Image is Everything: LeBron James and the Pratfall Effect

This article below takes a look at some of the possible psychology behind LeBron James recent actions and introduces the Pratfall Effect.

Recently, LeBron James was dunked on at his basketball camp by a college sophomore named Jordan Crawford. This caused quite the stir, not necessarily because a 20-year-old dunked on James, but because of the reaction by James and corporate giant, Nike. James and Nike representatives confiscated two videotapes of Crawford's dunk on James. Why did this happen and what does it reveal to us about James' mindset?

…James' reputation, to this point, has been stellar. He is a team player, conducts himself well in interviews, and has not been involved in any stories that call his character into question. His teammates appear to enjoy playing with him, and he with them (contrast that with stories about both Bryant and Jordan who were reported to berate teammates from time to time to the point where teammates feared them mightily). James is one of those pro athletes who parents are happy for their kids to follow as a role model. He deserves all of his accolades and has handled his success with grace and poise.

…However, as much as I am a fan of James, three recent incidents make me wonder whether his image as “King James” hasn't taken his reputation to a point where he can't live up to it. As a result, I worry James may be in a cycle where he can't live up to the perfection people expect, and that he is beginning to succumb to the pressure of these expectations.

Exhibit A: After sweeping their first two series with record-breaking ease (the Cavs set a record for most consecutive playoff wins by double digit margins), media and fans alike were ready to anoint King James as NBA Champ. However, in Game 1 of the Eastern Conference Finals against Orlando, favored Cleveland lost 107-106, in spite of a heroic 49 point effort by James. Immediately after the game, James crumpled to the floor, plagued by what appeared to be leg cramps. Now, as anyone who has had leg cramps can attest, they can be downright excruciating.

As James stayed on the floor, medical personnel rushed to his side. For nearly 10 minutes, Cavs fans waited, worried about their hero. Something struck me as odd – James had just played an unbelievable game, I wondered if he stayed on the floor to allow the fans a chance to watch their fallen hero. Was he using the cramps as an excuse? We'll never know, but in social psychology, we use the term self-handicapping to describe the use of an external factor to justify a failure. James' appeared to have cramps throughout the fourth quarter, but I remember calling a friend that night, wondering why James didn't hobble to the locker room (after all, he had the strength to play nearly the entire game) and get treated there. Was he trying to draw attention to his injury as a way to explain the unexpected loss? This was a minor event, and received virtually no attention in the media, but it was the first time James had done something that struck me as potentially “me-oriented”.

Exhibit B: Fast forward five games, after the Cavaliers had been beaten by the Magic four games to two. After the series, James broke tradition when he did not shake hands with the victorious Magic. James' actions were roundly criticized. After the fact, James said, “It's hard for me to congratulate someone after you lose to them. I'm a winner. It's not being a poor sport or anything like that. But somebody beats you up, you're not going to congratulate them on beating you up. That doesn't make sense.” To many, this came as less of an apology and more of a justification for his decision not to shake hands. Social psychologist Leon Festinger formulated cognitive dissonance theory to describe the process we go through when our behavior is inconsistent with our attitudes. Frequently, the result is that we justify our actions by changing our attitudes. Here, James appeared to justify his not shaking hands with the Magic. The danger of that logic is that if everyone followed James, shaking hands, along with other behaviors associated with good sportsmanship, would become obsolete.

Exhibit C: Let's return to LeBron James getting dunked on by Jordan Crawford. Keep in mind, this was not a pimply-faced high school kid. Crawford averaged 10 points per game as a freshman at Indiana University before transferring to Xavier due to a coaching change at Indiana. By all accounts, Crawford is a very talented player. Furthermore, anyone who has played basketball at a relatively high level has been dunked on at one time or another. It is simply part of the game.

James' (and Nike's) decision to confiscate the tape appears to be another attempt at maintaining a perfect image. While it is unclear what role James had and what role Nike had in the confiscation of the tape, what is ironic is that James has received far more negative attention for having the tape destroyed than if he had simply allowed the tape to be shared.

In fact, psychologists who have studied the “pratfall effect” find that when a person is generally competent, making a blunder can actually increase others' liking of that individual. In a classic study, Aronson and colleagues (1966) had participants rate a fellow student who was taking part in a quiz show. In one condition, the student spilled coffee on himself, but as long as he had otherwise behaved in a competent manner, participants actually liked him more than if he had behaved competently but not spilled coffee on himself.

The reason for this pratfall effect? Making mistakes humanizes people who otherwise may seem superhuman and too good for us. Thus, in James' case, allowing people to view Crawford's dunk might not damage his reputation; in fact, it may actually enhance it. (my cynical side thinks that Nike already knows about the pratfall effect, and that they already have a commercial in the works that will coincide with the release of LeBron's next pair of shoes).

Read the Full Article.

Collective Intelligence

In their research paper, Harnessing Crowds: Mapping the Genome of Collective Intelligence, Thomas Malone and his two co-authors, Robert Laubacher, a research scientist at M.I.T., and Chrysanthos Dellarocas, a professor at the University of Maryland, use a biological analogy in calling the design patterns of collective intelligence systems “genes.”

They studied the genelike building blocks in more than 250 examples of collective intelligence enabled by the Web. The intent, they write, is to provide a systematic framework for thinking about collective intelligence, so “managers can do more than just look at examples and hope for inspiration.”

I love this multi-disciplinary approach to thinking.

* * *

Google. Wikipedia. Threadless. All are well-known examples of large, loosely organized groups of people working together electronically in surprisingly effective ways. These new modes of organizing work have been described with a variety of terms—radical decentralization, crowd-sourcing, wisdom of crowds, peer production, and wikinomics. The phrase we find most useful is collective intelligence, defined very broadly as groups of individuals doing things collectively that seem intelligent.

By this definition, collective intelligence has existed for a very long time. Families, companies, countries, and armies are all groups of individuals doing things collectively that, at least sometimes, seem intelligent.

But over the past decade, the rise of the Internet has enabled the emergence of surprising new forms of collective intelligence. Google, for instance, takes the judgments made by millions of people as they create links to Web pages and harnesses that collective knowledge of the entire Web to produce amazingly intelligent answers to the questions we type into the Google search bar.

In Wikipedia, thousands of contributors from across the world have collectively created the world’s largest encyclopedia, with articles of remarkably high quality. Wikipedia has been developed with almost no centralized control. Anyone who wants to can change almost anything, and decisions about what changes to keep are made by a loose consensus of those who care. What’s more, the people who do all this work don’t even get paid; they’re volunteers.

In Threadless, anyone who wants to can design a T-shirt, submit that design to a weekly contest, and vote for their favorite designs. From the entries receiving the most votes, the company selects winning designs, puts them into production, and gives prizes and royalties to the winning designers. In this way, the company harnesses the collective intelligence of a community of over 500,000 people to design and select T-shirts.

 

These examples of Web enabled collective intelligence are inspiring to read about. But to take advantage of the new possibilities they represent, it’s necessary to go beyond just seeing the examples as a fuzzy collection of “cool” ideas. To unlock the potential of collective intelligence, managers instead need a deeper understanding of how these systems work.

In this article we offer a new framework to help provide that understanding. It identifies the underlying building blocks—to use a biological metaphor, the “genes”—that are at the heart of collective intelligence systems, the conditions under which each gene is useful, and the possibilities for combining and re-combining these genes to harness crowds effectively.

Food Inc. — The Psychological Weapons of Protest

The human brain is trained to respond to large and abstract threats in a way that is far from ideal. According to research by Harvard professor Daniel Gilbert, there are four key elements a threat must have for us to act on it.

The threat must: (1) have a face; (2) incite moral sensibility; (3) clear and present danger; and (4) cause absolute not relative changes.

 

The article below is from psychology today.

* * *

Food Inc. is a case in point of powerful activism. Its mission is to crystallize two things about food in America: a. what we eat is disturbingly unsafe b. the system in charge of what we eat is disturbingly corrupt. There is anecdotal evidence and statistics. The presentation is accessible and thorough.

I left the theater a little too cognizant of the candy and soda I'd just ingested, I wondered just how many minutes it was going to take for the sense of outrage and disgust I currently felt to dissolve back into indifference?

One of the reasons I am not ashamed to admit this is because of research by Daniel Gilbert, a social psychologist from Harvard.

He has studied our psychological response to such large and abstract threats as global warming and concluded that the human brain is naturally designed to respond in a manner that is far from ideal. When it comes to certain evolutionarily relevant threats like snakes and darkness, Gilbert maintains that our alarm systems are sleek, smooth and dependable. And yet for certain other threats this same alarm system goes haywire, producing an emotional baseline of apathy and acceptance that is challenging to change.

So, where does Big Agriculture lie on the “response to threat” spectrum and does the documentary effectively battle these psychological barriers?

According to Gilbert there are four key elements of a threat without which we will not act instantaneously and decisively:

A. The threat must have a face. We are highly social beings. Are brain size has increased to accommodate the need to think about others and our wiring is triggered by the aggressive action of others. This is why the Big Business CEO's of the agricultural industry were so wise in refusing to interview. Consequently, Food Inc.'s list of villains is long and vague: the greedy private enterprises, the corrupt government, the apathetic consumers etc. Here, too little is done in establishing a face to put on the dartboard.

B. The threat must incite a moral sensibility. When we are confronted with something repugnant, our minds generate such powerful emotions as disgust, which compel us to action as much as anything. On this barometer Food Inc. lands not too far behind puppy killing. In providing extending home footage of little Kevin, a three year-old victim of E-coli, Food Inc. activates our moral centers. Additional images of pigs that are too fat to move, cows that are knee-deep in their own feces and chickens with heads bigger than Barry Bonds provide an exclamation point.

C. The threat must represent a clear and present danger. Gilbert says that global warming is not happening fast enough in that sense that our brains best respond in milliseconds to flying baseball bats, not incremental recessions in icebergs. The documentary highlights the what-have-you-done-for-me-lately elements of threat by highlighting the various outbreaks and recalls that have soiled America's clean bill of health.

D. The threat must cause absolute, not relative changes. Just as we can detect one candle being lit in a dark room but not five candles in an already bright room, we respond to threats that unfold in real-time. The documentary does focus on such current crises as the obesity and diabetes II epidemics, but these disorders do not develop overnight.

Food Inc. tackles an issue that bats two-for-four leaving me to conclude that food impurity, as a villain that incites activism, ranks a little better than global warming, but worse than terrorism. Incidentally, a terrorist is an extremely gratifying enemy, psychological speaking. Fuse Osama Ben Laden with the 9/11 attacks and bat a thousand on Gilbert's categorical system.

This documentary shows the industrial food industry to be a small group of greedy, clever business men (probably old white and male, too) who abuse animals, workers and the welfare of just about everyone in the pursuit of another billion dollars. The veil has been lifted to reveal supermarkets that are barely a step removed from the grease and slime of McDonalds. Food Inc. convicts Big Agriculture of terrorizing a fair and healthy way of life. Indeed, this documentary will need to link the industrial food system with terrorism to incite the sort of feverish protest that is needed.

Continue Reading Article

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

***

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.

* * *

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.

* * *

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.

Mental Model: Supply and Demand

The law of demand states that there is an inverse relationship between the price of a good and the quantity of the good demanded. Demand can be influenced by: the income level of the buyer, the price of the good, the availability of substitutes. Stepping outside of economics, demand can be influenced by, among other things, social proof, envy and jealousy, incentives, feedback loops, association, commitment and consistency, over-influence from authority (or celebrity), contrast, and ideological bias.

The law of supply states there there is a positive relationship between the price of a good and the quantity supplied. The price levels of the good, the costs of inputs to produce the good, and the technological costs to produce a good are all factors that influence the level of goods supplied.

In Principles of Microeconomics, Greg Mankiw offers the following introduction to Supply and Demand:

When a cold snap hits Florida, the price of orange juice rises in supermarkets throughout the country. When the weather turns warn in New England every summer the price of hotel rooms in the Caribbean plummets. When a war breaks out in the Middle East, the price of gasoline in the United States rises, and the price of a used Cadillac falls. What doe these events have in common? They all show the workings of supply and demand.

Supply and demand are the two words that economists use most often–and for good reason. Supply and demand are the forces that make market economics work. They determine the quantity of each good produced and the price at which it is sold. If you want to know how any event will affect the economy, you must think first about how it will affect the supply and demand.

The terms supply and demand refer to the behavior of people as they interact with one another in markets. A market is a group of buyers and sellers of a particular good or service. The buyers as a group determine the demand for the product and the sellers as a group determine the supply of the product.

We assume (in this chapter) that markets are perfectly competitive. Perfectly competitive markets are defined by two primary characteristics: (1) the goods being offered for sale are all the same, and (2) the buyers and sellers are so numerous that no single buyer or seller can influence the market price. Because buyers and sellers in perfectly competitive markets must accept the price the market determines, they are said to be price takers.

The determinants of individual demand.

Consider your own demand for ice cream. How do you decide how much ice cream to buy each month, and what factors affect your decision. Here are some of the answers you might give.

Price: If the price of ice cream rose to $20 per scoop, you would buy less ice cream. You might buy frozen yogurt instead. If the price of ice cream fell to .20 per scoop, you would buy more. Because the quantity demanded falls the the price rises and as the price falls, we say that the quantity demanded is negatively related to the price. This is what the economists call the law of demand: Other things being equal, when the price of a good rises, the quantity demanded of the good falls.

Income: What would happen to your demand for ice cream if you lost your job one summer? Most likely it would fall. If the demand falls when income falls, the good is called a normal good. Not all goods are normal goods. If the demand for a good rises when income falls the cood is called an inferior good. An example of an inferior good might be bus rides. As your income falls, you are less likely to buy a car or take a cab and more likely to ride the bus.

Price of related goods: Suppose that the price of frozen yogurt falls. The law of demand says that you will buy more frozen yogurt. At the same time you will probably buy less ice cream. When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes.

Tastes: The most obvious determinant of your demand is your tastes. If you like ice cream you buy more of it.

Expectations: Your expectations about the future may affect your demand for a good or service today. For example, if you expect to earn a higher income next month, you may be more willing to spend some of your current savings to buy ice cream.

* * *

In his speech, entitled ‘Academic Economics Strengths and Faults after Considering Interdisciplinary needs,' Charlie Munger said:

I have posed at two different business schools the following problem. I say, “You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That's what you've learned?” They all nod yes. And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there's this long and ghastly pause. And finally, in each of the two business schools in which I've tried this, maybe one person in fifty could name one instance. They come up with the idea that occasionally a higher price acts as a rough indicator of quality and thereby increases sales volumes.

This happened in the case of my friend Bill Ballhaus. When he was head of Beckman Instruments it produced some complicated product where if it failed it caused enormous damage to the purchaser. It wasn't a pump at the bottom of an oil well, but that's a good mental example. And he realized that the reason this thing was selling so poorly, even though it was better than anybody else's product, was because it was priced lower. It made people think it was a low quality gizmo. So he raised the price by 20% or so and the volume went way up.

But only one in fifty can come up with this sole instance in a modern business school – one of the business schools being Stanford, which is hard to get into. And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy's purchasing agent? (Laughter). Is that going to work? And are there functional equivalents in economics – microeconomics – of raising the price and using the extra sales proceeds to drive sales higher? And of course there are zillion, once you've made that mental jump. It's so simple.

One of the most extreme examples is in the investment management field. Suppose you're the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions, which of course reduces the number of units of real investments delivered to the ultimate buyer, so you're increasing the price per unit of real investment that you're selling the ultimate customer. And you're using that extra commission to bribe the customer's purchasing agent. You're bribing the broker to betray his client and put the client's money into the high-commission product. This has worked to produce at least a trillion dollars of mutual fund sales.

This tactic is not an attractive part of human nature, and I want to tell you that I pretty completely avoided it in my life. I don't think it's necessary to spend your life selling what you would never buy. Even though it's legal, I don't think it's a good idea. But you shouldn't accept all my notions because you'll risk becoming unemployable. You shouldn't take my notions unless you're willing to risk being unemployable by all but a few.

I think my experience with my simple question is an example of how little synthesis people get, even in advanced academic settings, considering economic questions. Obvious questions, with such obvious answers. Yet people take four courses in economics, go to business school, have all these IQ points and write all these essays, but they can't synthesize worth a damn. This failure is not because the professors know all this stuff and they're deliberately withholding it from the students. This failure happens because the professors aren't all that good at this kind of synthesis. They were trained in a different way. I can't remember if it was Keynes or Galbraith who said that economics professors are most economical with ideas. They make a few they learned in graduate school last a lifetime.

Warren Buffett on Supply and Demand

Our second non-traditional commitment is in silver. Last year, we purchased 111.2 million ounces. Marked to market, that position produced a pre-tax gain of $97.4 million for us in 1997. In a way, this is a return to the past for me: Thirty years ago, I bought silver because I anticipated its demonetization by the U.S. Government. Ever since, I have followed the metal's fundamentals but not owned it. In recent years, bullion inventories have fallen materially, and last summer Charlie and I concluded that a higher price would be needed to establish equilibrium between supply and demand. Inflation expectations, it should be noted, play no part in our calculation of silver's value.

In the 1978 shareholder letter, Buffett offered the following comment on supply and demande as it relates to commodity businesses earning a profit:

The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.

In the 1982 annual letter to shareholders, Buffett wrote:

If, however, costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous.

Hence the constant struggle of every vendor to establish and emphasize special qualities of product or service. This works with candy bars (customers buy by brand name, not by asking for a “two-ounce candy bar”) but doesn't work with sugar (how often do you hear, “I'll have a cup of coffee with cream and C & H sugar, please”).

In many industries, differentiation simply can't be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent. For the great majority of companies selling “commodity”products, a depressing equation of business economics prevails: persistent over-capacity without administered prices (or costs) equals poor profitability.

Of course, over-capacity may eventually self-correct, either as capacity shrinks or demand expands. Unfortunately for the participants, such corrections often are long delayed. When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment. In other words, nothing fails like success.

What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years. Frequently that ratio is dismal. (It seems as if the most recent supply-tight period in our textile business – it occurred some years back – lasted the better part of a morning.)

In some industries, however, capacity-tight conditions can last a long time. Sometimes actual growth in demand will outrun forecasted growth for an extended period. In other cases, adding capacity requires very long lead times because complicated manufacturing facilities must be planned and built.

And In the 1991 letter, Buffett wrote:

In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.

The Present Mess

The combination of incentives, reinforcement, positive feedback loops, over-reliance on authority, and poor accounting contributed to the current mess. Bailing out these institutions, while necessary, creates a moral hazard going forward. And now, having lost money, institutions, like gamblers, will now be more likely to take risky bets with unfavorable odds in an effort to make up for lost ground.

How serious is the present mess?

Charlie Munger answered “Deadly serious.”

You can't tell what happens when people get disappointed enough of a dysfunctional civilization. The Depression led to Hitler. The government has been right to react vigorously.

What caused the mess?

It was an example of a lollapalooza effect: the result of a confluence of causes acting in the same direction.

Abusive practices in consumer credit, namely extending credit to people who couldn't handle it, knowing they couldn't handle it. Sometimes you have to resist sinking to the level of your competitors. But fomenting bad practices often becomes its own punishment. “If you do things that are immoral and stupid, there's likely to be a whirlwind” that sweeps you away.

The “scum of the earth” in mortgage credit who “rejoiced in rooking” their borrowers. “We had Wall Street go crazy,” pursuing any way of earning money short of armed robbery. In Merrill Lynch's last purchase of a mortgage outfit, they knowingly bought “a bunch of sleazy crooks,” thinking that if it makes money, who cares that they're crooks.

Poor regulation and legislation. Some of the legislators genuinely thought they were being pro-social in helping poor people buy houses, but they weren't; you need sound credit just as you need sound engineering. Some of the problem was Democrats pushing Fannie and Freddie to lend, some of it was “Republicans who overdosed on Ayn Rand” and thought unrestrained free enterprise was as good for the finance industry as for the restaurant industry.

The repo system of credit allowed this: “one of the best ways to create excess credit ever invented.” Credit default swaps that let you profit if someone else fails are a terrible idea; in buying life insurance, you're wisely required to have an insurable interest.

Mark-to-model accounting on derivatives let both sides show a profit; “the accounting was phoney because all the customers wanted it phoney.” But Charlie's never met an accountant who's ashamed of his profession. People like Greenspan made what was going on respectable by endorsing it, but “it isn't like free enterprise in restaurants”—more like legalized armed robbery. In the end, “We had to save a lot of these people whether we liked it or not.” To nationalize Fannie and Freddie and then lower interest rates so good borrowers could buy houses was “very smart government.” In the old days, regulators kept silent about banks until they had to act, then announced a fait accompli; “put me down as dubious” about the public stress-testing. Charlie probably won't like what Wells Fargo is made to do. Warren and Charlie think more highly of Wells Fargo than others do because of their low cost of funds. Charlie's willing to put up with less than perfection from the government; on the whole, “it's working out fairly well,” and “a lot of it has been done beautifully.”