www.ThinkMentalModels.com

How people like US get really smart

The better decision maker has at his/her disposal repertoires of possible actions; checklists of things to think about before he acts; and he has mechanisms in his mind to evoke these, and bring these to his conscious attention when the situations for decision arise.

! Herbert Simon, Nobel Laureate

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Behavior Models! 9Availability ! 9

Fool Yourself Tendency ! 10

Habit! 11

Human Action! 13

Negotiation! 14

Operant Conditioning! 15

Pain - Pleasure ! 16

Pavlovian Conditioning! 17

PLAGGES - 7 Sins! 18

Reader or Listener?! 19

Science of Achievement! 20

Behavior - Influence Models! 21Authority! 21

Commitment & Consistency ! 22

Deprival Syndrome ! 23

Framing the Issue ! 24

Incentive-Cause Bias! 25

Liking! 26

Reciprocation! 27

Scarcity ! 28

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Social Proof! 29

Big Thinking Models! 30As Simple As Possible ! 30

Big Picture Math! 32

Deduction or Induction?! 35

Disconfirming Evidence ! 36

Game Theory ! 37

Getting to Why ! 39

Ideas ! 40

Incentives ! 42

Information! 43

Invert! 44

Marginal Thinking! 45

Metaphors ! 46

Opportunity Costs! 48

Probabilistic Thinking! 49

Reductionism! 52

Scientific Method! 53

Spend - Conserve! 54

Systems Thinking! 56

The Argument! 57

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Unintended Consequences ! 59

80:20 Rule! 61

Business Models! 62Arbitrage! 62

Brand! 63

Business Model! 64

Core Competency ! 66

Cost Leader! 68

Culture! 69

Disruptive Innovation! 70

Entrepreneurship! 71

GRICS (Retailers)! 72

Key Factors for Success ! 73

Management Fanaticism! 74

Network Effect! 76

Porters 5-forces! 77

Pricing Ability ! 78

Protective Moat! 79

Scale ! 80

Specialization! 82

Standardization! 83

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Surf a Wave ! 84

Technology ! 85

Business - Financial Models! 86Bob-around Earnings! 86

Business Metrics! 87

Intrinsic Value! 88

Mr. Market! 90

Reversion-to-mean! 91

Scandal! 92

The Magic Formula ! 93

Business - Goods Models! 94Diminishing Utility! 94

Nature of Goods ! 95

Maslows Triangle! 96

Total Utility! 97

Value ! 98

Decision Models! 99Margin of Safety! 99

Pr O A C T! 100

Process v Outcome ! 101

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The Agency Problem! 102

Trade-offs ! 103

Your Circle of Competence ! 104

Decision - Common Mistakes Models! 105Anchor Effect! 105

Bayes Theorem! 106

Contrast Principle ! 107

Correlation or Causation! 108

Doubt Avoidance! 109

Extrapolation! 110

False Mental Accounting! 111

Groupthink! 112

Ideology ! 113

Information Bias ! 114

Over-optimism! 116

Overweighting Numbers ! 117

Statistics! 118

Economic Models! 119Animal Spirits! 119

Asymmetric Information! 121

Bubbles! 122

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Comparative Advantage ! 124

Creative Destruction! 125

Diminishing Returns! 127

Equilibrium! 128

Externalities! 129

Markets! 130

Moral Hazard! 131

Price Discrimination! 132

Property Rights! 133

Public/Private Goods ! 134

Sunk Costs! 135

Switching Costs! 136

Transaction Costs ! 137

System Models! 138Back-up/Redundancy! 138

Bottlenecks ! 139

Complex Adaptive Systems! 140

Evolution! 142

Feedback Loops ! 144

Momentum! 145

Newtons Laws! 146

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Power Law! 147

Reflexivity! 148

Six Degrees! 149

System Boundary! 151

Thermodynamics! 153

8

Behavior ModelsAvailability

A Behavior Changer

If a product or service is widely and conveniently available, consumers are less likely to try the competition. Further, the consumer may change his/her behavior in order to take advantage of the easily available product/service.

This idea plays to the concept of scale, whether it be in terms of physical presence or intense distribution.

Think Starbucks, where being everywhere links to the creatures of habit principle, reducing the need to try other coffee establishments; and consider how people have adapted their behavior to take advantage of Starbucks many locations - social gatherings, business meetings, study areas etc.

Another behavior changer could be a dominant local supermarket that encourages consumers to increase shopping frequency, as a result of its convenient location, opening hours and fresh daily produce.

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Fool Yourself Tendency

I Think She Really Likes Me

Cognitive Dissonance: When feelings and facts are in opposition, people will find, or invent, a way to reconcile them.

Richard Feynman stated it more memorably:

"The first rule is not to fool yourself, and you are the easiest person to fool."

Eric Beinhocker in The Origin of Wealth expands on the idea:

People have a general bias toward spinning their reality in positive ways and ignoring uncomfortable facts. It takes a real jolt to make them see that everything is not O.K.

[Experts] refer to such optimism in the face of countervailing facts as delusional optimism. Jack Welch was infamous for popping the unduly optimistic bubbles of his people, and one of his dicta was that managers must face reality [and] see things as they are not the way they wished it would be.

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Habit

My Burger Habit

The difficulty of getting consumers to change their behavior cannot be underestimated. It is one aspect of human behavior that can lead to outsize profits for companies.

Humans have a tendency to habituate to any unpleasant stimulus, from pain and sorrow to a persistent car alarm.

The idea is explained in Value Investing by Bruce Greenwald et al:

In an open and competitive economy, there are only a limited number of ways in which customer behavior leads to captivity. Habit, usually associated with high frequency purchase, is probably the most powerful. For a soda company to compete with Coca-Cola, it must induce Coca-Cola drinkers to stop drinking their favorite beverage.

This is no easy task. Consumer studies and historical experience suggest that Coke drinkers are fiercely attached to their Cokes.

By comparison, the attachment to Budweiser, another leading beverage brand, is weaker. When diners go to Chinese, Japanese, or Mexican restaurants, they are not reluctant to ordering a beer from that country, but the chances that they will ask for a local cola are slim.

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The tendency for people to stay with the status quo has produced the default behavior option. Thaler and Sunstein describe this idea in Nudge.

For lots of reasons, people have a more general tendency to stick with their current situation. This phenomenon... dubbed the status quo bias, has been demonstrated in numerous situations. Most teachers know that students tend to sit in the same seats in class, even without a seating chart. Status quo bias is easily exploited (Examples include never-changing asset allocations in 401(k) plans; automatic renewals of subscriptions on credit cards etc.).

One of the causes of status quo bias is a lack of attention. Many people adopt what we will call the yeah, whatever heuristic. A good illustration is the carryover effect in television viewing.

The combination of loss aversion with mindless choosing implies that if an option is designated as the default, it will attract a large market share. Default options thus act as powerful nudges. In many contexts defaults have some extra nudging power because consumers may feel, rightly or wrongly, that default options come with an implicit endorsement from the default setter, be it the employer, government, or TV scheduler.

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Human Action

A Vision of a Better State

Ludwig von Mises, in 'Human Action', describes the conditions necessary for a person to act:

! [1. Unease or dissatisfaction with the present state of affairs]! [2. A vision of a better state]! [3. Belief that they can reach the better state]!

! Acting man is eager to substitute a more satisfactory state of affairs for a less satisfactory one. His mind imagines conditions which suit him better, and his action aims at bringing about this desired state. The incentive that impels a man to act is always some uneasiness. A man perfectly content with the state of his affairs would have no incentive to change things. He would have neither wishes nor desires; he would be perfectly happy. He would not act; he would simply live free from care.

! But to make a man act, uneasiness and the image of a more satisfactory state alone are not sufficient. A third condition is required: the expectation that purposeful behavior has the power to remove or at least to alleviate the felt uneasiness. In the absence of this condition no action is feasible.

! Action is not simply giving preference. Man also shows preference in situations in which things and events are unavoidable or are believed to be so. Thus a man may prefer sunshine to rain and may wish that the sun would dispel the clouds. He who only wishes and hopes does not interfere actively with the course of events and with the shaping of his own destiny. But acting man chooses, determines, and tries to reach an end. Of two things both of which he cannot have together he selects one and gives up the other. Action therefore always involves both taking and renunciation.

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Negotiation

Roger Fisher & William Ury outline their methods for principled negotiation in 'Getting To Yes':

... in contrast to positional bargaining, the principled negotiation method of focusing on basic interests, mutually satisfying options, and fair standards typically results in a wise agreement. The method permits you to reach a gradual consensus on a joint decision efficiently without all the transactional costs of digging in to positions only to have to dig yourself out of them.

People: Separate the people from the problem.

Interests: Focus on interests, not positions.When you do look behind opposed positions for the motivating interests, you can often find an alternative position which meets not only your interests but theirs as well. The Egyptian-Israeli peace treaty blocked out at Camp David in 1978 demonstrates the usefulness of looking behind positions. Israel's interest lay in security; they did not want Egyptian tanks poised on their border ready to roll across at any time. Egypt's interest lay in sovereignty; the Sinai has been part of Egypt since the time of the Pharaohs. At Camp David, President Sadat of Egypt and Prime Minister Begin of Israel agreed to a plan that would return the Sinai to complete Egyptian sovereignty and, by demilitarizing large areas, would still assure Israeli security.

Options: Generate a variety of possibilities before deciding what to do.

Criteria: Insist that the result be based on some objective standard.An episode during the Law of the Sea Conference illustrates the merits of using objective criteria. At one point, India, representing the Third World bloc, proposed an initial fee for companies mining in the deep seabed of $60 million per site. The United States rejected the proposal, suggesting there be no initial fee. Both sides dug in; the matter became a contest of will. Then someone discovered that the Massachusetts Institute of Technology (MIT) had developed a model for the economics of deep-seabed mining. This model, gradually accepted by the parties as objective, provided a way of evaluating the impact of any fee proposal on the economics of mining.

BATNA: What is your BATNA - your Best Alternative To a Negotiated Agreement? That is the standard against which any proposed agreement should be measured. That is the only standard which can protect you both from accepting terms that are too unfavorable and from rejecting terms it would be in your interest to accept.

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Operant Conditioning

Killing the Messenger

Operant conditioning is discussed by author B.F. Skinner in 'About Behaviorism':

A behavior is followed by a consequence, and the nature of the consequence modifies the organism's tendency to repeat the behavior in the future.

The behavior is said to be strengthened by its consequences, and for that reason the consequences themselves are called 'reinforcers'.

The probability of behavior depends upon the kind or frequency of reinforcement in similar situations in the past.

The things which make us happy are the things which reinforce us, but it is the things, not the feelings, which must be identified and used in prediction, control, and interpretation.

In The Origin of Wealth, Eric Beinhocker talks of Freud and Skinner :

Preferences are a psychological phenomenon. Freud postulated that our material needs are driven by the animal needs of our id and kept in check by our superego - thus, our economic preferences are the result of battles between I really want that expensive car now! and But I need to save for my childrens education!

B.F. Skinner, on the other hand, thought that preferences were essentially learned. So, a Skinnerian might say that we want the fancy car because we have learned from society that fancy cars are desirable, and the maker of the car has taught us to want it by exposing us to alluring marketing messages.

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Pain - Pleasure

Pain or Pleasure?

The sovereign masters that determine what people will do are not pleasure and pain, but fallible memories of pleasure and pain.

Real pleasure is derived from experiences over physical goods, pastimes over knick-knacks, and doing over having.

Anthony Robbins describes the principle in 'Awaken the Giant Within':

What is this force that is controlling you even now and will continue to do so for the rest of your life? PAIN and PLEASURE! Everything you and I do, we do either out of our need to avoid pain or our desire to gain pleasure.

! 'If you are distressed by anything external, the pain is not due to the thing itself but to your own estimate of it; and this you have the power to revoke at any moment.' - Marcus Aurelius

The truth is that we can learn to condition our minds, bodies, and emotions to link pain or pleasure to whatever we choose. By changing what we link pain and pleasure to, we will instantly change our behaviors.

! 'I conceive that pleasures are to be avoided if greater pains be the consequence, and pains to be coveted that will terminate in greater pleasures.' - Michel De Montaigne

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Pavlovian Conditioning

Time to Get a Beer

Conditional reflexes that are taught or learnt sub-consciously.

The application is discussed in 'Poor Charlie's Almanack', by Charles Munger:

! Pavlov's most famous experiment showed that dogs tend to salivate before food is actually delivered to their mouths. This result led him to a long series of experiments in which he manipulated the stimuli occurring before the presentation of food. He thereby established the basic laws for the establishment and extinction of what he called 'conditional reflexes', later mistranslated from the original Russian as 'conditioned reflexes'.

[Charles Munger describes a hypothetical situation in which the Pavlovian conditioning concept could have been used as someone was dreaming-up Coca-Cola]

! In Pavlovian conditioning, powerful effects come from mere association. The neural system of Pavlov's dog causes it to salivate at the bell it can't eat. And the brain of man yearns for the type of beverage held by the pretty woman he can't have. And so... we must use every sort of decent, honorable Pavlovian conditioning we can think of. For as long as we are in business, our beverage and its promotion must be associated in consumer minds with all things consumers like or admire.! Such extensive Pavlovian conditioning will cost a lot of money, particularly for advertising. We will spend big money as far ahead as we can imagine. But the money will be effectively spent. As we expand fast in our new-beverage market, our competitors will face gross disadvantages of scale in buying advertising to create the Pavlovian conditioning they need.

! Moreover, Pavlovian effects from mere association will help us choose the flavor, texture, and color of our new beverage. Considering Pavlovian effects, we will have wisely chosen the exotic and expensive-sounding name 'Coca-Cola', instead of a pedestrian name like 'Glotz's Sugared, Caffeinated Water'. For similar Pavlovian reasons, it will be wise to have our beverage look pretty much like wine instead of sugared water. And so, we will artificially color our beverage if it comes out clear. And we will carbonate our water, making our product seem like champagne, or some other expensive beverage.

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PLAGGES - 7 Sins

Naughty but Nice

PRIDE - excessive belief in one's abilities or vanityLUST - inordinate craving for a person or thingANGER - individual opting for furyGREED - desire for material gain or wealthGLUTTONY - desire to consume more than that which one requiresENVY - desire for others' traits, status, abilities, or situationSLOTH - avoidance of physical/mental work

'The Moral Animal', by Robert Wright:

! What the theory of natural selection says, rather, is that people's minds were designed to maximize fitness in the environment in which those minds evolved... the 'ancestral environment'... the question, properly put, is always whether a trait would be in the 'genetic interest' of someone in the [ancestral environment]. Only traits that would have propelled the genes responsible for them through the generations in our ancestral social environment should, in theory, be part of human nature today.

! ... there are recurring themes among contemporary hunter-gatherer societies, and they suggest that some features probably stayed fairly constant during much of the evolution of the human mind. For example: people grew up near close kin in small villages where everyone knew everyone else and strangers didn't show up very often.

! ... whatever the ancestral environment was like, it wasn't much like the environment we're in now. We aren't designed to stand on crowded subway platforms, or to live in suburbs next door to people we never talk to, or to get hired or fired...

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Reader or Listener?

Do I Need to Spell it Out?

Peter Drucker presents this concept in 'Management Challenges for the 21st Century':

! The first thing to know about how one performs is whether one is a reader or a listener. Yet very few people even know that there are readers and there are listeners, and that very few people are both.

! When he was Commander-in-Chief of the Allied Forces in Europe, General Dwight Eisenhower was the darling of the press, and attendance at one of his press conferences was considered a rare treat. These conferences were famous for their style, for Eisenhower's total command of whatever question was being asked and, equally, for his ability to describe a situation or to explain a policy in two or three beautifully polished and elegant sentences. Ten years later, President Eisenhower was held in open contempt by his former admirers. They considered him a buffoon. He never, they complained, even addressed himself to the question asked, but rambled on endlessly about something else. And he was constantly ridiculed for butchering the King's English in his incoherent and ungrammatical answers. Yet Eisenhower had owed his brilliant career in large measure to a virtuoso performance as a speechwriter for General MacArthur, one of the most demanding stylists in American public life.

! The explanation: Eisenhower apparently did not know himself that he was a reader and not a listener. When he was Commander-in-Chief in Europe, his aides made sure that every question from the press was handed in, in writing, at least half an hour before the conference began. And then Eisenhower was in total command.

! [on the other hand] Roosevelt knew himself to be so much of a listener that he insisted that everything first be read out loud to him - only then did he look at anything in writing.

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Science of Achievement

A Big Hairy Audacious Goal - BHAG

The science of taking ideas, and dreams, and making them happen is generally considered as:

1. Setting a goal.2. Creating a written plan to reach the goal within a certain timeframe.3. Taking action by implementing the plan.4. Getting feedback from actions - negative and positive - and making changes, if necessary.

The process is underpinned by a strong 'self-concept' as described in 'Maximum Achievement' by Brian Tracy -

The access ports to your subconscious are both internal and external. Internally, you are affected by your thoughts, your mental pictures or imagination and your feelings. Externally, you are influenced by your suggestive environment, by everything that registers on your conscious mind.

The thoughts you think, the images you hold, the feelings you experience trigger words and actions consistent with them.

Every attitude, behavior, value, opinion, belief and fear you have today has been learned. Therefore, if there are elements of your self-concept that do not serve your purposes, you can unlearn them.

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Behavior - Influence ModelsAuthority

Don't Challenge Authority

The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice':

! The strength of this tendency to obey legitimate authorities comes from systematic socialization practices designed to instill in members of society the perception that such obedience constitutes correct conduct. In addition, it is frequently adaptive to obey the dictates of genuine authorities because such individuals usually possess high levels of knowledge, wisdom, and power. For these reasons, deference to authorities can occur in a mindless fashion as a kind of decision-making shortcut.

! The worrisome possibility arises, then, that when a physician makes a clear error, no one lower in the hierarchy will think to question it - precisely because, once a legitimate authority has given an order, subordinates stop thinking in the situation and start reacting. Mix this kind of click, whirr response into a complex hospital environment and mistakes are inevitable. Indeed, a study by the U.S. Health Care Financing Administration shows that, for patient medication alone, the average hospital has a 12 percent daily error rate.

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Commitment & Consistency

Very Public Commitment

The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice':!! Once we make a choice or take a stand, we will encounter personal and interpersonal pressures to behave consistently with that commitment. Those pressures will cause us to respond in ways that justify our earlier decision.

! Indeed, we all fool ourselves from time to time in order to keep our thoughts and beliefs consistent with what we have already done or decided.

! For instance, suppose you wanted to increase the number of people in your area who would agree to go door-to-door collecting donations for your favorite charity. You would be wise to study the approach taken by social psychologist Steven J. Sherman. He simply called a sample of Bloomington, Indiana, residents as part of a survey he was taking and asked them to predict what they would say if asked to spend three hours collecting money for the American Cancer Society. Of course, not wanting to seem uncharitable to the survey-taker or to themselves, many of these people said that they would volunteer. The consequence of this subtle commitment procedure was a 700 percent increase in volunteers when, a few days later, a representative of the American Cancer Society did call and ask for neighborhood canvassers.

! ...he did something that fits perfectly with the commitment/consistency principle you talk about. He told his receptionists to stop saying, "Please call us if you change your plans," and to start asking, "Will you please call us if you change your plans," and to wait for a response. His no-show rate immediately dropped from 30 percent to 10 percent.

! In all, it seems that active commitments give us the kind of information we use to shape self-image, which then shapes future actions, which solidify the new self-image.

! Commitments are most effective when they are active, public, effortful, and viewed as internally motivated (not coerced).

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Deprival Syndrome

Ready for Any Takeaway

Charles Munger, in 'Poor Charlie's Almanack', describes the concept:

! The quantity of man's pleasure from a ten-dollar gain does not exactly match the quantity of his displeasure from a ten-dollar loss. That is, the loss seems to hurt much more than the gain seems to help.

! A man ordinarily reacts with irrational intensity to even a small loss, or threatened loss, of property, love, friendship, dominated territory, opportunity, status, or any valued thing.

! Deprival-Superreaction Tendency has ghastly effects in labor relations. Most of the deaths in the labor strife that occurred before World War I came when employers tried to reduce wages. Nowadays, we see fewer deaths and more occasions when whole companies disappear, as competition requires either takeaways from labor - which it will not consent to - or death of the business. Deprival-Superreaction Tendency causes much of this labor resistance, often in cases where it would be in labor's interest to make a different decision.

'Why Smart People Make Big Money Mistakes and How to Correct Them', by Gary Belsky & Thomas Gilovich:

Behavioral economists describe the takeaway idea as the 'endowment effect'. Businesses understand this effect - once you take a product home and use it, there's a strong chance that the endowment effect will kick in; whatever value you might have placed on, say, a stereo at a store will likely be increased once it sits in your den for a few weeks.

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Framing the Issue

Necessary or Welfare?

'If you would persuade, appeal to interest and not to reason' - Ben Franklin

Robert Rubin describes, 'In an Uncertain World':

I learned through this episode that from the moment a President presents an important proposal to the nation, he has to spend time painting a picture of it his way. Otherwise, his opponents will color it their way and put him on the defensive. Our opponents went right to work casting our plan as a tax increase - a grave distortion in relation to the majority of taxpayers, who saw no increase in their income taxes and a gas tax estimated at only $36 a year for an average family of four.

We, on the other hand, spent little time explaining how few people were affected by the tax increase or, more important, painting our own picture of the program as a restoration of fiscal discipline to create jobs, increase standards of living, and promote economic growth.

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Incentive-Cause Bias

Potential for Bad Behavior

Charles Munger, in 'Poor Charlie's Almanack', describes the concept:

! One of the most important consequences of incentive superpower is what I call 'incentive-caused bias'. A man has an acculturated nature making him a pretty decent fellow, and yet, driven both consciously and subconsciously by incentives, he drifts into immoral behavior in order to get what he wants, a result he facilitates by rationalizing his bad behavior.

! Widespread incentive-caused bias requires that one should often distrust, or take with a grain of salt, the advice of one's professional advisor, even if he is an engineer. The general antidotes here are: 1) fear professional advice when it is especially good for the advisor; 2) learn and use the basic elements of your advisor's trade as you deal with your advisor; and 3) double check, disbelieve, or replace much of what you're told, to the degree that seems appropriate after objective thought.

! The inevitable ubiquity of incentive-caused bias has vast, generalized consequences. For instance, a sales force living only on commissions will be much harder to keep moral than one under less pressure from the compensation arrangement. On the other hand, a purely commissioned sales force may well be more efficient per dollar spent. Therefore, difficult decisions involving trade-offs are common in creating compensation arrangements in the sales function.

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Liking

Easy to Like

The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice':

! People prefer to say yes to individuals they know and like. Recognizing this rule, compliance professionals commonly increase their effectiveness by emphasizing several factors that increase their overall attractiveness and likability.

! Physical attractiveness seems to engender a halo effect that extends to favorable impressions of other traits such as talent, kindness, and intelligence. As a result, attractive people are more persuasive both in terms of getting what they request and in changing others' attitudes.! A second factor that influences liking and compliance is similarity. We like people who are like us, and we are more willing to say yes to their requests, often in an unthinking manner.

! "It's gotten to the point now where I hate to be invited to Tupperware parties. I've got all the containers I need; and if I wanted any more, I could buy another brand cheaper in the store. But when a friend calls up, I feel like I have to go. And when I get there, I feel like I have to buy something. What can I do? It's for one of my friends."

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Reciprocation

Just Reciprocating

The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice':

! According to sociologists and anthropologists, one of the most widespread and basic norms of human culture is embodied in the rule for reciprocation. The rule requires that one person try to repay, in kind, what another person has provided. This sense of future obligation within the rule makes possible the development of various kinds of continuing relationships, transactions, and exchanges that are beneficial to society. Consequently, all members of the society are trained from childhood to abide by the rule or suffer serious social disapproval.

! I know of no better illustration of the way reciprocal obligations can reach long and powerfully into the future than the perplexing story of $5,000 of relief aid that was exchanged between Mexico and Ethiopia. In 1985, Ethiopia could justly lay claim to the greatest suffering and privation in the world. Under these circumstances, I would not have been surprised to learn of a $5,000 relief donation from Mexico... I remember my feeling of amazement, though, when a brief newspaper item I was reading insisted that the aid had gone in the opposite direction.

! Fortunately, a journalist who had been as bewildered as I by the Ethiopians' actions had asked for an explanation. The answer he received offered eloquent validation of the reciprocity rule: Despite the enormous needs prevailing in Ethiopia, the money was being sent to Mexico because, in 1935, Mexico had sent aid to Ethiopia when it was invaded by Italy.

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Scarcity

Now She Really Wants It

The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice':

! According to the scarcity principle, people assign more value to opportunities when they are less available. The use of this principle for profit can be seen in such compliance techniques as the 'limited number' and 'deadline' tactics, wherein practitioners try to convince us that access to what they are offering is restricted by amount or time.

! According to psychological reactance theory, we respond to the loss of freedoms by wanting to have them (along with the goods and services connected to them) more than before.

! The scarcity principle is most likely to hold true under two optimizing conditions. First, scarce items are heightened in value when they are newly scarce. That is, we value those things that have become recently restricted more than those that were restricted all along. Second, we are most attracted to scarce resources when we compete with others for them.

! People seem to be more motivated by the thought of losing something than by the thought of gaining something of equal value. For instance, college students experienced much stronger emotions when asked to imagine losses as opposed to gains in their romantic relationships or in their grade point averages. Especially under conditions of risk and uncertainty, the threat of potential loss plays a powerful role in human decision making.

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Social Proof

Do They Know Something?

The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice':

! We view a behavior as correct in a given situation to the degree that we see others performing it. Whether the question is what to do with an empty popcorn box in a movie theater, how fast to drive on a certain stretch of highway, or how to eat chicken at a dinner party, the actions of those around us will be important guides in defining the answer.! Social proof is most influential under two conditions. The first is uncertainty. When people are unsure, when the situation is ambiguous, they are more likely to attend to the actions of others and to accept those actions as correct. The second condition under which social proof is most influential is similarity: People are more inclined to follow the lead of similar others.

! Advertisers love to inform us when a product is the 'fastest-growing' or 'largest-selling' because they don't have to convince us directly that the product is good; they need only say that many others think so, which seems proof enough.! The best illustration I know, however, comes from Singapore, where a few years ago, for no good reason, customers of a local bank began drawing out their money in a frenzy. The run on this respected bank remained a mystery until much later... an unexpected bus strike had created an abnormally large crowd waiting at the bus stop in front of the bank that day. Mistaking the gathering for a crush of customers poised to withdraw their funds from a failing bank, passersby panicked and got in line to withdraw their deposits, which led more passersby to do the same. Soon after opening its doors, the bank was forced to close to prevent a complete crash.

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Big Thinking ModelsAs Simple As Possible

As Simple As Possible, But No Simpler

The process requires asking why, why and why until one can go no further - essentially trying to reduce to a more fundamental body of knowledge.

In 'No Ordinary Genius', Richard Feynman discusses his ability to simplify:

But the game is to try to figure a thing out, with what we know is possible. It requires imagination to think of whats possible, and then it requires an analysis back, checking to see whether it fits, whether its allowed, according to what is known.

When you explain a why you have to be in some kind of framework where you allow something to be true, otherwise you are perpetually asking why? Learn by trying to understand simple things in terms of other ideas always honestly and directly. What keeps clouds up, why do colors appear on oily water, etc. Look about you and think of what you see there.

It was my father who got me into this business of having to imagine things all the time. Things like, if a Martian landed wouldnt they ask: Why does everyone go to sleep every night?

For example, Aunt Minnie is in hospital. Why - Because she slipped on the ice and broke her hip. That satisfies people. But it wouldnt satisfy someone who came from another planet.

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Occam's Razor provides another approach to the 'as simple as possible' approach. William of Occam, a 14th century philosopher, said, 'Non sunt entia multiplicanda oracter necessitatem,' which translates to, 'Hypotheses should not be multiplied without reason.' In other words, look for the simplest answer possible.

In 'The Nature of Science', James Trefil, the author, explains it this way:

For example, suppose that someone sees a bright and unexpected light in the night sky, a UFO. One explanation is that this person has seen the lights of a spacecraft piloted by extraterrestrials.

This explanation requires many of Occam's superfluous 'hypotheses' - the existence of extraterrestrials, their ability to build interstellar ships, their interest in Earth, their inability to avoid detection, and so on.

But there are many other, simpler explanations for lights in the sky - airplanes, the planet Venus (the number one explanation for 'UFOs'), weather balloons, and so on. Each of these explanations requires a relatively small number of hypotheses.

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Big Picture Math

Nobody Compounds Better

Using elementary math to quickly appraise a situation. Here, the idea is to use numbers to evaluate the big idea in the argument, to see whether or not it makes sense.A widely used rule of thumb is compounding - Think of 72

Compounding has only half-jokingly been referred to as the eighth wonder of the world. The rule of '72' provides a handy calculation tool. If $10,000 were invested in an account yielding 7%, it would double about every 10 years (72 divided by 7 equals 10, the doubling period). So after 20 years, the $10,000 investment will be $40,000. At 15%, the $10,000 would double about every 5 years (72 divided by 15 equals 5, the doubling period).

Another Big Picture approach, described by Peter Drucker in The Practice of Management.

Instead of forecasting the future, this method focuses on past events - events which, however, have not yet expressed themselves economically. Instead of attempting to guess economic conditions, this method tries to find the bedrock underlying economic conditions. [For example]... the bedrock underlying the economy, namely, the pattern of family formation and population structure that had emerged in the United States between 1937 and 1943.

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Whilst there isnt a formula set for Big Picture Math, the following examples highlight the methodology of looking for the big part of the argument.

In Poor Charlies Almanack, Charles Munger provides this piece of numerical reasoning as he discusses the potential of a hypothetical Cola company:

We can guess reasonably that by 2034 there will be about eight billion beverage consumers in the world. On average, each of these consumers will be much more prosperous in real terms than the average consumer of 1884. Each consumer is composed mostly of water and must ingest about sixty-four ounces of water per day. This is eight, eight-ounce servings. Thus, if our new beverage, and other imitative beverages in our new market, can flavor and otherwise improve only twenty-five percent of ingested water worldwide, and we can occupy half of the new world market, we can sell 2.92 trillion eight-ounce servings in 2034. And if we can then net four cents per serving, we will earn $117 billion. This will be enough, if our business is still growing at a good rate, to make it easily worth $2 trillion.

Alfred Rappaport and Michael Mauboussin get to the heart of the rollout success of McDonalds in Expectations Investing:

The world's leading fast food purveyor, McDonald's, is an illustration of how fixed-capital investment efficiency can add value. Through standardization, global sourcing, and purchasing power, McDonald's trimmed its average U.S. unit development costs significantly in the early 1990s. Notably, expected sales and operating profit margins from these units did not diminish. The improved efficiency translated directly into higher cash flows and shareholder value.

McDonalds Investment per Unit ($ 000s)McDonalds Investment per Unit ($ 000s)McDonalds Investment per Unit ($ 000s)McDonalds Investment per Unit ($ 000s)McDonalds Investment per Unit ($ 000s)McDonalds Investment per Unit ($ 000s)

1994 1993 1992 1991 1990

Land 317 328 361 433 433

Building 483 482 515 608 720

Equipment 295 317 361 362 403

Avge. Cost $1,095 $1,127 $1,237 $1,403 $1,556

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The last example of math reasoning is taken from a Heard on the Street article in the Wall Street Journal:

Washington's "cash for clunkers" isn't just a way of getting you to buy a car you didn't know you wanted. The administration also touts its green credentials.

Assume 250,000 vehicles are exchanged, with the new ones getting 9.6 miles more per gallon. Based on each driving 12,000 miles a year, that equates to almost 200 million gallons of fuel saved every day. Sounds big, but the U.S. burns that much every 22 seconds.

Every gallon of gasoline burned emits about 19 pounds of carbon dioxide. Say the old cars would have been driven another five years without the clunkers subsidy. The implied saving is about 3.5 million tons of carbon dioxide. Even apportioning only half of the $1 billion cost of the subsidy to carbon reduction works out at $144 a ton - about seven times what carbon permits trade for in Europe. As a cost-effective green initiative, "clunkers" emit a fair amount of hot air.

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Deduction or Induction?

Elementary My Dear Watson

Latin roots of the two words mean: leading from and leading in. Deduction forms the basis of classical logic, while induction is the foundation of scientific method.

Deductive reasoning begins with a general truth/hypothesis and leads to a knowledge of a particular instance of it. The classic form is a SYLLOGISM, in which a necessary conclusion is derived from two accepted premises.

If all cows are ruminants, and Bossy is a cow, it follows that Bossy chews her cud.

Induction begins with the particular and moves to the universal (a generalization that accounts for other examples of the same category or class). It relies on observation and experimentation.

In the case of Bossy, it can be demonstrated that she digests by rumination; if all the other cows we observe do likewise, we can declare, if not a certainty then a high probability, that cud chewing is a distinguishing feature of all cows.

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Disconfirming Evidence

A Disconfirming Figure

The tendency to rationalize preconceived ideas and not look for disconfirming evidence.

Described in 'Decision Traps', by Edward Russo and Paul Schoemaker:

Most of us seem to possess a built-in tendency to favor data that support our current beliefs and to dismiss evidence that upsets them. This can lead large organizations far off-course because often a diligent search can turn up hundreds of pieces of evidence that seem to confirm a hypothesis even though the hypothesis isn't true.

Most of us favor confirming evidence even when the search for confirming evidence has clearly become unhelpful. Confirming evidence gives us a mental reward. Every shred says: 'You're on the right track... You're doing a good job.'

Disconfirming evidence, on the other hand, says: 'Your idea wasn't as good as you thought.' In short, confirmation feels good and disconfirmation feels (at least momentarily) painful. Thus people tend to neglect evidence that might undermine their ideas.! Moral: Have the discipline to seek information that might disconfirm your opinions. If you look for it and can't find it, then you have reason to be confident. One way to look for it is to generate an alternative hypothesis and test both.

The human understanding when it has once adopted an opinion draws all things else to support and agree with it. And though there be a greater number and weight of instances to be found on the other side, yet these it either neglects and despises, or else by some distinction sets aside and rejects, in order that by this great and pernicious predetermination the authority of its former conclusion may remain inviolate. - Francis Bacon

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Game Theory

A framework for studying situations in which decisions are influenced by the choices of others.

Consider, for example a new company that wishes to enter a market segment against the industry leader. How should the new company set its prices? Should it go in with its original pricing scheme, or does it go in lower judging that the leader will lower prices to drive out the new entrant?The matrix outlines the possibilities:

LeaderLeaderLower Maintain

New Company

Lower 0A

0

0B

1New Company

Maintain 1C

0

1D

1

Box A: If both the new company and leader adopt lower prices, they both lose (score = 0) as profits are lower all around.Box B: If the new company goes lower price, but the leader maintains, then the new company is likely to gain market share (score = 1).Box C: If the new company maintains its price, but the leader opts for a low price strategy then the new company is unlikely to get a foothold in the leaders market.Box D: If they both maintain pricing, they will both be better off as profits are maximized.From this basic analysis the best and worst joint scenarios are clear. However, for the leader the best choice is the least worst option. Since it is already the leader if it chooses the lower price strategy, it may win (Box C) or at the worst (Box A) it will prevent the new company from gaining an advantage.

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From 'The Moral Animal', by Robert Wright:

Game theorists, then, may want to follow a few simple rules when applying their tools to human [behavior]. First, the object of the game should be to maximize genetic proliferation. Second, the context of the game should mirror reality in the ancestral environment, an environment roughly like a hunter-gatherer society. Third, once the optimal strategy has been found, the experiment isn't over. The final step - the payoff - is to figure out what feelings would lead human beings to pursue that strategy. Those feelings, in theory, should be part of human nature; they should have evolved through generations and generations of the evolutionary game.!

'Thinking Strategically', by Avinash Dixit and Barry Nalebuff:

Everyones best choice depends on what others are going to do, whether its going to war or maneuvering in a traffic jam. These situations, in which peoples choices depend on the behavior or the choices of other people, are the ones that usually dont permit any simple summation. Rather we have to look at the system of interaction.

Your Rivals Response Look Ahead, Reason BackUse decision trees to think through alternatives. Reason back from outcomes to determine initial strategy.

A player has a Dominant Strategy when he has one course of action that outperforms all others no matter what the other players do. (Prisoners Dilemma players follow their dominant strategy but the outcome is jointly worse)

When leading it may be better to copy those against whom you are competing in order to guarantee staying ahead. Sometimes moving first can be a disadvantage.

Credibility1.! Establish and use a reputation (threats/promises must be credible)2.! Write contracts3.! Burn bridges behind you4.! Employ mandated negotiating agents

Unpredictability - Acting randomly, deliberately.The most widespread use of randomized strategies in business is to motivate compliance at a lower monitoring cost.

Slippery SlopeContinual small steps and lack of focus on overall package can start one on slippery slope and then one cannot back out: Auctions; trade arguments; military arguments.

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Getting to Why

In 'The New Rational Manager', Charles Kepner and Benjamin Tregoe, outline their approach to solving problems. Their framework targets the gap - deviation - between expected and actual outcomes.

What is the TROUBLE STATEMENT? What is wrong with what: 1. Object - 1. Defect/Fault

What is the TROUBLE STATEMENT? What is wrong with what: 1. Object - 1. Defect/Fault

IS IS NOT

WHAT What object or group of objects are you having trouble with?What is wrong with the object or objects - (Defect/Fault)?

WHAT What object(s) could you be having trouble with but are not?What else could be wrong with the object/s but is not?

WHEREWhere is the object when the defect is noticed (Geographic Location)?Where is the defect/fault located on the object?

WHAT Where could the defective object be observed but is not?Where could the defect/fault be located on the object but is not?

WHEN When was the defect/fault first noticed (Date & Time)?When has the defect/fault been noticed since (Pattern)?When in the life cycle of the object was the defect/fault first noticed?

WHEN When could the defect/fault have been first noticed but was not?When could the defect/fault have been noticed since but was not?When in the life cycle could the defect/fault have been noticed but was not?

EXTENT/SIZEHow many defective objects are there?What is the size of the defect/fault on the object?How many defects/faults are on any one object?What is the trend?

EXTENT/SIZEHow many defective objects could there be, but are not?What could the size of the defect/fault be, but is not?How many defects/faults could there be but are not?What could the trend be, but is not?

The analysis can then start by asking what, if anything, is distinctive about the 'is' from the 'is not' for each parameter. Since people tend to think 'what is' rather than 'what is not', the Kepner Tregoe approach helps target the 'what is not' deficiency.

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Ideas

A Good Idea?

James Webb Young describes the process from an advertising perspective in 'A Technique for Producing Ideas':

What is most valuable to know is not where to look for a particular idea, but how to train the mind in the method by which all ideas are produced and how to grasp the principles which are at the source of all ideas.

An idea is nothing more nor less than a new combination of old elements. The second important principle involved is that the capacity to bring old elements into new combinations depends largely on the ability to see relationships.

1. Gather new material. The materials which must be gathered are of two kinds: they are specific and they are general. In advertising, the specific materials are those relating to the product and the people to whom you propose to sell it. General materials come from being intensely curious about all manner of things. Extensive browsing produces this general data bank.

2. In advertising an idea results from a new combination of specific knowledge about products and people with general knowledge about life and events.

3. Then really work these materials over in your mind. Trying first to fit one way and then looking from another angle, or trying to combine in a different way. Mindset: To be constantly pre-occupied (with its brooding quality) with the possibilities of new combinations.

4. Then incubate, by letting the conscious mind think about something completely different. This will aid the synthesis process.

5. Once the eureka moment has arrived and the idea given birth, review it in the cold light of day so that it can take its final shape and form, helping to overcome those last minute doubts as to its usefulness.

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In 'why not?' the authors Barry Nalebuff and Ian Ayres describe four tools for generating good ideas:

What would Croesus do?

Since Croesus was the supremely rich king of Lydia (modern day Turkey), the question is what would you do if money wasn't an issue?

If money was not a problem, you would use your own private plane to jet around the world. So how, more realistically, can you get your own jet? Enter the business model that is now known as fractional jet ownership - first conceived by NetJets.

Why don't you feel my pain?

In addition to watching what consumers do well, it is also useful to pay attention to what they do wrong. In other words, how do the incentives cause them to behave in the 'wrong' way?

Busy highways full of no passenger cars, at peak hours, have led many states to introduce car pool lanes in an attempt to provide the correct incentive. Perhaps tolls could be used, based on the number of passengers (the greater the number, the lower the toll), to reinforce this incentive.

Where else would it work?

You've come up with a great solution. What other problems does it solve?

The idea of self-checkout at the supermarket has now been adapted to self-checkin airline counters, automated library checkouts and self-service post office kiosks.

Would flipping it work?

Sometimes flipping things around provides a powerful new solution.

In South Africa, as most other places, the utility provides electricity and then bills you for the amount used. You consume and then pay. But what if you pay first and then consume? This was the scheme devised by Eskom, the electricity utility, as it provided electricity to crowded black townships. Consumers bought prepaid electricity cards and inserted them into their meters to 'turn-on the lights'.

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Incentives

Say No More

Incentives drive behavior. Self-interest makes the world go round. Consider the total utility of the given incentive when predicting behavior.

This incentive story is recounted by Charles Munger in 'Poor Charlie's Almanack':!From all business, my favorite case on incentives is Federal Express. The heart and soul of its system - which create the integrity of the product - is having all its airplanes come to one place in the middle of the night and shift all the packages from plane to plane. If there are delays, the whole operation can't deliver a product full of integrity to Federal Express customers.

And it was always screwed up. They could never get it done on time. They tried everything - moral suasion, threats, you name it. And nothing worked.

Finally, somebody get the idea to pay all these people not so much an hour, but so much a shift - and when it's all done, they can go home. Well, their problems cleared up overnight.

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Information

Important & Knowable

Is it important?If it's not important then it can be discarded.But if it is important, is it knowable?

'In Seeking Wisdom', the author Peter Bevelin quotes Warren Buffett:

There are two questions you ask yourself as you look at the decision you'll make.

A) is it knowable? B) is it important?

If it is not knowable, as you know there are all kinds of things that are important but not knowable, we forget about those. And if it's unimportant, whether it's knowable or not, it won't make any difference. We don't care. But there are enough things that are knowable and important that we focus on those things. And everything else, we forget about.

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Invert

Who Woulda Thought?

Often when trying to solve a difficult problem, it is wise to concentrate on the outcome that you do not want and thereby avoid it to reach the desired result.

! In every business deal or transaction, identify the worst thing that can possibly go wrong, and then make sure it doesn't happen - John Paul Getty

Charles Munger, in 'Poor Charlie's Almanack', highlights the point:!! The great algebraist, Jacobi... was known for his constant repetition of one phrase: 'Invert, always invert.' It is in the nature of things, as Jacobi knew, that many hard problems are best solved only when they are addressed backward.

A further Charles Munger explanation is given in 'Seeking Wisdom', by Peter Bevelin:

! The mental habit of thinking backward forces objectivity - because one of the ways you think through backward is you take your initial assumption and say, 'Let's try and disprove it.'

! That is not what most people do with their initial assumption. They try and confirm it. It's an automatic tendency in psychology - often called 'first-conclusion bias'. But it's only a tendency. You can train yourself away from the tendency to a substantial degree. You just constantly take your own assumptions and try to disprove them.

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Marginal Thinking

The Cost of an Extra Passenger

Rational people can make better decisions by thinking at the margin. For example:

Although the average cost of flying a passenger may be $500, the marginal cost is merely the extra bag of peanuts and a drink. As long as the marginal passenger pays more than the marginal cost, selling him a ticket is profitable.

'The Economic Way of Thinking' by Paul Heyne:

Economic analysis is basically marginal analysis. Marginal means additional. Economic theory is marginal analysis because it assumes that decisions are always reached by weighing additional costs against additional benefits. Nothing matters in decision making except marginal costs and marginal benefits.

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Metaphors

Politics Loves Metaphors

Its often difficult to tell whether similarities between a familiar and an unfamiliar problem are deep or superficial. People facing choices can improve their odds of using analogies well by following these 4 steps:

Understand the source.Actively search for differences between the source and the target; and assess similarities.Find the solution, and adjust for glaring differences.

SOURCE PROBLEM ! " TARGET PROBLEM

Apparently similar problem Recognize the Your companys problemfrom another context analogy and identify its purpose

Source Problem Target Problem

Candidate Solution Your Solution

Application

Translate, decide & adapt

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The method is illustrated as follows:

Source Problem: The business and high-value checking customers of a well known local bank had been complaining about branch service. They said teller waiting times were unacceptable and that personal bankers were hardly ever available to deal with important issues.

Candidate Solution: The bank reviewed every single account and applied a cost to it based on customer transactions per year, for a 3-year period. It then decided to transfer all the small accounts of its least profitable customers to an internet only account. Some of these customers decided to close their accounts. The majority, however, remained. After six months an independent branch survey showed a high degree of satisfaction among business and high-value checking customers.

Target Problem: The international airline has been slipping recently and business customers, its most profitable passengers, have been complaining.

The airline has decided to adapt the local bank strategy. It already knows that business class passengers generate the bulk of its profits, whilst economy passengers are barely profitable. The airline reviews all the costs associated with its economy passengers and decides that extra baggage and on-board drinks represent significant 'hidden' costs.

Your Solution: The airline will therefore reduce its baggage allowance for economy passengers, and will further ask them to pay for on-board drinks. The additional income will be used to improve food and beverage service in business class.

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Opportunity Costs

The cost of any action is the value of the opportunity forgone by taking that action.Resources have other opportunities for their employment. Hence to acquire them one must 'crowd out' the next best application. Only actions have costs. One must do something to incur the cost. And costs are always to someone.

This is the 'broken window' concept as described by Henry Hazlitt in 'Economics in one Lesson':

" A young hoodlum, say, heaves a brick through the window of a bakers shop. The shopkeeper runs out furious, but the boy is gone. A crowd gathers, and begins to stare with quiet satisfaction at the gaping hole in the window and the shattered glass over the bread and pies. After a while the crowd feels the need for philosophic reflection. And several of its members are almost certain to remind each other or the baker that, after all, the misfortune has its bright side. It will make business for some glazier. As they begin to think of this they elaborate upon it. How much does a new plate glass window cost? Two hundred and fifty dollars? That will be quite a sum. After all, if windows were never broken, what would happen to the glass business? Then, of course, the thing is endless. The glazier will have $250 more to spend with other merchants, and these in turn will have $250 more to spend with still other merchants, and so ad infinitum. The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be, if the crowd drew it, that the little hoodlum who threw the brick, far from being a public menace, was a public benefactor.

! Now let us take another look. The crowd is at least right in its first conclusion. This little act of vandalism will in the first instance mean more business for some glazier. The glazier will be no more unhappy to learn of the incident than an undertaker to learn of a death. But the shopkeeper will be out $250 that he was planning to spend for a new suit. Because he has had to replace a window, he will have to go without the suit (or some equivalent need or luxury). Instead of having a window and $250 he now has merely a window. Or, as he was planning to buy the suit that very afternoon, instead of having both a window and a suit he must be content with the window and no suit. If we think of him as a part of the community, the community has lost a new suit that might otherwise have come into being, and is just that much poorer.

" The glaziers gain of business, in short, is merely the tailors loss of business. No new employment has been added. The people in the crowd were thinking only of two parties to the transaction, the baker and the glazier. They had forgotten the potential third party involved, the tailor. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye.

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Probabilistic Thinking

Whats the Chance?

Robert Rubin describes the decision by probabilities mindset in 'In an Uncertain World':

All decisions are about probabilities.

For me, probabilistic thinking has long been a highly conscious process. I imagine the mind as a virtual legal pad, with the factors involved in a decision gathered, weighed, and totaled up. To describe probabilistic thinking this way does not, however, mean that it can be reduced to a mathematical formula, with the best decision jumping automatically off a legal pad. Sound decisions are based on identifying relevant variables and attaching probabilities to each of them. Thats an analytic process but also involves subjective judgements. The ultimate decision then reflects all of this input, but also instinct, experience, and feel. All the time bearing in mind that reality is always more complex than concepts and models.

A true probabilistic view of life quickly leads to the recognition that almost all significant issues are enormously complex and demand that one delve into those complexities to identify the relevant considerations and the inevitable trade-offs. With an enormous number of competing considerations, the key to reaching the best possible decision is to identify all of them and decide what odds and import to attach to each.

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A widely used tool for probabilistic thinking is decision tree analysis.

For example, consider a company that wishes to conduct a 10,000 piece test marketing campaign and must decide between mail and email. The company obtains pricing from its vendor for both options - $4,000 for mail campaign and $1,500 for email.The company then asks its vendor what the average, best case and worst case orders would be in each case. The vendor is confident of its mail figures due to a large body of prior experience and the nature of delivery (physical address); and therefore informs the company that the average rate is 3%, best case would be 8% and worst case 0.25%.The vendor feels that email is much more unpredictable due to spam filters and the quality of the email list; and therefore informs the company that the average order rate is 1%, best case would be 10% and worst case 0.25%.

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In 'Take The Risk', Dr. Ben Carson illustrates his approach to probabilistic thinking:

" Being successful is simply a matter of making good choices by using our incredibly sophisticated brains. We all have the means to analyze risks and decide which are worth taking and which should be avoided. Thats a simple but powerful prescription for life, love and success.

! With respect to the best/worst analysis, when wrestling with an important decision, ask yourself these four questions:

! What is the best thing that can happen if I do this?

! What is the worst thing that can happen if I do this?

" What is the best thing that can happen if I dont do it?

" What is the worst thing that can happen if I dont do it?

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Reductionism

From 'An Introduction to General Systems Thinking', by Gerald Weinberg.

Reductionism - Getting Your Hands Around It. it is his chosen task to understand the simplifying assumptions of a science those objects of interest and well-defined conditions that delimit its domain of application and magnify its power of prediction.

The concept is further explored in 'Consilience The Unity of Knowledge', by Edward O. Wilson:

! Here is how reductionism works most of the time, as it might appear in a user's manual. Let your mind travel around the system. Pose an interesting question about it. Break the question down and visualize the elements and questions it implies.

Think out alternative conceivable answers. Phrase them so that a reasonable amount of evidence makes a clear-cut choice possible. If too many conceptual difficulties are encountered, back off. Search for another question. When you finally hit a soft spot, search for the model system say a controlled emission in particle physics or a fast breeding organism in genetics on which decisive experiments can be most easily conducted.

Become thoroughly familiar with the system; love the details. Design the experiment, so that no matter what the result, the answer to the question will be convincing. Use the result to press on to new questions, new systems.

In 'More Than You Know', author Michael Mauboussin, explains the limits to reductionism:

! Reductionism is the cornerstone of discovery in the Newtonian world, the basis for much of science's breathtaking advance in the seventeenth through nineteenth centuries. As scientist John Holland explains, 'The idea is that you could understand the world, all of nature, by examining smaller and smaller pieces of it. When assembled, the small pieces would explain the whole.' In many systems reductionism works brilliantly.

! But reductionism has its limits. In systems that rely on complex interactions of many components, the whole system often has properties and characteristics that are distinct from the aggregation of the underlying components. Since the whole of the system emerges from the interaction of the components, we cannot understand the whole simply by looking at the parts. Reductionism fails.! When a system has low complexity and we can define interactions linearly, reductionism is very useful. Many engineered systems fit this bill.

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Scientific Method

A Very Scientific Approach

Observe & Impartially Consider DataLook for Regularities in UnderstandingDevelop Hypothesis Hypothesis cannot be verified, only falsified.Predict Unobserved PhenomenaUsing observed initial conditions and hypothesisReview HypothesisAre the observed final conditions explained by the hypothesis, or has the hypothesis been falsified.

The Meaning Of It All by Richard Feyman

! ...science as a method of finding things out. This method is based on the principle that observation is the judge of whether something is so or not. All other aspects and characteristics of science can be understood directly when we understand that observation is the ultimate and final judge of the truth of an idea.

" Or, put another way, The exception proves that the rule is wrong. That is the principle of science. If there is an exception to any rule, and if it can be proved by observation, that rule is wrong.

! So the more specific the rule, the more powerful it is, the more liable it is to exceptions, and the more interesting and valuable it is to check.

" The method is Try it and see and accumulate the information and so on. And so the question If I do it what will happen? is a typically scientific question.

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Spend - Conserve

Abundant Information

The concept of spending abundances to conserve scarcities is described by George Gilder in a 'Gilder Technology Report' from January, 2000:

Every new era is marked and measured by key abundances and scarcities. They shape the field of economics, the substance of business, the fabric of culture, and the foundation of life. As Japanese futurist Taichi Sakaiya has written: 'Survival dictates that human beings... develop an ethics and aesthetics that favor exploiting fully those resources that exist in abundance and economizing on items that are in short supply'. That is how we exist.

Economists have traditionally focused on scarcity. Abundances tend to end in a near zero price and thus escape economics altogether. As the price declines and their role in the economy becomes more vast and vital, their role in economic analyses diminishes. When they are ubiquitous, like air and water, they are invisible... 'externalities'.

Every economic era has a defining abundance, a critical resource or technology that is expanding in production and plummeting in price so rapidly that it appears virtually free when compared to an array of competing critical resources for which it can be substituted. These abundances come to define the very character of their age, whether an age of 'steam' or 'oil' or an age of 'information'.

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During the pre-industrial era in America, the scarcity was horsepower and the abundance was land. In the industrial age, horsepower - physical force, translated eventually into watts, or kilowatt-hours - abounded while land grew relatively scarce. Between 1660 and 1950, the cost of an effective kilowatt-hour dropped from thousands of dollars to some seven cents. We splurged on cheap horsepower - to clear farmland, to refine ores, to manufacture goods etc.

Over the last 30 years... transistors became asymptotically costless. On a computer memory chip the price of a transistor, with support circuits, dropped from some seven dollars to a few millionths of a cent.

An era's defining abundances relieve its critical scarcities. We use transistors to compensate for a shortage of human servants and... broadband communications capacity.

But abundances can also create new scarcities. The plethora of cheap fuel created a dearth of roads and a need for pollution controls. The more recent glut of transistors led to a shortage of the very communications capacity it was meant to enhance.

(Simon, H. A. (1971), 'Designing Organizations for an Information-Rich World', in Martin Greenberger, Computers, Communication, and the Public Interest, Baltimore, MD: The Johns Hopkins Press, p. 40-41).

'...in an information-rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes. What information consumes is rather

obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the

overabundance of information sources that might consume it.'

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Systems Thinking

A Systematic Thinker

From 'An Introduction to General Systems Thinking', by Gerald Weinberg:

The Three Great Questions of Systems ThinkingWhy do I see what I see? Why do things stay the same? Why do things change?All general systems thinking starts with one of the three and pursues it until forced to move to another.

Law of Large NumbersThe larger the population, the more likely we are to observe values that are close to the predicted average values.

RandomnessOne suggestive phrase is that statistical mechanics deals with unorganized complexity - that is, systems that are complex, but yet sufficiently random in their behavior so that they are sufficiently regular to be studied statistically.

Law of Medium NumbersFor medium number systems, we can expect that large fluctuations, irregularities, and discrepancy with any theory will occur more or less regularly.

StabilityWhen we speak of stability, we are speaking of two things: a set of acceptable behaviors of the system and a set of expected behaviors of the environment.

Principle of InvarianceWe understand change only by observing what remains invariant, and permanence only by what is transformed.

Count-to-Three PrincipleIf you cannot think of three ways of abusing a tool, you do not understand how to use it.

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The Argument

Lets Debate

In 'Asking the Right Questions', the authors Neil Browne and Stuart Keeley, lay out a framework for critical thinking:

What are the issue and the conclusion?Finding an author's main point is the first step in deciding whether you will accept or reject that main point.

What are the reasons?Reasons are beliefs, evidence, metaphors, analogies, and other statements offered to support or justify conclusions. Reasons are the why.

Which words or phrases are ambiguous?You can be certain you have identified an especially important unclear term by performing the following test -If you can express two or more alternative meanings for a term, each of which makes sense in the context of the argument, and if the extent to which a reason would support a conclusion is affected by which meaning is assumed, then you have located a significant ambiguity. Thus, a good test for determining whether you have identified an important ambiguity is to substitute the alternative meanings into the reasoning structure and see whether changing the meaning makes a difference in how well a reason supports the conclusion...

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Consider the following paragraph:

! The quality of education at this university is not declining. In my interviews, I found that an overwhelming majority of the students and instructors responded that they saw no decline in the quality of education here.

! The 'quality of education' is obviously the key point, but does it refer to grade point average, the starting salary of graduating students, a third party ranking etc.

What are the assumptions?Descriptive assumptions are beliefs about the way the world is.By value assumption we mean a taken-for-granted belief about the relative desirability of certain competing values.

Keep asking, 'How do you get from the reason to the conclusion?' Ask, 'If the reason is true, what else must be true for the conclusion to follow?' And, to help answer that question, you will find it helpful to ask, 'Supposing the reason(s) were true, is there any way in which the conclusion nevertheless could be false?'

How good is the evidence: Intuition, appeals to authority, and testimonials?Other examples of evidence include personal observation, analogies and the validity of presented statistics.

Are there rival causes?Is there a plausible interpretation, different from that argued, that can explain the outcome?This is one reason why control samples are used in science.

What significant information is omitted?When an author is trying to persuade you of something, he or she often leaves out important information. This information is often useful in assessing the worth of the argument. By explicitly looking for omitted information, you can determine whether the author has provided you with enough information to support the reasoning.

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Unintended Consequences

Not So Fast

The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups; and to think of primary and secondary consequences. To see the problem as a whole and not in individual fragments.

Consequences: Everybody looks to extra-vivid, observable evidence. But also consider what cannot be seen, or what never came into existence because of a particular course of action.

In 'Applied Economics' by Thomas Sowell, the author applies the 'And then what..' framework. As he explains -

When I was an undergraduate studying economics under Professor Arthur Smithies of Harvard, he asked me in class one day what policy I favored on a particular issue of the times. Since I had strong feelings on that issue, I proceeded to answer him... "And then what will happen?" he asked.

The question caught me off guard. However, as I thought about it, it became clear that the situation I described would lead to other economic consequences, which I then began to consider and to spell out. "And then what will happen after that?" Professor Smithies asked.

As I analyzed how the further economic reactions to the policy would unfold, I began to realize that these reactions would lead to consequences much less desirable than those at the first stage, and then I began to waver somewhat. "And then what will happen?" Smithies persisted.

By now I was beginning to see that the economic reverberations of the policy I advocated were likely to be pretty disastrous - and, in fact, much worse than the initial situation that it was designed to improve.

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Warren Buffett gives an example of this analysis (Originally in Outstanding Investor Digest, but quoted from 'Seeking Wisdom', by Peter Bevelin):!The key thing in economics, whenever someone makes an assertion to you, is to always ask, "And then what?" Actually, it's not such a bad idea to ask it about everything. But you should always ask, "And then what?"

So when you read that the merchandise trade deficit is $9 billion, what else does that mean? It means that somehow we must also have traded $9 billion of capital assets - (future) claims on our production - and given them to somebody else in the world. So they have to invest. They don't have a choice. And when somebody says, "Won't it be terrible if the Japanese sell all of their government bonds?" Well, they can't without getting another American asset in exchange. There's simply no other way to do it. They could sell it to the French, but then the French have the same problem.

So trace through the transactions on the circle whenever you talk about any specific action in economics.

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80:20 Rule

The 80/20 Principle was discovered in 1897 by Italian economist Vilfredo Pareto. It simply maintains that a minority of causes, inputs, or effort usually lead to a majority of the results, outputs, or rewards. Whilst the exact split may not be 80/20, a significant imbalance is often found in a myriad of situations. In part this is explained by the nature of feedback loops and the idea of tipping points.

'The 80/20 Principle', by Richard Koch, develops numerous applications of the concept. The author's top 10 business uses of the 80/20 Principle are -! Strategy! Quality! Cost reduction and service improvement! Marketing! Selling! Information technology! Decision making and analysis

Considering the 80/20 idea forces one to look for the biggest issue, or the point of greatest leverage. This is illustrated in the following approach by Bill Gates:

1. Determine a Goal 2. Find the highest-leverage approach 3. Discover the ideal technology for that approach 4. In the meantime, make the smartest application of the technology that you already have.

For example, consider the AIDS epidemic:

1. To end the disease 2. Prevention is the highest leverage approach 3. Vaccine for a lifetime4. Get people to avoid risky behavior

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Business ModelsArbitrageA process for identifying market inefficiencies. The classic idea is that of buying an item in one place and selling it in another. For example buying gold in London at $900 and selling it in New York at $910. But the mis-pricing mindset can apply just as well in business. Outsourcing, for example, is the buying of labor in one location for sale in another.

In the 1988 Berkshire Hathaway Annual Report, Warren Buffett discusses arbitrage:

Once, the word applied only to the simultaneous purchase and sale of securities or foreign exchange in two different markets. The goal was to exploit tiny price differentials that might exist between, say, Royal Dutch stock trading in guilders in Amsterdam, pounds in London, and dollars in New York. Some people might call this scalping; it wont surprise you that practitioners opted for the French term, arbitrage.

Since World War I the definition of arbitrage - or risk arbitrage, as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. In most cases the arbitrageur expects to profit regardless of the behavior of the stock market. The major risk he usually faces instead is that the announced event wont happen.

Some offbeat opportunities occasionally arise in the arbitrage field. I participated in one of these when I was 24 and working in New York for Graham-Newman Corp. Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 50 cents per pound. In 1954 a temporary shortage of cocoa caused the price to soar to over 60 cents. Consequently Rockwood wished to unload its valuable inventory - quickly, before the price dropped. But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

The 1954 Tax Code came to the rescue. It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporations business. Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity. Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share. For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts. The profits were good and my only expense was subway tokens.

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Brand

Difficult to Reproduce

Thomas Sowell, 'Basic Economics':

! Brand names are not guarantees. But they do reduce the range of uncertainty. Since brand names are a substitute for specific knowledge, how valuable they are depends on how much knowledge you already have about the particular product or service. Someone who is very knowledgeable about photography might be able to get a bargain on an off-brand camera or lens, or even a second-hand camera or lens. But the same person might be well advised to stick with well known brands of new stereo equipment, if his knowledge in that field falls far short of his expertise in photography.

The importance of brands as an intangible asset is described in 'The Little Book That Builds Wealth', by Pat Dorsey:

! The bottom line is that brands can create durable competitive advantages, but the popularity of the brand matters much less than whether it actually affects consumers' behavior. If consumers will pay more for a product - or purchase it with regularity - solely because of the brand, you have strong evidence of a moat. But there are plenty of well-known brands attached to products and companies that struggle to earn positive economic returns.

! Popular brands aren't always profitable brands. If a brand doesn't entice consumers to pay more, it may not create a competitive advantage.

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Business Model

The Oldest Business Model

Discussed in 'The Practice of Management', by Peter Drucker:

" What business are we in?; 'What business SHOULD we be in?'

The emphasis of defining and thinking about the business from the customer's perspective is further highlighted in 'Marketing Myopia', by Theodore Levitt, a Harvard Business Review article.

! Always ask where the competition might come from; and examine substitutable products. The customer group often never articulates their greatest unsatisfied need.

" Do not focus on the product, rather keep focusing on the people who consume it (or dont consume it) and their changing needs and desires, remembering that the consumer always buys to accomplish something.

! If you weren't already in this business would you enter it today? If not, what are you going to do about it?

Linked to the process is the idea of business model - as described by Joan Magretta in 'What Management Is':

! A business model is a set of assumptions about how an organization will perform by creating value for all the players on whom it depends, not just its customers. [It] is a story of how an enterprise works. Like all good stories, a business model relies on the basics of character, motivation, and plot. For a business, the plot revolves around how it will make

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money. The characters must be precisely delineated, their motivations must be plausible, and the plot must turn on an insight about value.

! Underpinning every successful organization - whether the people who run that organization know it or not - is a business model that any sensible person can understand after the fact. We see who the characters are, why they will behave as they do, and the underlying economic logic that drives the plot and makes a self-sustaining system of the whole.

Strategy is another representation of this idea. The following extract is taken from 'Winning', by Jack Welch:

! ... I do want to disagree with the scientific approach to strategy... It is taught in many business schools, peddled by countless consulting firms, and practiced in far too many corporate headquarters.

! It's just so unproductive! If you want to win, when it comes to strategy, ponder less and do more.

" First, come up with a big aha for you business - a smart, realistic, relatively fast way to gain sustainable competitive advantage.

! Look, what is strategy but resource allocation? When you strip away all the noise, that's what it comes down to. Strategy means making clear-cut choices about how to compete. You cannot be everything to everybody, no matter what the size of your business or how deep its pockets.

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Core Competency

An Engine for Both of Your Cars

As a company moves along a product (or process) path, knowledge is accumulated. Since most innovation is a rearrangement of existing knowledge units, the company is able to further innovate, and therefore move quicker, along this chosen path. Companies that have developed a knowledge base valued by customers in their industry make it more difficult for a new entrant to compete.

Consider Toyota in this description of how a process was studied from a Fortune Magazine article:

Explicit