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Mental Model: The Principles of Comparative Advantage

In economics, comparative advantage refers to the ability of a person or nation to produce a good or service at a lower opportunity cost than another person (or nation). This is why trade can create value for both parties—because each person (or nation) can concentrate on the activity for which they have the lower opportunity cost.

Trade can benefit everyone because it allows people to specialize in activities in which they have a comparative advantage.

The term “comparative advantage” is usually attributed to David Ricardo. In his 1817 book On The Principles Of Political Economy And Taxation, Ricardo used the example of trade between England and Portugal. Portugal could produce both wine and cloth with less labor than it would have taken to produce the same output in England. However, the relative costs are different (currencies have different values). From Ricardo's point of view, England had difficulty producing wine and very little difficulty producing cloth. Portugal, however, could easily produce both wine and cloth. Ricardo concluded that while it was cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine and trade this for English cloth. England would benefit from this trade because its cost for producing cloth has not changed but it can now get wine at a lower price. Thus, each country can gain by specializing in the good that has comparable advantage. (Still confused? Keep reading, some of the examples below are clearer.)

Comparative advantage also creates increasing interdependence among people or nations. In Ricardo's example England and Portugal relied on each other for certain goods which was made possible because it was in the self-interest of each nation. We see the effects of interconnectedness in today's global economy. A crisis is no longer limited to the country of origin and quickly ripples through the global economy.

Comparative advantage is different than absolute advantage. A country has an absolute advantage in producing a good if its cost is lower than the cost in another country. A comparative advantage, on the other hand, implies that a country's cost — relative to other opportunities — is lower than the other countries.

comparative advantage

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Greg Mankiw, in Principles of Microeconomics offers the following:

Differences in opportunity cost and comparative advantage create the gains from trade. When each person specializes in producing the good for which he or she has a comparative advantage, total production in the economy rises, and this increase in the size of the economic pie can be used to make everyone better off. In other words, as long as two people have different opportunity costs, each can benefit from trade by obtaining a good at a lower price than his or her opportunity cost of that good.

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Examples
Should Tiger Woods Mow His Own Lawn?

Tiger is a great athlete. One of the best golfers to have every lived. Most likely he is better at other activities too. Tiger is probably in better shape than most: He can run faster, lift more, and work quicker. For example, Tiger can probably mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should?

To answer this question we can use the concepts of opportunity cost and comparative advantage. Let's say that Tiger can mow his lawn in 2 hours. In the same two hours he could film a television commercial for golf clubs and earn $100,000. By contrast, Joe, the kid next door can mow Tiger's lawn in 4 hours. In that same 4 hours he could work at McDonald's and earn $24.

In this example, Tiger's opportunity cost is $100,000 and Joe's is $24. Tiger has an absolute advantage in mowing lawns because he can do the work in less time. Yet Joe has a comparative advantage because he has the lower opportunity cost. The gains in trade from this example are tremendous. Rather than mowing his own lawn, Tiger should make the commercial and hire Joe to mow his lawn. As long as Tiger pays Joe more than $24 and less than $100,000, both of them are better off.

(Another example, this one from wikipedia)

Two men live alone on an isolated island. To survive they must undertake a few basic economic activities like water carrying, fishing, cooking and shelter construction and maintenance. The first man is young, strong, and educated. He is also, faster, better, more productive at everything. He has an absolute advantage in all activities. The second man is old, weak, and uneducated. He has an absolute disadvantage in all economic activities. In some activities the difference between the two is great; in others it is small.

Despite the fact that the younger man has absolute advantage in all activities, it is not in the interest of either of them to work in isolation since they both can benefit from specialization and exchange. If the two men divide the work according to comparative advantage then the young man will specialize in tasks at which he is most productive, while the older man will concentrate on tasks where his productivity is only a little less than that of a young man. Such an arrangement will increase total production for a given amount of labor supplied by both men and it will make both of them richer.

Hindsight Bias

hindsight bias

“Judgments about what is good and what is bad, what is worthwhile and what is a waste of talent, what is useful and what is less so, are judgments that seldom can be made in the present. They can safely be made only by posterity.”Tulving

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Hindsight bias occurs when we look backward in time and see events are more predictable than they were at the time a decision was made. This bias, also known as the “knew-it-all-along effect,” typically involves those annoying “I told you so” people who never really told you anything.

For instance, consider driving in the car with your partner and coming to a T in the road. Your partner decides to turn right and 4 miles down the road when you realize you are lost you think “I knew we should have taken that left.”

Hindsight bias can offer a number of benefits in the short run. For instance, it can be flattering to believe that our judgment is better than it actually is. And, of course, hindsight bias allows us to participate in one of our favorite pastimes — criticizing the decisions of others for their lack of foresight.

Aside from helping aid in a more objective reflection of decisions, hindsight bias also has several practical implications. For example, consider someone asked to review a paper but knows the results of the previous review from someone else? Or a physician asked for a second opinion after knowing the results of the first. The results of these actions will likely be biased by some degree. Once we know an outcome it becomes easy to find some plausible explanation.

Hindsight bias helps us become less accountable for our decisions, less critical of ourselves, and over-confident in our ability to make decisions.

One of the most interesting things I discovered when researching hindsight bias was the impact on our legal system and the perceptions of jurors.

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Harvard Professor Max Bazerman offers:

The processes that give rise to anchoring and overconfidence are also at play with the hindsight bias. According to this explanation, knowledge of an event's outcome works as an anchor by which individuals interpret their prior judgments of the event's likelihood. Due to the selective accessibility of the confirmatory information during information retrieval, adjustments to anchors are inadequate. Consequently, hindsight knowledge biases our perceptions of what we remember knowing in foresight. Furthermore, to the extent that various pieces of data about the event vary in support of actual outcome, evidence that is consistent with the known outcome may become cognitively more salient and thus more available in memory. This tendency will lead an individual to justify a claimed foresight in view of “the facts provided.” Finally, the relevance of a particular piece of that may later be judged important to the extent to which it is representative of the final observed outcome.

In Cognitive Illusions, Rudiger Pohl offered the following explanations of hindsight bias:

Most prominent among the proposes explanations are cognitive accounts which assume that hindsight bias results from an inability to ignore the solution. Among the early approaches are the following three: (1) Fischhoff (1975) assumed an immediate and irreversible assimilation of the solution into one's knowledge base. As a consequence, the reconstructed estimate will be biased towards the solution. (2) Tversky and Kahneman (1974) proposed a cognitive heuristic for the anchoring effected, named anchoring and insufficient adjustment. The same mechanism may apply here, if the solution is assumed to serve as an “anchor” in the reconstruction process. The reconstruction starts from this anchor and is then adjusted in the direction of one's knowledge base. However, this adjustment process may stop too early, for example at the point where the first plausible value is reached, thus ending to a biased reconstruction. (3) Hell (1988) argued that the relative trace strengths of the regional estimate and of the solution might predict the amount of hindsight bias. The stronger the trace strength of the solution relative to that of the original estimate, the larger hindsight bias should be.

Pohl also offers an evolutionary explanation of hindsight bias:

Finally, some authors argued that hindsight bias is not necessarily a bothersome consequence of a “faulty” information process system, but that is may rather represent an unavoidable by-product of an evolutionary evolved function, namely adaptive learning. According to this view, hindsight bias is seen as the consequence of our most valuable ability to update previously held knowledge. This may be seen as a necessary process in order to prevent memory overload and thus to maintain normal cognitive functioning. Besides, updating allows us to keep our knowledge more coherent and to draw better inferences.

Ziva Junda, in social cognition, offers the following explanation of why hindsight bias occurs:

Preceding events take on new meaning and importance as they are made to cohere with the known outcome. Now that we know the our friends have filed for divorce, any ambiguous behavior we have seen is reinterpreted as indicative of tension, any disagreement gains significance, and any signs of affection seem irrelevant. It now seems obvious that their marriage was doomed from the start…Moreover, having adjusted our interpretations in light of current knowledge, it is difficult to imagine how things could have happened differently.

When making likelihood judgments, we often rely on the availability heuristic: The more difficult it is for us to imagine an outcome, the more unlikely it seems. Therefore, the difficulty we experience imagining how things might have turned out differently makes us all the more convinced that the outcomes that did occur were bound to have occurred.

Hindsight bias has large implications for criminal trials. In Jury Selection Hale Starr and Mark McCormick offer the following:

The effects of hindsight bias – which result in being held to a higher standard – are most critical for both criminal and civil defendants. The defense is more susceptible to the hindsight bias since their actions are generally the ones being evaluated fro reasonableness in foresight-foreseeability. When jurors perceive that the results of particular actions were “reasonably” more likely after the outcome is known, defendants are judged as having been capable of knowing more than they knew at the time the action was taken and therefore as capable of preventing the “bad” outcome.

In post-verdict surveys jurors unknowingly demonstrate some of the effects of hindsight bias:

“I can't understand why the managers didn't try to get more information or use the information they had available. They should have known there would be safety problems at the plant”.

“The defendants should have known people would remove the safety shield around the tire. There should have been warnings so people wouldn't do that”

“Even though he was a kid, he should have known that once he showed the others who had been drinking that he had a gun, things would get out of hand. He should have known guns invited violence.

Jurors influenced by the hindsight bias look at the evidence presented and determine that the defendants knew or should have known their actions were unsafe, unwise, or created a dangerous situation. Hindsight bias often results in the judgment that the event was “an accident or tragedy waiting to happen.”

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Protection Against Hindsight Bias

In Principles of Forecasting, Jon Scott Armstrong, offers the following advice on how to protect yourself:

The surest protection against (hindsight bias) is disciplining ourselves to make explicit predictions, showing what we did in fact know (sounds like a decision journal). That record can also provide us with some protection against those individuals who are wont to second guess us, producing exaggerated claims of what we should have known (and perhaps should have told them). If these observers look to this record, it may show them that we are generally less proficient as forecaster than they would like while protecting us against charges of having blown a particular assignment. Having an explicit record can also protect us against overconfidence in our own forecasting ability: If we feel that we “knew all along” what was going to happen, then it is natural enough to think that we will have similar success in the future. Unfortunately, an exaggerated perception of a surprise-free past maybe portend a surprised-full future.

Documenting the reasons we made a forecast makes it possible for us to know not only how well the forecast did, but also where it went astray. For example, subsequent experiences may show that we used wrong (or misunderstood) inputs. In that case, we can, in principle, rerun the forecasting process with better inputs and assess the accuracy of our (retrospectively) revised forecasts. Perhaps we did have the right theory and procedures, but were applying them to a mistaken picture of then-current conditions…Of course inputs are also subject to hindsight bias, hence we need to record them explicitly as well. The essence of making sense out of outcome knowledge is reinterpreting the processes and conditions that produced the reported event.

Hindsight Bias is part of the Farnam Street latticework of mental models.

The Crow and the Pitcher

aesop fables

A Crow, half-dead with thirst, came upon a Pitcher which had once been full of water; but when the Crow put its beak into the mouth of the Pitcher he found that only very little water was left in it, and that he could not reach far enough down to get at it. He tried, and he tried, but at last had to give up in despair. Then a thought came to him, and he took a pebble and dropped it into the Pitcher. Then he took another pebble and dropped it into the Pitcher. Then he took another pebble and dropped that into the Pitcher. Then he took another pebble and dropped that into the Pitcher. Then he took another pebble and dropped that into the Pitcher. Then he took another pebble and dropped that into the Pitcher. At last, at last, he saw the water mount up near him, and after casting in a few more pebbles he was able to quench his thirst and save his life.

— Aesop

The Mis-Match Problem

In this video, Malcolm Gladwell speaks on the challenge of hiring in the modern world.

One of those challenges, the mis-match problem, happens when we use criteria to judge someone for a job that is radically out of step with the actual demands of the job itself. Despite our best intentions we do this all of the time. Gladwell says “we want to cling to these incredibly outdated and simplistic measures of ability.”

Why do mis-match problems exist?
1. Our desire for certainty — the desire to impose certainty on something that is not certain.
2. Increase in complexity in professions.

“The craving for that physics-style precision does nothing but get you in terrible trouble.”

See more on the mis-match problem.

Malcolm Gladwell is a staff writer at the New Yorker and the author of The Tipping Point: How Little Things Make a Big Difference, Blink, Outliers and most recently, What the Dog Saw.

The Psychology of Pirates: How to Choose a Ransom

Reading The Invisible Hook really got me hooked on learning more about pirates.

How do pirates decide what ransom to ask for?

The answer, from an interview with an actual pirate, might surprise you. Despite what many think, they are very smart and intuitively grasp governance, incentives, and other aspects of human nature. This interview touches on incentives, reinforcement, moral hazard, and anchoring.

How do you pirates decide on what ransom to ask for?

Once you have a ship, it's a win-win situation. We attack many ships everyday, but only a few are ever profitable. No one will come to the rescue of a third-world ship with an Indian or African crew, so we release them immediately. But if the ship is from Western country or with valuable cargo like oil, weapons or then its like winning a lottery jackpot. We begin asking a high price and then go down until we agree on a price.

How do you know a ship in far away coast in the first place and its flagship?

Often we know about a ship's cargo, owners and port of origin before we even board it. That way we can price our demands based on its load. For those with very valuable cargo on board then we contact the media and publicize the capture and put pressure on the companies to negotiate for its release.

From what I've seen, initial demands tend to be about 10 times the previous publicized ransom, is this a rule of thumb?

We know that we won't get our initial demands, but we use it as a starting point and negotiate downwards to our eventual target.  But as a rule, yes, that's about right.

Does the length of a hijacking change the ransom that pirates are willing to accept?

Yes. Armed men are expensive as are the laborers, accountants, cooks and khat suppliers on land. During long negotiations our men get tired and we need to rotate them out three times a week. Add to that the risk from navies attacking us and we can be convinced to lower our demands.

 

What are the key factors to making a successful attack on a ship?

The key to our success is that we are willing to die, and the crews are not. Beyond that, in my case deploy a boat with six men to get close to the ship and leave another in reserve near the coast just in case we need backup. We use sophisticated equipment that allows us to spot our targets from a distance. We always have to be close to the main sea lane and keep in touch with each other using talkie phones.

 

How much does it cost to outfit a pirate mission?

A single mission with 12 armed men and boats costs a little over $30,000. But a successful investor has to dispatch at least three or four missions to get lucky once.

How are the pirates organized? (Are there pirate leaders, financiers, and specialists?)

The financiers are the most important since they organize and plan the big shot operations and are able to pay running cost[s]. Financiers always need to forge deals with traders, land cruiser owners, translators, business people to keep the supplies flowing during operations and manage the logistics.  There is a long supply chain involved in every hijacking.

 

Are there internal conflicts within the pirate gangs?

No. In piracy, everyones' life depends on everyone else's. There is some professional competition between groups, but we cooperate with information and logistics when it's required. We won't fight amongst ourselves as long as the money is paid as promised.  We have never had any conflicts within my group.

 

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Still curious? The Invisible Hook looks at legendary pirate captains like Blackbeard, Black Bart Roberts, and Calico Jack Rackam, and shows how pirates' search for plunder led them to pioneer remarkable and forward-thinking practices.

The Anatomy of a Decision: An Introduction to Decision Making

An Introduction to Decision Making

“The only proven way to raise your odds of making a good decision is
to learn to use a good decision-making process—one that can
get you the best solution with a minimal
loss of time, energy, money, and composure.”
— John Hammond

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This is an introduction to decision making.

A good decision-making process can literally change the world.

Consider the following example from Predictable Surprises: In 1962, when spy planes spotted Soviet missiles in Cuba, U.S. military leaders urged President Kennedy to authorize an immediate attack. Fresh from the bruising failure of the Bay of Pigs, Kennedy instead set up a structured decision-making process to evaluate his options. In a precursor of the Devil's Advocacy method, Kennedy established two groups each including government officials and outside experts, to develop and evaluate the two main options–attack Cuba or set up a blockade to prevent more missiles from reaching its shores. Based on the groups' analysis and debate, Kennedy decided to establish a blockade. The Soviets backed down, and nuclear war was averted. Recently available documents suggest that if the United States had invaded Cuba the consequences would have been catastrophic: Soviet missiles that had not been located by U.S. Intelligence could still have struck several U.S. cities.

The concept of a decision-making process can be found in the early history of thinking. Decisions should be the result of rational and deliberate reasoning. Plato argues that human knowledge can be derived on the basis of reason alone using deduction and self-evident propositions. Aristotle formalized logic with logical proofs where someone could reasonably determine if a conclusion was true or false. However, as we will discover not all decisions are perfectly rational. Often, we let our system one thinking–intuition–make decisions for us. Our intuition is based on long-term memory that has been primarily acquired over the years through learning and allows our mind to process and judge without conscious awareness. System one thinking, however, does not always lead to optimal solutions and often tricks our mind to thinking that consequences and second-order effects are either non-existent or less probable than reality would indicate.

In Predictable Surprises Max Bazerman writes:

Rigorous decision analysis combines a systematic assessment of the probabilities of future events with a hard-headed evaluation of the costs and benefits of particular outcomes. As such, it can be an invaluable tool in helping organizations overcome the biases that hinder them in estimating the likelihood of unpleasant events. Decision analysis begins with a clear definition of the decision to be made, followed by an explicit statement of objectives and explicit criteria for assessing the “goodness” of alternative courses of action, by which we mean the net cost or benefit as perceived by the decision-maker. The next steps involve identifying potential courses of action and their consequences. Because these elements often are laid out visually in a decision tree, this technique is known as “decision tree analysis.” Finally, the technique instructs decision-makers to explicitly assess and make trade-offs based on the potential costs and benefits of different courses of action.

To conduct a proper decision analysis, leaders must carefully quantify costs and benefits, their tolerance for accepting risk, and the extent of uncertainty associated with different potential outcomes. These assumptions are inherently subjective, but the process of quantification is nonetheless extremely valuable' it forces participants to express their assumptions and beliefs, thereby making them transparent and subject to challenge and improvement.

From Judgment in Management Decision Making by Max Bazerman:

The term judgment refers to the cognitive aspects of the decision-making process. To fully understand judgment, we must first identify the components of the decision-making process that require it.

Let's look at six steps you should take, either implicitly or explicitly, when applying a “rational” decision-making process to each scenario.

1. Define the problem. (M)anagers often act without a thorough understanding of the problem to be solved, leading them to solve the wrong problem. Accurate judgment is required to identify and define the problem. Managers often err by (a) defining the problem in terms of a proposed solution, (b) missing a bigger problem, or (c) diagnosing the problem in terms of its symptoms. Your goal should be to solve the problem not just eliminate its temporary symptoms.

2. Identify the criteria. Most decisions require you to accomplish more than one objective. When buying a car, you may want to maximize fuel economy, minimize cost, maximize comfort, and so on. The rational decision maker will identify all relevant criteria in the decision-making process.

3. Weight the criteria. Different criteria will vary in importance to a decision maker. Rational decision makers will know the relative value they place on each of the criteria identified. The value may be specified in dollars, points, or whatever scoring system makes sense.

4. Generate alternatives. The fourth step in the decision-making process requires identification of possible courses of action. Decision makers often spend an inappropriate amount of search time seeking alternatives, thus creating a barrier to effective decision making. An optimal search continues only until the cost of the search outweighs the value of added information.

5. Rate each alternative on each criterion. How well will each of the alternative solutions achieve each of the defined criteria? This is often the most difficult stage of the decision-making process, as it typically requires us to forecast future events. The rational decision maker carefully assesses the potential consequences on each of the identified criteria of selecting each of the alternative solutions.

6. Compute the optimal decision. Ideally, after all of the first five steps have been completed, the process of computing the optimal decision consists of (a) multiplying the ratings in step 5 by the weight of each criterion, (b) adding up the weighted ratings across all of the criteria for each alternative, and (c) choosing the solution with the highest sum of weighted ratings.

Hammond, Keeney, and Raiffa suggest 8 steps in their book Smart Choices:

1. Work on the right problem.
2. Identify all criteria.
3. Create imaginative alternatives.
4. Understand the consequences.
5. Grapple with your tradeoffs.
6. Clarify your uncertainties.
7. Think hard about your risk tolerance.
8. Consider linked decisions.

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People, however, are not always perfectly logical machines. In Judgment in Managerial Decision Making, the distinction between System One and System Two thinking becomes clear:

System 1 thinking refers to our intuitive system, which is typically fast, automatic, effortless, implicit, and emotional. We make most decisions in life using System 1 thinking. For instance, we usually decide how to interpret verbal language or visual information automatically and unconsciously. By contrast, System 2 refers to reasoning that is slower, conscious, effortful, explicit, and logical. System 2 thinking can be broken down into (1) define the problem; (2) identify the criteria; (3) weigh the criteria; (4) generate alternatives; (5) rate each alternative on each criterion; (6) compute the optimal decision.

In most situations, our system 1 thinking is quite sufficient; it would be impractical, for example, to logically reason through every choice we make while shopping for groceries. But System 2 logic should preferably influence our most important decisions.

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When making a decision we are psychologically influenced either consciously or unconsciously. By exploring these biases and other elementary worldly wisdom, I hope to make you a better decision maker.

Following a rational decision process can help us focus on outcomes that are low in probability but high in potential costs. Without easily quantifiable costs, we often dismiss low probability events or fall prey to biases. We don't want to be the fragilista.

Even rational decision-making processes like the one presented above make several assumptions. The first assumption is that a rational decision maker is completely informed which means they know about all the possible options and outcomes. The second major assumption is that the decision maker does not fall prey to any biases that might impact the rational decision.

In researching decision-making processes it struck me as odd that few people question the information upon which criteria are measured. For instance, if you are purchasing a car and use fuel efficiency as the sole criterion for decision making you would need to make sure that the cars under consideration were all tested and measured fuel consumption in the same way. This second order of thinking can help you make better decisions.

If you want to make better decisions, you should read Judgment in Managerial Decision Making. Hands down that is the best book I've come across on decision making. If you know of a better one, please send me an email.

Stanovich’s book, What Intelligence Tests Miss: The Psychology of Rational Thought, proposes a whole range of cognitive abilities and dispositions independent of intelligence that have at least as much to do with whether we think and behave rationally.

 

Follow your curiosity to The best books on the psychology behind human decision making and Problem Solving 101.