly the opposite direction.
145
Newton’s Laws
There is an attractive force - gravity - between each and every pair of objects in the universe.
An object moving in a straight line will continue to do so, unless acted upon by an external
force.
! It tells us that if we see a change in the motion of an object, there must be a force
causing that change.
The acceleration of an object is proportional to the applied force and inversely proportional to
the object's mass
! ! ! Force = mass * acceleration
!
If body A exerts a force on body B, then body B will exert an equal and opposite force on
body A.
!
The operation of a rocket illustrates all three of Newton's laws of motion. Once launched, the
rocket will keep going (first law), it will keep accelerating as long as it burns its fuel (second
law), and its forward motion is a reaction to the gases blasting out in the opposite direction
(third law).
146
Power Law
In terms of energy, it turns out that the Gutenberg-Richter law boils down to one very simple
rule: If earthquakes of type A release twice the energy of those of type B, then type A quakes
happen four times less frequently. Double the energy, that is, and an earthquake becomes
four times as rare. This simple pattern - a power law - holds for quakes over a tremendous
range of energies.
! Remarkably, Bak and his colleagues found a similar relationship for avalanches in the
sandpile game. Counting up how frequently avalanches of each size happened, they found
that avalanches toppling anything from a few up to a few million grains follow a regular
pattern: Double the number of grains involved, and the avalanche becomes just a bit more
than twice as unlikely (more precisely, about 2.14 times as unlikely).
! ...their data for 4,284 fires on U.S. Fish and Wildlife Service lands between 1986 and
1995 reveals a remarkably strong power law. Once again we find the same geometric
pattern: double the area covered by a fire, and it becomes about 2.48 times as rare, and the
pattern holds for fires varying in size by a factor of a million. In other words, despite the
immensely complex picture of how fires spread, a startlingly simple pattern emerges when
you look at how often you find fires of different sizes - a kind of Gutenberg-Richter law for
ecological conflagration.
! Using data for the twenty-four hundred largest cities in the United States, Zanette and
Manrubia counted up how many cities there are with populations of around one hundred
thousand, two hundred thousand, three hundred thousand, and so on... The numbers reveal
that for every city such as Atlanta, Georgia, population four million, there are four cities having
populations half that size. Cincinnati, Ohio, is one such city, and for every Cincinnati there are
in turn four cities just half as large again, and so on down the line. This perfect geometrical
pattern continues down to the smallest cities of just ten thousand people or so.
! Things that live in critical states tend to show similar kinds of organization, and this
organization arises not from specific details of those systems and the elements that make
them up, but from the far deeper skeleton of basic geometry and logic behind these details.
The critical form wells up in things regardless of what they are. When something is
recognized to be in a critical state, its essential character can be understood even by
ignoring most of the details.
147
Reflexivity
Interacting Observers
I envision reflexivity as a feedback loop between the participants’ understanding and the
situation in which they participate, and I contend that the concept of reflexivity is crucial to
understanding situations that have thinking participants. Reflexivity renders the participants’
understanding imperfect and ensures that their actions will have unintended consequences.
When we act as outside observers we can make statements that do or do not correspond to
the facts without altering the facts; when we act as participants, our actions alter the
situation we seek to understand.
… markets are almost always wrong but their bias is validated during both the self-fulfilling
and self-defeating phases of boom/bust sequences. Only at inflection points is the prevailing
bias proven wrong.
The major insight I gained from the theory of reflexivity and what I now call the human
uncertainty principle is that all human constructs (concepts, business plans or institutional
arrangements) are flawed. The flaws may be revealed only after the construct has come into
existence. That is the key to understanding reflexive processes. Recognizing the flaws that
are likely to appear when a hypothesis becomes reality puts you ahead of the game.
148
Six Degrees
! ... the science of networks has taught us that distance is deceiving. That two
individuals on the opposite sides of the world, and with little in common, can be connected
through a short chain of network ties - through only six degrees.
! The explanation derives from the existence of social connections that span long
distances, and from the fact that only a few such ties can have a big impact on the
connectedness of the whole world.
! The origin of these long-distance links resides in the multidimensional nature of social
identity - we tend to associate with people like ourselves, but we have multiple independent
ways of being alike. People know each other because of the things they do, or more
generally the contexts they inhabit. Being a university professor is a context, as is being a
naval officer. Flying frequently for business is a context...
! And because we know not only who our friends are, but also what kind of people they
are, even very large networks can be navigated in only a few links. Social identity is what
leads networks to be searchable.
! What all cascades have in common is that once one commences, it becomes self-
perpetuating; that is, it picks up new adherents largely on the strength of having attracted
149
previous ones. Hence, an initial shock can propagate throughout a very large system, even
when the shock itself is small.
! As a result, the primary feature of the cascade model - that apparently stable
systems can suddenly exhibit a very large cascade - can also be interpreted as a statement
about the inherent fragility of complex systems, even those that seem robust.
[Bringing these two concepts together one can see, as the author explains, how...]
" In 1997, the decoupling of the Thai bhat from the U.S. dollar triggered a real estate
crisis in Thailand that led to the collapse of its banking system... within months, financial
distress had spread to the other ‘Asian Tigers’ prompting a depression in the prices of
commodities. Russia, meanwhile, was heavily dependent on its oil exports. A Russian
budgetary crisis ensued, and the government was forced to default on its sovereign debt...
the shock to the world debt markets caused investors to flee bonds of any kind other than
those of the U.S. government.
[Thus completing the link from the distressed Thai real estate investor to the holder of U.S.
treasuries.]
150
System Boundary
The idea of drawing a system boundary around the area to be studied is not only
valid in engineering, but also in business.
The idea of clean separation of one part from another is so deeply ingrained that we have
confidence that we can always separate inside from outside, even though it may take much
mental effort. By analogy, we apply this concept to all our systems, using the term 'system'
to mean the inside and 'environment' to mean 'outside'. By the principle of indifference, we
might imagine that we can call either one 'the system', for one man's system may be another
man's environment.
... when we choose boundaries, we are powerfully influenced by easily recognized physical
features. A place where sharp color change is seen, where difference in texture is felt, where
solid meets liquid or liquid meets gas - all these and many more make popular boundary
choices. On the other hand, we hesitate to define a boundary between two solid bodies
rigidly attached so that they always move together.
151
We commonly consider hair to be part of the body, because it is attached to it. When we are
thinking of thermal problems, parasite problems, or swimming problems, it is useful to
consider the hair in such a way. But this accepted mode of thought blinds us to the
possibility that, for some purposes, hair is better thought of as being outside of the body.
Unlike the material in body cells, material once secreted into the hair no longer participates in
the body's physiological processes. Since material in the hair was once inside the body's
physiological system and is now outside, it is useful for the physiologist to think of hair as
excrement - just like perspiration, urine, feces, and, for that matter, toenails.
152
Thermodynamics
Impromptu Cooling
! This means that the total amount of energy in an isolated system cannot change,
even though the form it takes can vary.
! It turns out that if, for example, we burn coal to produce electricity, fully two-thirds of
the energy in the coal is lost to the environment. This is why the most striking feature of
modern generating plants are huge cooling towers - this is where the waste heat is being
returned to the environment.
! We can easily see why things happen this way by looking at how [an] ice cube and air
interact on the molecular scale. We know that temperature is related to the speed of
molecules in an object - the faster they move, the higher the object's temperature. This must
mean that the molecules in the air are moving faster than the molecules in the ice cube.
When a molecule in the air collides with a water molecule at the surface of the cube, our
experience tells us that, on average, the fast molecule will slow down and the slow molecule
will speed up. The molecules in the ice will thus move faster and faster or, equivalently, the
temperature of the cube will increase.
153
3. Transfer occurs by CONDUCTION; CONVECTION (movement of matter); and
RADIATION (wavelengths).
! Convection is the transfer of heat by the bulk motion of matter. Material absorbs heat
in one place and then moves to another place, carrying the heat with it. This is in contrast
to conduction, in which the medium remains stationary while heat is transferred through it.
! Every object with a temperature above absolute zero radiates energy into its
environment. This notion is part of of our common experience - a piece of metal in a
blacksmith's forge will first glow orange, then red, then white-hot as its temperature changes.
This is an indication that as the temperature of the object increases, so too does the
frequency of the radiation it emits.
! During the twenty-two-day Tour de France race, the cyclists neither gain nor lose
weight, so what happens to the energy? Only 25 percent of it goes into the mechanical work
of overcoming air drag and propelling the bicycle and racer forward. A full 75 percent is
dissipated as extra body heat - so much heat that the racer needs ten quarts of water to
evaporate from his skin each day of the race in order to stay at constant temperature. This
requires continual drinking, but the racer also needs a strong breeze to help evaporation;
speeding along at twenty-five miles an hour or more provides this breeze. No breeze means
saturated vapor pressure, no evaporation, and heat buildup. The result is that the Eddy
Merckx who can ride at top speed for eight hours falls off a stationary bike in a state of total
exhaustion after sixty minutes.
154