Tag: Economics

Jared Diamond: How to Get Rich

We're constantly asked for examples of the “multiple mental models” approach in practice. Our standard response includes great books like Garrett Hardin's Filters Against Folly and Will Durant's The Lessons of History.

One of the well-known examples of this brand of thinking is Guns, Germs, and Steel, a book that opened thousands of eyes to the power of leaping across the walls of history, sociology, biology, geography and other fields to truly understand the world. (If you haven't read it yet, why are you still here? Go order it and read it!)

Jared Diamond, the book's author, is a great master of synthesis across many fields — works like The Third Chimpanzee and Collapse show great critical thinking prowess, even if you don't come to 100% agreement with him.

Lesser known than Guns, Germs, and Steel is a follow-up talk Diamond gave entitled How to Get Rich:

… probably most lectures one hears at the museum are on fascinating but impractical subjects: namely, they don't help you to get rich. This evening I plan to redress the balance and talk about the natural history of becoming rich.

The talk is a great, and short, introduction to “multiple mental models” thinking. Diamond, of course, does not literally answer the question of How to Get Rich. He's smart enough to know that this is charlatan territory if answered too literally. (Three steps to surefire wealth!)

But he does effectively answer an interesting part of the equation of getting rich: What conditions do we need to set up maximal productivity, learning, and cooperation among our groups? 

Diamond answers his question through the same use of inter-disciplinary synthesis his readers would be familiar with: As you read it, you'll see models from biology, military history, business/economics, and geography.

His answer has two main parts: Optimal group size/fragmentation, and optimal exposure to outside competition:

So what this suggests is that we can extract from human history a couple of principles. First, the principle that really isolated groups are at a disadvantage, because most groups get most of their ideas and innovations from the outside. Second, I also derive the principle of intermediate fragmentation: you don't want excessive unity and you don't want excessive fragmentation; instead, you want your human society or business to be broken up into a number of groups which compete with each other but which also maintain relatively free communication with each other. And those I see as the overall principles of how to organize a business and get rich.

Those are wonderful lessons, and you should read the piece to see how he arrives at them. But there's another important reason we bring the talk to your attention, one of methodology.

Diamond's talk offers us a powerful principle for our efforts to understand the world: Look for and study natural experiments, the more controlled, the better.

I propose to try to learn from human history. Human history over the last 13,000 years comprises tens of thousands of different experiments. Each human society represents a different natural experiment in organizing human groups. Human societies have been organized very differently, and the outcomes have been very different. Some societies have been much more productive and innovative than others. What can we learn from these natural experiments of history that will help us all get rich? I propose to go over two batches of natural experiments that will give you insights into how to get rich.

This wonderfully useful approach, reminiscent of Peter Kaufman's idea about the Three Buckets of Knowledge, is one we see used effectively all the time.

Judith Rich Harris used the naturally controlled experiment of identical twins separated at birth to solve the problem of human personality development. Michael Abrashoff had a naturally controlled experiment in leadership principles when he had to turn around the USS Benfold without hiring or firing, or changing ships or missions, or offering any financial incentive to his cadets. Ken Iverson had a naturally controlled experiment in business principles by succeeding dramatically in a business with massive headwinds and no tailwinds.

And so if we follow in the steps of Diamond, Peter Kaufman, Judith Rich Harris, Ken Iverson, and Michael Abrashoff, we might find natural experiments that help illuminate the solutions to our problems in unusual ways. As Diamond says in his talk, the world has already tried thousands of things: All we have to do is study them and then align with the way the world works.

Ben Franklin and the Virtues and Ills of Pursuing Luxury

In a letter written in 1784 to his friend Benjamin Vaughan, Ben Franklin has a very interesting cogitation on the aggregate effect of the pursuit of luxuries beyond our needs.

Franklin displays a mastery of rational, balanced thought, and a deep understanding of human nature. Is the pursuit of luxury a net benefit or detriment to a country? Why do we pursue it?

The salient passages are below. (You can find his full writings here.) The last paragraph, in particular, is a gem, but taking 10 minutes to read it through is worth the time.

I have not, indeed yet thought of a Remedy for Luxury  I am not sure, that in a great State it is capable of a Remedy. Nor that the Evil is in itself always so great as it is represented.  Suppose we include in the Definition of Luxury all unnecessary Expence, and then let us consider whether Laws to prevent such Expence are possible to be executed in a great Country, and whether, if they could be executed, our People generally would be happier, or even richer. Is not the Hope of one day being able to purchase and enjoy Luxuries a great Spur to Labour and Industry? May not Luxury, therefore, produce more than it consumes, if without such a Spur People would be, as they are naturally enough inclined to be, lazy and indolent?

[…]

In our Commercial Towns upon the Seacoast, Fortunes will occasionally be made. Some of those who grow rich will be prudent, live within Bounds, and preserve what they have gained for their Posterity ; others, fond of showing their  Wealth, will be extravagant and ruin themselves. Laws  cannot prevent this; and perhaps it is not always an evil to the Publick. A Shilling spent idly by a Fool, may be picked up by a Wiser Person, who knows better what to do with it.  It is therefore not lost. A vain, silly Fellow builds a fine House, furnishes it richly, lives in it expensively, and in few years ruins himself; but the Masons, Carpenters, Smiths, and other honest Tradesmen have been by his Employ assisted in maintaining and raising their Families ; the Farmer has been paid for his labour, and encouraged, and the Estate is now in better Hands. In some Cases, indeed, certain Modes of Luxury may be a publick Evil, in the same Manner as it is a Private one. If there be a Nation, for Instance, that exports its Beef and Linnen, to pay for its Importation of Claret and Porter, while a great Part of its People live upon Potatoes, and wear no Shirts, wherein does it differ from the Sot, who lets his Family starve, and sells his Clothes to buy Drink? Our American Commerce is, I confess, a little in this way. We sell our Victuals to your Islands for Rum and Sugar; the substantial Necessaries of Life for Superfluities. But we have Plenty, and live well nevertheless, tho' by being soberer, we might be richer.

[…]

It has been computed by some Political Arithmetician, that, if every Man and Woman would work for four Hours each Day on something useful, that Labour would produce sufficient to procure all the Necessaries and Comforts of Life, Want and Misery would be banished out of the World, and the rest of the 24 hours might be Leisure and Pleasure.

What occasions then so much Want and Misery? It is the Employment of Men and Women in Works, that produce neither the Necessaries nor Conveniences of Life, who, [along] with those who do nothing, consume the Necessaries raised by the Laborious.

To explain this.

The first Elements of Wealth are obtained by Labour, from the Earth and Waters. I have Land, and raise Corn. With this, if I feed a Family that does nothing, my Corn will be consum'd, and at the end of the Year I shall be no richer than I was at the beginning. But if, while I feed them, I employ them, some in Spinning, others in hewing Timber and sawing Boards, others in making Bricks, &c. for Building, the Value of my Corn will be arrested and remain with me, and at the end of the Year we may all be better clothed and better lodged. And if, instead of employing a Man I feed in making Bricks, I employ him in fiddling for me, the Corn he eats is gone, and no Part of his Manufacture remains to augment the Wealth and Convenience of the family; I shall therefore be the poorer for this fiddling Man, unless the rest of my Family work more, or eat less, to make up the Deficiency he occasions.

Look round the World and see the Millions employ'd in doing nothing, or in something that amounts to nothing, when the Necessaries and Conveniences of Life are in question. What is the Bulk of Commerce, for which we fight and destroy each other, but the Toil of Millions for Superfluities, to the great Hazard and Loss of many Lives by the constant Dangers of the Sea? How much labour is spent in Building and fitting great Ships, to go to China and Arabia for Tea and Coffee, to the West Indies for Sugar, to America for Tobacco! These things cannot be called the Necessaries of Life, for our Ancestors lived very comfortably without them.

A Question may be asked; Could all these People, now employed in raising, making, or carrying Superfluities, be subsisted by raising Necessaries? I think they might. The World is large, and a great Part of it still uncultivated. Many hundred Millions of Acres in Asia, Africa, and America are still Forest, and a great Deal even in Europe. On 100 Acres of this Forest a Man might become a substantial Farmer, and 100,000 Men, employed in clearing each his 100 Acres, would hardly brighten a Spot big enough to be Visible from the Moon, unless with HerschelTs Telescope ; so vast are the Regions still in Wood unimproved.

‘Tis however, some Comfort to reflect, that, upon the whole, the Quantity of Industry and Prudence among Mankind exceeds the Quantity of Idleness and Folly. Hence the Increase of good Buildings, Farms cultivated, and populous Cities filled with Wealth, all over Europe, which a few Ages since were only to be found on the Coasts of the Mediterranean; and this, notwithstanding the mad Wars continually raging, by which are often destroyed in one year the Works of many Years' Peace. So that we may hope the Luxury of a few Merchants on the Seacoast will not be the Ruin of America.

One reflection more, and I will end this long, rambling Letter. Almost all the Parts of our Bodies require some Expence. The Feet demand Shoes; the Legs, Stockings; the rest of the Body, Clothing; and the Belly, a good deal of Victuals. Our Eyes, tho' exceedingly useful, ask, when reasonable, only the cheap Assistance of Spectacles, which could not much impair our Finances. But the Eyes of other People are the Eyes that ruin us. If all but myself were blind, I should want neither fine Clothes, fine Houses, nor fine Furniture.

Adieu, my dear Friend, I am

Yours ever
B. FRANKLIN.

***

Still Interested? Check out Franklin's Rule for Decision Making, and check out the excellent book The Way to Wealth and Other Writings on Finance for an edited and condensed look at Franklin's various essays on economics, business, and finance.

 

Why Fiddling With Prices Doesn’t Work


“The fact is, if you don't find it reasonable that prices should reflect relative scarcity,
then fundamentally you don't accept the market economy,
because this is about as close to the essence of the market as you can find.”

— Joseph Heath

***

Inevitably, when the price of a good or service rises rapidly, there follows an accusation of price-gouging. The term carries a strong moral admonition on the price-gouger, in favor of the price-gougee. Gas shortages are a classic example. With a local shortage of gasoline, gas stations will tend to mark up the price of gasoline to reflect the supply issue. This is usually rewarded with cries of unfairness. But does that really make sense?

In his excellent book Economics Without Illusions, Joseph Heath argues that it doesn't.

In fact, this very scenario is market pricing reacting just as it should. With gasoline in short supply, the market price rises too so that those who need gasoline have it available, and those who simply want it do not. The price system ensures that everyone makes their choice correctly. If you're willing to pay up, you pay up. If you're not, you make alternative arrangements – drive less, use less heat, etc. This is exactly what market pricing is for – to give us a reference as we make our choices. But it's still hard for many well-intentioned people to understand. Let's think it through a little, with Heath's help.

***

As Heath points out in the book, the objection to so-called “price gouging” goes back at least to the Roman Emperor Diocletian, who in AD 301 imposed an Edict of Maximum Prices:

If the excesses perpetrated by persons of unlimited and frenzied avarice could be checked by some self-restraint—this avarice which rushes for gain and profit with no thought for mankind; or if the general welfare could endure without harm this riotous license by which, in its unfortunate state, it is being very seriously injured every day, the situation could perhaps be faced with dissembling and silence, with the hope that human forbearance might alleviate the cruel and pitiable situation.

And with that, Diocletian set a hard cap on the price of over a thousand different items. Some were tangible, like wheat and barley, and some were intangible, like farm labor and barber services.

This was, of course, very dumb and did not last very long as people realized that one barber and another were not equal, that wheat and barley might have local supply constraints, and that an arbitrary government price was not the fair one for most of the 1000+ items.

Inflation vs. Supply

As Heath points out in his book, there are two separate issues to untangle when we talk about “price-gouging” — general inflation and constraints on supply. The two are very different, and confusing a supply issue for general inflation leads to a lot of wrong thinking:

If you wander into a Polish supermarket and discover that a kilo of carrots is selling for four zlotys, you probably haven't learned very much. It's only once you find out what a pound of potatoes costs, and a chicken, and a pint of beer, that you begin to discover whether carrots are expensive or cheap.

As a result, the price of everything going up is analytically equivalent to the price of nothing going up. It follows that if the price of everything seems to be going up, it must be because the price of at least one thing is (inconspicuously) going down. Usually that inconspicuous item with the falling price is hidden in plain sight — money. We tend to overlook money because it's not directly consumed; it simply circulates, thus we forget that it has a price. We think of “four zlotys per kilo” as the price of carrots, expressed in zlotys, while forgetting that it is also the price of zlotys, expressed in carrots.

As Garrett Hardin would well recognize, part of the problem is the way language misleads us. When the price of stuff is going up, we don't always make the equivalent connection that the value of our money is going down. And thus, we can often confuse a rising price environment for greedy so and so's who are simply reacting to the declining value of money.

Often, governments hurt the value of money purposely. In Diocletian's time, a denarius coin went from being made entirely of silver to being made of about 2% silver and 98% base metals – the origin of the term currency debasement. In a world of inflation, what seems like greed is often an illusion caused by money losing its value generally (a complex phenomenon in its own right).

To see the flow-through effects of this, imagine that all wage-earners were given a significant raise next month. Sounds good, right? Problem is, the increased cost of labor would be passed through in the form of higher prices for everything, or alternatively, businesses would figure out how to operate with fewer workers altogether. The owners of society's capital don't just sit back and lose money — they figure out a new plan or reallocate their resources elsewhere.

Thus, a wage increase would put us right back to where we started. This is why the minimum wage debate isn't simply a humanitarian “business versus workers” issue — there are no easy answers. (In other words, The consequences have consequences.)

Prices are simply signals which allow us to make decisions on how much we really need that thing. If each of us was handed $5,000 to spend each month, we could choose to spend X amount on food, Y amount on housing, and Z amount of organic 97% cacao chocolate. The alternative would be a state planner sitting in a high tower trying to fix prices based on how he or she thought everyone should make their food/housing/chocolate allocation for the month. The history of planned economies would show this to be a majorly bad idea.

This leads us to our next point which is that, of course, our income allocations are not the same. Might price-fixing help level the playing field?

Fixing What, Exactly?

Heath quotes the economist Abba Lerner who once said that the problem for the poor is not that prices are too high, but that they don't have enough money. (“The solution of poverty lay not with the manipulation of prices but with the distribution of money income.”)

On this, Heath turns to the example of electricity prices, an occasional hot-button issue which leads to subsidies because high electricity prices are seen as regressive — poor people spend a larger percentage of their money on electric power than those more well-off. Why not subsidize electricity prices to help?

The problem is that it's a massively inefficient way to help, and puts a lot of dollars into pockets of those who don't need it. Citing Canadian statistics on the use of subsidies to keep electricity prices down, Heath writes:

The middle-income quintile spends an average of $1,117 per year (2.4% of income), while the upper quintile spends $1,522 per year (1.1% of income). This means that the $250 million annual gift being bestowed upon the poor is coupled with a $408 million gift to the middle class and a $556 million gift to the richest 20% of the population. Needless to say, a welfare program that required giving $2 to a rich person for every $1 directed to a poor person would hardly be regarded as progressive (despite the fact that, when expressed as a percentage of income, the poor person is receiving “more”).

Of course, finding a way to get the entire $1.2 billion to the people who truly need it, through a deserving program, would be a far better solution, and one that would also avoid encouraging people to use more electricity than they need (which artificially lower prices can do).

This kind of thing happens, but worse, when it comes to rent control, the system of fixing rental prices for apartments in cities. In addition to subsidizing some of the wrong people, who also have access to rent-controlled housing, the lower prices tend to distort the market for apartment and housing construction.

With apartments so affordable, people who might otherwise have purchased a house now choose to rent, crowding out some people who could never afford a home at all. And with prices artificially low, fewer apartment houses are built! Not a great outcome for the people rent control hopes to help.

To understand why think about the massive spike in energy prices leading up to the 2008 financial crisis. At one time, oil neared $140 per barrel and natural gas reached $13 per MMbtu. The result was somewhat predictable: A massive investment went into the energy complex, leading to new resources and new technologies, while demand quickly abated. Almost no one correctly predicted that 8 years later, oil would be sitting below $50 per barrel and natural gas around $2 per MMbtu. This is, of course, how pricing markets are supposed to work. The signals did their job. Artificial prices for metropolitan apartments don't allow the market to do this job effectively.

Relative Scarcity: The Key to Understanding Market Prices

The main problem with manipulating and fixing prices is a misunderstanding of what determines prices. What usually determines prices in a true market is relative scarcity, the intersection between how much you want a particular good relative to another one, and the availability of that good. As our wants and needs change, and available supplies change, prices go up and down (ignoring, for now, speculative factors, which play a huge role in some price markets).

What exactly are we paying for when we buy an item?

Clearly, it's not just the cost of the physical thing being produced. A cup of coffee costs a lot more than a few beans and some water. The total cost is something Heath calls the “social cost” of the good, which includes the entire chain of costs and opportunity costs in producing it:

Whenever someone consumes a good (say, a cup of coffee), this can be thought of as creating a benefit for that individual, combined with a loss for the rest of society (all the time and trouble it took to produce that cup of coffee, now gone). Paying for things is our way of compensating all the people who have been inconvenienced by our consumption. (Next time you buy a cup of coffee at Starbucks, imagine yourself saying to the barista, “I'm sorry that you had to serve me coffee when you could have been doing other things. And please communicate my apologies to the others as well: the owner, the landlord, the shipping company, the Columbian peasants. Here's $1.75 for all the trouble. Please divide it amongst yourselves.)

“Social cost” represents the level of renunciation, or foregone consumption, imposed upon the rest of society by each individual's own consumption. This is a fairly abstract notion, since it's not just that the good could have been consumed by someone else, but that the labor and resources that went into making that good could have been used to produce something else, which then could have been consumed by someone else. (So when I drink a cup of coffee, I am not only taking away that cup of coffee from all those who might like to have drunk it, but taking away vegetables from those who might like to have used the land to grow food, clothing from those who might like to have employed the agricultural workers in a garment factory, and so on.)

[…]

If the price of coffee tracks changes in supply and demand, it will tend to reflect this level of hardship. If the rest of us really want coffee, then we will be prepared to pay more for it, and so the price will rise. Coffee will become more “dear” (as the British would say), reflecting the fact that the person who drinks it is denying the rest of us something we really want. Thus the coffee-drinker had better really want it in order to justify depriving us of it. His willingness to pay the higher price is precisely what ensures that he does, in fact, really want it.

At the price where the hardship of creating a certain amount of some good meets the desire for a good, a price emerges. It's this “market clearing” price which efficiently allocates most of society's resources the way we need them allocated.

If prices are systematically lower than they should be, consumers benefit from society's hard work in a way that might be better allocated elsewhere, where some other group would happily pay more for the same level of “social costs” imposed, and the producers would receive more for all their work.

Conversely, if prices are too high, then consumers don't really get to be as happy as they should be relative to the modest “social cost” they've imposed. Each outcome is inefficient and produces less happiness and material wealth. A well-established pricing mechanism does the job of sending the right signals about wants, needs, and supplies.

Income Over Pricing

Heath makes a final important point about the inequality of income in society, and that in many cases, people who have had a rough hand dealt to them do deserve help. It's just that playing with the pricing mechanism is usually the worst way to do it — as we saw above, you hand people money who don't need it while distorting an efficient allocation of resources throughout society. Heath calls this the just price fallacy — the idea that some alternative level of prices are more “fair” and that we should intervene to ensure them. The “just price fallacy” fails because it doesn't ask the crucial question: And then what?

Returning to the dictum that poor people simply don't have enough money (ridiculous as it sounds), the better method is to attack the other side — income — through the system of taxation and other mechanisms, things which we do in great heaps in modern society, but will always be argued over. If market prices tend to efficiently signal suppliers about the wants and needs of society, we can usually help the less fortunate best by giving them more “claim checks” rather than distorting the very thing that works.

***

Still Interested? Try reading more from the wonderful book Economics Without Illusions, where Heath takes on some fallacies from the left and some fallacies from the right in the economic debate.

For more from Farnam Street, check out Charlie Munger's speech on what could make the economics profession work a little better or check out economist John Kay's recommendations on books about economics in the real world.

Incentives Gone Wrong: Cobras, Severed Hands, and Shea Butter

“You must have the confidence to override people with more credentials than you whose cognition is impaired by incentive-caused bias or some similar psychological force that is obviously present. But there are also cases where you have to recognize that you have no wisdom to add— and that your best course is to trust some expert.”
— Charlie Munger

***

There's a great little story on incentives which some of you may already know. The tale may be apocryphal, but it instructs so wonderfully that it's worth a repeat.

During British colonial rule of India, the government began to worry about the number of venomous cobras in Delhi, and so instituted a reward for every dead snake brought to officials. In a wonderful demonstration of the importance of second-order thinking, Indian citizens dutifully complied and began breeding venomous snakes to kill and bring to the British. By the time the experiment was over, the snake problem was worse than when it began. The Raj government had gotten exactly what it asked for.

***

There's another story, much more perverse, from the Congolese massacre in the late 19th and early 20th century under Belgian rule — the period Joseph Conrad wrote about in Heart of Darkness. (Some of you might know the tale better as Apocalypse Now, which was a Vietnam retelling of Heart of Darkness.)

As the wickedly evil King Leopold II of Belgium forced the Congolese to produce rubber, he sent in his Force Publique to whip the natives into shape through genocidal murder. (Think of them as a Belgian Congo version of the Nazi's SS.) Fearful that his soldiers would waste bullets hunting animals, Leopold ordered that the soldiers bring back the severed hands of dead Congolese as proof that they were enforcing the rubber decree. (Leopold himself never even visited his colony, although he did cause at least 10 million deaths.)

Given that Leopold's quotas were impossible to meet, shortfalls were common. And with the incentives placed on Belgian soldiers, many decided they could get human hands more easily than meeting rubber quotas, while still conserving their ammo for hunting. An interesting result ensued, as described by Bertrand Russell in his book Freedom and Organisation, 1814-1914.

Each village was ordered by the authorities to collect and bring in a certain amount of rubber – as much as the men could collect and bring in by neglecting all work for their own maintenance. If they failed to bring the required amount, their women were taken away and kept as hostages in compounds or in the harems of government employees. If this method failed, native troops, many of them cannibals, were sent into the village to spread terror, if necessary by killing some of the men; but in order to prevent a waste of cartridges, they were ordered to bring one right hand for every cartridge used. If they missed, or used cartridges on big game, they cut off the hands of living people to make up the necessary number.

In fact, as Peter Forbath describes in his book The River Congo, the soldiers were paid explicitly on the number of hands they collected. So hands gained in demand.

The baskets of severed hands, set down at the feet of the European post commanders, became the symbol of the Congo Free State. … The collection of hands became an end in itself. Force Publique soldiers brought them to the stations in place of rubber; they even went out to harvest them instead of rubber… They became a sort of currency. They came to be used to make up for shortfalls in rubber quotas, to replace… the people who were demanded for the forced labour gangs; and the Force Publique soldiers were paid their bonuses on the basis of how many hands they collected.

Looking to bolster an economy of rubber, Leopold II got an economy of severed hands. Like the British Raj, he got exactly what he asked for.

***

Joseph Heath describes another case of incentives gone wrong in his book Economics Without Illusions, citing the book Out of Poverty: And Into Something More Comfortable by John Stackhouse.

Stackhouse spent time in Ghana in the 1990s, and noticed that the “socially conscious” retailer The Body Shop was an enormous purchaser of shea nuts, which were produced in great quantities by Ghanians. The Body Shop used shea butter, produced from the nuts, to produce a variety of skin products, and as a part of its socially conscious mission, and its role in the Trade, Not Aid campaign, decided they were willing to pay above-market prices to Ghanian farmers, to the tune of an extra 50% on top of the going rate. And on top of that premium price, The Body Shop also decided to throw in a bonus payment for every kilogram of shea butter purchased, to be used for local development projects at the farmers' discretion.

Thinking that the Body Shop's early shea nut orders were a harbinger of a profitable boom, farmers began to rapidly up their production of shea butter. Stackhouse describes the result in his book:

A shea-nut rush was on, and neither the British chain nor the aid agencies were in a position to absorb the glut. In the first season, the northern villages, which normally produced two tonnes of shea butter a year, churned out twenty tonnes, nearly four times what the Body Shop wanted….Making matters worse, the Body Shop, after discovering it had overestimated the international market for shea products, quickly scaled back its orders for the next season. In Northern Ghana, it wasn't long before shea butter prices plunged.

Unfortunately, in its desire to do good in a poor part of the world, the Body Shop created a situation which was worse than when they began: Massive resources went into shea butter production only to find that it was not needed, and the overproduction of nuts ended up being mostly worthless.

These three cases above, and many more, lead us to the conclusion that people follow incentives the way ants follow sugar. It's imperative that we think very literally about the incentive systems we create. Remember that incentives are not only financial. Frequently it's something else: prestige, freedom, time, titles, sex, power, admiration…all of these and many other things are powerful incentives. But if we're not careful, we do the equivalent of creating an economy for severed hands.

***

Still Interested? Learn about one company that understood and harnessed incentives correctly, or re-read Munger's discussion on incentive-caused bias in his famous speech on human psychology. Also, check out the Distorting Power of Incentives.

How (Supposedly) Rational People Make Decisions

There are four principles that Gregory Mankiw outlines in his multi-disciplinary economics textbook Principles of Economics.

I got the idea for reading an Economics textbook from Charlie Munger, the billionaire business partner of Warren Buffett. He said:

Economics was always more multidisciplinary than the rest of soft science. It just reached out and grabbed things as it needed to. And that tendency to just grab whatever you need from the rest of knowledge if you’re an economist has reached a fairly high point in Mankiw’s new textbook Principles of Economics. I checked out that textbook. I must have been one of the few businessmen in America that bought it immediately when it came out because it had gotten such a big advance. I wanted to figure out what the guy was doing where he could get an advance that great. So this is how I happened to riffle through Mankiw’s freshman textbook. And there I found laid out as principles of economics: opportunity cost is a superpower, to be used by all people who have any hope of getting the right answer. Also, incentives are superpowers.

So we know that we can add Opportunity cost and incentives to our list of Mental Models.

Let's dig in.

Principle 1: People Face Trade-offs

You have likely heard the old saying, “There is no such thing as a free lunch.” There is much to this old adage and it's one we often forget when making decisions. To get more of something we like we almost always have to give up something else we like. A good heuristic in life is that if someone offers you something for nothing, turn it down.

Making decisions requires trading off one goal against another.

Consider a student who must decide how to allocate her most valuable resource—her time. She can spend all of her time studying economics, spend all of it studying psychology, or divide it between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other. And for every hour she spends studying, she gives up an hour that she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money.

Or consider parents deciding how to spend their family income. They can buy food, clothing, or a family vacation. Or they can save some of the family income for retirement or for children’s college education. When they choose to spend an extra dollar on one of these goods, they have one less dollar to spend on some other good.

These are rather simple examples but Mankiw offers some more complicated ones. Consider the trade-off that society faces between efficiency and equality.

Efficiency means that society is getting the maximum benefits from its scarce resources. Equality means that those benefits are distributed uniformly among society’s members. In other words, efficiency refers to the size of the economic pie, and equality refers to how the pie is divided into individual slices.

When government policies are designed, these two goals often conflict. Consider, for instance, policies aimed at equalizing the distribution of economic well-being. Some of these policies, such as the welfare system or unemployment insurance, try to help the members of society who are most in need. Others, such as the individual income tax, ask the financially successful to contribute more than others to support the government. Though they achieve greater equality, these policies reduce efficiency. When the government redistributes income from the rich to the poor, it reduces the reward for working hard; as a result, people work less and produce fewer goods and services. In other words, when the government tries to cut the economic pie into more equal slices, the pie gets smaller.

Principle 2: The Cost of Something Is What You Give Up to Get It

Because of trade-offs, people face decisions between the costs and benefits of one course of action and the cost and benefits of another course. But costs are not as obvious as they might first appear — we need to apply some second-level thinking:

Consider the decision to go to college. The main benefits are intellectual enrichment and a lifetime of better job opportunities. But what are the costs? To answer this question, you might be tempted to add up the money you spend on tuition, books, room, and board. Yet this total does not truly represent what you give up to spend a year in college.

There are two problems with this calculation. First, it includes some things that are not really costs of going to college. Even if you quit school, you need a place to sleep and food to eat. Room and board are costs of going to college only to the extent that they are more expensive at college than elsewhere. Second, this calculation ignores the largest cost of going to college—your time. When you spend a year listening to lectures, reading textbooks, and writing papers, you cannot spend that time working at a job. For most students, the earnings they give up to attend school are the single largest cost of their education.

The opportunity cost of an item is what you give up to get that item. When making any decision, decision makers should be aware of the opportunity costs that accompany each possible action. In fact, they usually are. College athletes who can earn millions if they drop out of school and play professional sports are well aware that the opportunity cost of their attending college is very high. It is not surprising that they often decide that the benefit of a college education is not worth the cost.

Principle 3: Rational People Think at the Margin

For the sake of simplicity economists normally assume that people are rational. While this causes many problems, there is an undercurrent of truth to the fact that people systematically and purposefully “do the best they can to achieve their objectives, given opportunities.” There are two parts to rationality. The first is that your understanding of the world is correct. Second you maximize the use of your resources toward your goals.

Rational people know that decisions in life are rarely black and white but usually involve shades of gray. At dinnertime, the question you face is not “Should I fast or eat like a pig?” More likely, you will be asking yourself “Should I take that extra spoonful of mashed potatoes?” When exams roll around, your decision is not between blowing them off and studying twenty-four hours a day but whether to spend an extra hour reviewing your notes instead of watching TV. Economists use the term marginal change to describe a small incremental adjustment to an existing plan of action. Keep in mind that margin means “edge,” so marginal changes are adjustments around the edges of what you are doing. Rational people often make decisions by comparing marginal benefits and marginal costs.

Thinking at the margin works for business decisions.

Consider an airline deciding how much to charge passengers who fly standby. Suppose that flying a 200-seat plane across the United States costs the airline $100,000. In this case, the average cost of each seat is $100,000/200, which is $500. One might be tempted to conclude that the airline should never sell a ticket for less than $500. But a rational airline can increase its profits by thinking at the margin. Imagine that a plane is about to take off with 10 empty seats and a standby passenger waiting at the gate is willing to pay $300 for a seat. Should the airline sell the ticket? Of course, it should. If the plane has empty seats, the cost of adding one more passenger is tiny. The average cost of flying a passenger is $500, but the marginal cost is merely the cost of the bag of peanuts and can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal cost, selling the ticket is profitable.

This also helps answer the question of why diamonds are so expensive and water is so cheap.

Humans need water to survive, while diamonds are unnecessary; but for some reason, people are willing to pay much more for a diamond than for a cup of water. The reason is that a person’s willingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit, in turn, depends on how many units a person already has. Water is essential, but the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large.

A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.

Principle 4: People Respond to Incentives

Incentives induce people to act. If you use a rational approach to decision making that involves trade offs and comparing costs and benefits, you respond to incentives. Charlie Munger once said: “Never, ever, think about something else when you should be thinking about the power of incentives.”

Incentives are crucial to analyzing how markets work. For example, when the price of an apple rises, people decide to eat fewer apples. At the same time, apple orchards decide to hire more workers and harvest more apples. In other words, a higher price in a market provides an incentive for buyers to consume less and an incentive for sellers to produce more. As we will see, the influence of prices on the behavior of consumers and producers is crucial for how a market economy allocates scarce resources.

Public policymakers should never forget about incentives: Many policies change the costs or benefits that people face and, as a result, alter their behavior. A tax on gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars. That is one reason people drive smaller cars in Europe, where gasoline taxes are high, than in the United States, where gasoline taxes are low. A higher gasoline tax also encourages people to carpool, take public transportation, and live closer to where they work. If the tax were larger, more people would be driving hybrid cars, and if it were large enough, they would switch to electric cars.

Failing to consider how policies and decisions affect incentives often results in unforeseen results.

Paul Graham on Free Speech, Suburbia, Getting Rich, and Nerds

“I think a society in which people can do and say what they want will also tend to be one in which the most efficient solutions win.”

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Paul Graham is a programmer, writer, and investor. His 2004 anthology Hackers and Painters explores not only topics like where good ideas come from but also touches on social and cultural issues such as free speech, getting rich, and geek culture. Here are a few interesting tidbits worth pondering.

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Free Speech

I wonder how Graham thinks about this in the context of organizations. Ideas are the lifeblood of organizations but it seems to me that in certain workplaces “free speech” is not so free. The best ideas fall to politics, consensus, and pettiness. Suffering from such intellectual corruption dysfunctional behaviour results, which causes an ultimately self-correcting spiral into bankruptcy.

I think a society in which people can do and say what they want will also tend to be one in which the most efficient solutions win, rather than those sponsored by the most influential people. Authoritarian countries become corrupt; corrupt countries become poor; and poor countries are weak.

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Getting Rich

Graham illuminates how the industrial revolution changed the incentives from corruption to wealth creation as the primary vehicle to getting rich.

Once it became possible to get rich by creating wealth, society as a whole started to get richer very rapidly. Nearly everything we have was created by the middle class. Indeed, the other two classes have effectively disappeared in industrial societies, and their names been given to either end of the middle class. (In the original sense of the word, Bill Gates is middle class.)

But it was not till the Industrial Revolution that wealth creation definitively replaced corruption as the best way to get rich. In England, at least, corruption only became unfashionable (and in fact only started to be called “corruption”) when there started to be other, faster ways to get rich.

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Nerds

Highlighting the difference between the popular kids and nerds, Graham writes:

While the nerds were being trained to get the right answers, the popular kids were being trained to please.

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Suburbia

In exploring suburbia, Graham looks at how the environment encourages helicopter parenting.

Why do people move to suburbia? To have kids! So no wonder it seemed boring and sterile. The whole place was a giant nursery, an artificial town created explicitly for the purpose of breeding children.

Where I grew up, it felt as if there was nowhere to go, and nothing to do. This was no accident. Suburbs are deliberately designed to exclude the outside world, because it contains things that could endanger children.

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Still Curious?

All of the essays in Hackers & Painters: Big Ideas from the Computer Age are worth reading and thinking about.