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Behavior Models!
Availability !
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
21
Authority!
21
22
Deprival Syndrome !
23
24
Incentive-Cause Bias!
25
Liking!
26
Reciprocation!
27
Scarcity !
28
2
Social Proof!
29
30
As Simple As Possible !
30
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
3
Unintended Consequences !
59
80:20 Rule!
61
Business Models!
62
Arbitrage!
62
Brand!
63
Business Model!
64
Core Competency!
66
Cost Leader!
68
Culture!
69
Disruptive Innovation!
70
Entrepreneurship!
71
GRICS (Retailers)!
72
73
Management Fanaticism!
74
Network Effect!
76
Porters 5-forces!
77
Pricing Ability!
78
Protective Moat!
79
Scale !
80
Specialization!
82
Standardization!
83
4
Surf a Wave!
84
Technology !
85
86
Bob-around Earnings!
86
Business Metrics!
87
Intrinsic Value!
88
Mr. Market!
90
Reversion-to-mean!
91
Scandal!
92
93
94
Diminishing Utility!
94
Nature of Goods!
95
Maslows Triangle!
96
Total Utility!
97
Value !
98
Decision Models!
99
Margin of Safety!
99
Pr O A C T!
100
Process v Outcome!
101
102
Trade-offs!
103
104
105
Anchor Effect!
105
Bayes Theorem!
106
Contrast Principle !
107
Correlation or Causation!
108
Doubt Avoidance!
109
Extrapolation!
110
111
Groupthink!
112
Ideology !
113
Information Bias !
114
Over-optimism!
116
Overweighting Numbers!
117
Statistics!
118
Economic Models!
119
Animal Spirits!
119
Asymmetric Information!
121
Bubbles!
122
6
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!
138
Back-up/Redundancy!
138
Bottlenecks !
139
140
Evolution!
142
Feedback Loops !
144
Momentum!
145
Newtons Laws!
146
7
Power Law!
147
Reflexivity!
148
Six Degrees!
149
System Boundary!
151
Thermodynamics!
153
Behavior Models
Availability
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.
10
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.
11
The tendency for people to stay with the status quo has produced the
default behavior option. Thaler and Sunstein describe this idea in
Nudge.
For lots of reasons, people have a more general tendency to stick with their current situation.
This phenomenon... dubbed the status quo bias, has been demonstrated in numerous
situations. Most teachers know that students tend to sit in the same seats in class, even
without a seating chart. Status quo bias is easily exploited (Examples include never-changing
asset allocations in 401(k) plans; automatic renewals of subscriptions on credit cards etc.).
One of the causes of status quo bias is a lack of attention. Many people adopt what we will
call the yeah, whatever heuristic. A good illustration is the carryover effect in television
viewing.
The combination of loss aversion with mindless choosing implies that if an option is
designated as the default, it will attract a large market share. Default options thus act as
powerful nudges. In many contexts defaults have some extra nudging power because
consumers may feel, rightly or wrongly, that default options come with an implicit
endorsement from the default setter, be it the employer, government, or TV scheduler.
12
Human Action
!
Acting man is eager to substitute a more satisfactory state of affairs for a less
satisfactory one. His mind imagines conditions which suit him better, and his action aims at
bringing about this desired state. The incentive that impels a man to act is always some
uneasiness. A man perfectly content with the state of his affairs would have no incentive to
change things. He would have neither wishes nor desires; he would be perfectly happy. He
would not act; he would simply live free from care.
!
But to make a man act, uneasiness and the image of a more satisfactory state alone
are not sufficient. A third condition is required: the expectation that purposeful behavior has
the power to remove or at least to alleviate the felt uneasiness. In the absence of this
condition no action is feasible.
!
Action is not simply giving preference. Man also shows preference in situations in
which things and events are unavoidable or are believed to be so. Thus a man may prefer
sunshine to rain and may wish that the sun would dispel the clouds. He who only wishes and
hopes does not interfere actively with the course of events and with the shaping of his own
destiny. But acting man chooses, determines, and tries to reach an end. Of two things both
of which he cannot have together he selects one and gives up the other. Action therefore
always involves both taking and renunciation.
13
Negotiation
Roger Fisher & William Ury outline their methods for principled negotiation
in 'Getting To Yes':
... in contrast to positional bargaining, the principled negotiation method of focusing on basic
interests, mutually satisfying options, and fair standards typically results in a wise agreement.
The method permits you to reach a gradual consensus on a joint decision efficiently without
all the transactional costs of digging in to positions only to have to dig yourself out of them.
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.
14
Operant Conditioning
15
Pain - Pleasure
Pain or Pleasure?
The sovereign masters that determine what people will do are not pleasure and
pain, but fallible memories of pleasure and pain.
Real pleasure is derived from experiences over physical goods, pastimes over
knick-knacks, and doing over having.
16
Pavlovian Conditioning
Time to Get a Beer
17
PLAGGES - 7 Sins
18
Reader or Listener?
19
Science of Achievement
The science of taking ideas, and dreams, and making them happen is generally considered
as:
1. Setting a goal.
2. Creating a written plan to reach the goal within a certain timeframe.
3. Taking action by implementing the plan.
4. Getting feedback from actions - negative and
positive - and making changes, if necessary.
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21
22
Deprival Syndrome
'Why Smart People Make Big Money Mistakes and How to Correct Them',
by Gary Belsky & Thomas Gilovich:
Behavioral economists describe the takeaway idea as the 'endowment effect'. Businesses
understand this effect - once you take a product home and use it, there's a strong chance
that the endowment effect will kick in; whatever value you might have placed on, say, a
stereo at a store will likely be increased once it sits in your den for a few weeks.
23
Necessary or Welfare?
'If you would persuade, appeal to interest and not to reason' - Ben Franklin
24
Incentive-Cause Bias
25
Liking
Easy to Like
26
Reciprocation
Just Reciprocating
27
Scarcity
28
Social Proof
29
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.
30
Occam's Razor provides another approach to the 'as simple as possible' approach.
William of Occam, a 14th century philosopher, said, 'Non sunt entia multiplicanda
oracter necessitatem,' which translates to, 'Hypotheses should not be multiplied
without reason.' In other words, look for the simplest answer possible.
In 'The Nature of Science', James Trefil, the author, explains it this way:
For example, suppose that someone sees a bright and unexpected light in the night sky, a
UFO. One explanation is that this person has seen the lights of a spacecraft piloted by
extraterrestrials.
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.
31
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).
32
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.
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.
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
33
The last example of math reasoning is taken from a Heard on the Street
article in the Wall Street Journal:
Washington's "cash for clunkers" isn't just a way of getting you to buy a car you didn't know
you wanted. The administration also touts its green credentials.
Assume 250,000 vehicles are exchanged, with the new ones getting 9.6 miles more per
gallon. Based on each driving 12,000 miles a year, that equates to almost 200 million gallons
of fuel saved every day. Sounds big, but the U.S. burns that much every 22 seconds.
Every gallon of gasoline burned emits about 19 pounds of carbon dioxide. Say the old cars
would have been driven another five years without the clunkers subsidy. The implied saving is
about 3.5 million tons of carbon dioxide. Even apportioning only half of the $1 billion cost of
the subsidy to carbon reduction works out at $144 a ton - about seven times what carbon
permits trade for in Europe. As a cost-effective green initiative, "clunkers" emit a fair amount
of hot air.
34
Deduction or Induction?
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.
35
Disconfirming Evidence
A Disconfirming Figure
The tendency to rationalize preconceived ideas and not look for disconfirming
evidence.
36
Game Theory
A framework for studying situations in which decisions are influenced by the
choices of others.
Consider, for example a new company that wishes to enter a market segment
against the industry leader. How should the new company set its prices? Should it
go in with its original pricing scheme, or does it go in lower judging that the
leader will lower prices to drive out the new entrant?
The matrix outlines the possibilities:
Leader
Lower
Lower
Maintain
0
0
New Company
Maintain
C
0
D
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.
37
38
Getting to Why
In 'The New Rational Manager', Charles Kepner and Benjamin Tregoe,
outline their approach to solving problems. Their framework targets the
gap - deviation - between expected and actual outcomes.
What is the TROUBLE STATEMENT?
What is wrong with what: 1. Object - 1. Defect/Fault
IS
IS NOT
WHAT
WHAT
WHERE
WHAT
WHEN
WHEN
EXTENT/SIZE
EXTENT/SIZE
The analysis can then start by asking what, if anything, is distinctive about the 'is'
from the 'is not' for each parameter.
Since people tend to think 'what is' rather than 'what is not', the Kepner Tregoe
approach helps target the 'what is not' deficiency.
39
Ideas
A Good Idea?
40
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'.
41
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.
42
Information
Is it important?
If it's not important then it can be discarded.
But if it is important, is it knowable?
'In Seeking Wisdom', the author Peter Bevelin quotes Warren Buffett:
There are two questions you ask yourself as you look at the decision you'll make.
A) is it knowable?
B) is it important?
If it is not knowable, as you know there are all kinds of things that are important but not
knowable, we forget about those. And if it's unimportant, whether it's knowable or not, it
won't make any difference. We don't care. But there are enough things that are knowable
and important that we focus on those things. And everything else, we forget about.
43
Invert
44
Marginal Thinking
Rational people can make better decisions by thinking at the margin. For
example:
Although the average cost of flying a passenger may be $500, the marginal cost
is merely the extra bag of peanuts and a drink. As long as the marginal passenger
pays more than the marginal cost, selling him a ticket is profitable.
45
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:
SOURCE PROBLEM
Apparently similar problem
from another context
TARGET PROBLEM
!"
Recognize the
analogy and identify
its purpose
Target Problem
Candidate Solution
Your Solution
Translate, decide
& adapt
Application
46
47
Opportunity Costs
The cost of any action is the value of the opportunity forgone by taking that
action.Resources have other opportunities for their employment. Hence to acquire
them one must 'crowd out' the next best application. Only actions have costs.
One must do something to incur the cost. And costs are always to someone.
48
Probabilistic Thinking
49
50
In 'Take The Risk', Dr. Ben Carson illustrates his approach to probabilistic
thinking:
"
Being successful is simply a matter of making good choices by using our incredibly
sophisticated brains. We all have the means to analyze risks and decide which are worth
taking and which should be avoided. 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:
"
"
51
Reductionism
From 'An Introduction to General Systems Thinking', by Gerald Weinberg.
Reductionism - Getting Your Hands Around It.
it is his chosen task to understand the simplifying assumptions of a science those
objects of interest and well-defined conditions that delimit its domain of application and
magnify its power of prediction.
In 'More Than You Know', author Michael Mauboussin, explains the limits
to reductionism:
!
Reductionism is the cornerstone of discovery in the Newtonian world, the basis for
much of science's breathtaking advance in the seventeenth through nineteenth centuries. As
scientist John Holland explains, 'The idea is that you could understand the world, all of
nature, by examining smaller and smaller pieces of it. When assembled, the small pieces
would explain the whole.' In many systems reductionism works brilliantly.
!
But reductionism has its limits. In systems that rely on complex interactions of many
components, the whole system often has properties and characteristics that are distinct from
the aggregation of the underlying components. Since the whole of the system emerges from
the interaction of the components, we cannot understand the whole simply by looking at the
parts. Reductionism fails.
!
When a system has low complexity and we can define interactions linearly,
reductionism is very useful. Many engineered systems fit this bill.
52
Scientific Method
53
Spend - Conserve
Abundant Information
54
During the pre-industrial era in America, the scarcity was horsepower and the abundance
was land. In the industrial age, horsepower - physical force, translated eventually into watts,
or kilowatt-hours - abounded while land grew relatively scarce. Between 1660 and 1950, the
cost of an effective kilowatt-hour dropped from thousands of dollars to some seven cents.
We splurged on cheap horsepower - to clear farmland, to refine ores, to manufacture goods
etc.
Over the last 30 years... transistors became asymptotically costless. On a computer memory
chip the price of a transistor, with support circuits, dropped from some seven dollars to a few
millionths of a cent.
An era's defining abundances relieve its critical scarcities. We use transistors to compensate
for a shortage of human servants and... broadband communications capacity.
But abundances can also create new scarcities. The plethora of cheap fuel created a dearth
of roads and a need for pollution controls. The more recent glut of transistors led to a
shortage of the very communications capacity it was meant to enhance.
55
Systems Thinking
A Systematic Thinker
56
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...
57
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Unintended Consequences
Not So Fast
59
60
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.
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 lifetime
4. Get people to avoid risky behavior
61
Business Models
Arbitrage
A process for identifying market inefficiencies. The classic idea is that of buying
an item in one place and selling it in another. For example buying gold in London
at $900 and selling it in New York at $910. But the mis-pricing mindset can apply
just as well in business. Outsourcing, for example, is the buying of labor in one
location for sale in another.
62
Brand
Difficult to Reproduce
63
Business Model
The emphasis of defining and thinking about the business from the
customer's perspective is further highlighted in 'Marketing Myopia', by
Theodore Levitt, a Harvard Business Review article.
!
Always ask where the competition might come from; and examine substitutable
products. The customer group often never articulates their greatest unsatisfied need.
"
Do not focus on the product, rather keep focusing on the people who consume it (or
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?
64
money. The characters must be precisely delineated, their motivations must be plausible, and
the plot must turn on an insight about value.
!
Underpinning every successful organization - whether the people who run that
organization know it or not - is a business model that any sensible person can understand
after the fact. We see who the characters are, why they will behave as they do, and the
underlying economic logic that drives the plot and makes a self-sustaining system of the
whole.
65
Core Competency
So, it may be that Toyota's proprietary learning curve is its thinking and
implementation culture, and high quality is the result?
Similarly, we might ask what is about Honda that has led to its core competency
in engines? Or why does Virgin seem to be further along the learning curve of
setting up successful entrepreneurial businesses?
66
Energy
Information
Production
Service Delivery
Store
Supporting Management
Systems
Process
Transport
Business Design
Strategy
67
Cost Leader
68
Culture
A superstar manager will likely provide exceptional company performance only
whilst at the helm, but the underlying attributes of a company's culture should be
more enduring.
!
!
!
!
!
!
!
!
69
Disruptive Innovation
Disruptive Technology
Digital photography
Digital printing
Automated decisions based upon credit scores
Distributed power generation
70
Entrepreneurship
In 'Innovation and Entrepreneurship', Peter Drucker outlines six recurring
patterns of success:
Unexpected Successes and Failures.
Analyze both unexpected successes and failures, by asking what does it mean if this is
exploited?'
Incongruities.
Think what is it at the moment and what should it be. The gap between these two is the
opportunity. For example, people are seeking more leisure pursuits yet cinema audiences are
going down. Why? Be ready to challenge the most basic industry assumptions.
Process Need.
Look hard for the weak link within a self-contained process. You should be struck by the
realization of there should be a better way.
Industry/Market Changes.
See the value migrating within the industry, by spotting commoditization or changing
technologies or society changes. For example, from computer hardware to software, from
big steel mills to mini-mills or from public to private medicine.
Demographics.
Are the demographics of your market changing? Clearly the population of Japan is aging,
what opportunities does this create? The young urban population of many middle-eastern
countries provides different opportunities.
Mood/Perception.
Take advantage of changing tastes within society. Timing is crucial, as those who move too
early on a change often meet with disaster. Some recent changes include wildlife
conservation, healthy eating, women in the workplace and holidays abroad.
New Knowledge.
The advent of a new technology or new knowledge can create opportunities. This need not
be in your direct market in order to affect you. Technology/knowledge scanning across
industry segments can be useful.
71
GRICS (Retailers)
Nelson Peltz (Fortune Magazine Article): His lieutenants prepare detailed comparisons
on margins, the percentage of sales spent on marketing, deals and allowances paid to
retailers, and growth in overhead versus sales. They worship free cash flow, and believe its
more efficient to revitalize a great brand than to try to build one from scratch. He also loves
exploring what grabs the public taste "I try to figure out the marketing puzzle."
72
73
Management Fanaticism
A Fanatical JOB
Managers acting as owners is a Warren Buffett prerequisite. In his observations,
management requires superior capital allocation skills, a desire for outstanding
performance and a singular focus on lowering costs and improving productivity.
But the grand overlord of management excellence may be fanaticism. Success
from obsessive - bordering on unreasonable - entrepreneurs consumed by their
business.
74
there in a while, I can remind myself of something about it, the manager maybe, and then I
can remember later that they are doing this much business this week and that their wage
cost is such and such. I do this with each store every Saturday morning. It usually takes
about three hours, but when I'm done I have as good a feel for what's going on in the
company as anybody here - maybe better on some days.
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Network Effect
Ur Network
The Network effect results from positive feedback, where success begets success
and economies of scale undermine the competition. The effect can be observed
with Ebay, Microsoft, or even the largest local newspaper. Once Ebay had
established itself as the site to visit in order to sell things, this attracted even
more sellers as they realized it had the largest audience. So why bother to list on
another site? The process snowballs and provides a barrier to competition.
Microsoft has network economies with both the Windows operating system and
Microsoft Office. In addition, complementary products provide an important
reinforcement to the network. For example, a video game producer will obviously
want to develop the program for Windows and if the game is a hit, this provides
the end-user with another benefit from the Windows platform.
This powerful network effect was encapsulated by Bob Metcalf, the inventor, of
Ethernet. He stated that if there are n people in a network, and the value of the
network to each of them is proportional to the number of other users, then the
total value of the network (to all the users) is
proportional to n*(n-1) = n2 - n.
If the value of a network to single user is $1 for each other user on the network,
then a network of size 10 has a total value of roughly $100.
In contrast, a network of size 100 has a total value of roughly $10,000. A tenfold
increase in the size of the network leads to a hundredfold increase in its value.
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Porters 5-forces
A widely used model for diagnosing industry structure, developed by Prof.
Michael Porter.
Issues to Consider:
Economies of Scale
Proprietary Product Differences (Trademarks, Patents)
Brand Identity
Switching Costs
Capital Requirements
Access to Distribution
Absolute Costs Advantages
Proprietary Learning Curve
Access to Necessary Inputs
Regulations
Decision Makers' Incentives
Industry Headwinds or Tailwinds
Bankruptcy Laws
Is Competition Rational?
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Pricing Ability
A company that can raise prices, relatively easily, is likely to have some kind of
enduring competitive advantage.
This may be the result of no, or few, product/service substitutes:
It may be due to patent protection;
A trademark, in association, with powerful brand attributes could be a cause;
Or, perhaps, an exclusive franchise of some kind.
The ideal investment contains hidden pricing power - examples include retailers
renewing leases in a recessionary environment; operators with a back-catalogue
that can be exploited through new technologies; and companies with an underexploited brand.
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Protective Moat
Hard to Replicate
The idea of the moat is further discussed in 'The Warren Buffet CEO:
Secrets From the Berkshire Hathaway Managers', by Robert Miles:
Build the brand, build the brand and build the brand. Invest, as much as possible, in the
customer relationship. Focus on building for the long term, even if that means taking shortterm hits. Plan ahead. Search for ways to keep building the competitive advantage
distribution, manufacturing, branding, acquisitions etc. Dominate, profitably, the markets you
are in. Its not necessary to do extraordinary things to make extraordinary profits. It is
necessary to do the basics extraordinarily well.
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Scale
In 'The Little Book That Builds Wealth', author Pat Dorsey, discusses
another scale advantage:
!
Although building and operating the delivery network is an expensive proposition for a
base level of service, the incremental profit on each item that the truck fleet delivers is
enormous. Think about it - once the fixed costs are covered, delivering an extra item that is
on a delivery route is extremely profitable because the variable cost of making an extra stop
is almost nothing.
!
Now imagine that you need to try to compete with a company that has an established
distribution network. It has likely covered its fixed costs and is making large incremental
profits as it delivers more stuff, while you'll need to take on large losses for a time until (if) you
gain enough scale to become profitable.
But scale can also work against you as discussed in 'Six Degrees, The
Science of A Connected Age', by Duncan Watts:
!
In slowly changing environments in which generic products appeal to large numbers
of consumers and the range of competing choices is limited, economies of scale are optimal.
But in [a] rapidly globalizing world... with uncertain economic and political forecasts... and
with increasingly heterogeneous tastes of consumers... uncertainty, ambiguity, and rapid
change favor flexibility and adaptability over sheer scale.
80
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Specialization
The concept of Adam Smith's pin factory, as described in 'The Wealth of
Nations':
!
To take an example, therefore, from a very trifling manufacture; but one in which the
division of labour has been very often taken notice of, the trade of the pin-maker; a workman
not educated to this business (which the division of labour has rendered a distinct trade), nor
acquainted with the use of the machinery employed in it (to the invention of which the same
division of labour has probably given occasion), could scarce, perhaps, with his utmost
industry, make one pin in a day, and certainly could not make make twenty. But in the way in
which this business is now carried on, not only the whole work is a peculiar trade, but it is
divided into a number of branches, of which the greater part are likewise peculiar trades. One
man draws out the wire, another straights it, a third cuts it, a fourth points it... I have seen a
small manufactory of this kind where ten men only were employed... But though they were
very poor, and therefore but indifferently accommodated with the necessary machinery, they
could, when they exerted themselves, make among them about [forty-eight thousand] pins in
a day.
!
In every other art and manufacture, the effects of the division of labour are similar to
what they are in this very trifling one; though, in many of them, the labour can neither be so
much subdivided, nor reduced to so great a simplicity of operation. The division of labour,
however, so far as it can be introduced, occasions, in every art, a proportionate increase of
the productive powers of labour.
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Standardization
The following ideas are more fully developed in 'Lean Thinking' and 'The
Machine That Changed the World', by James Womack and Daniel Jones.
Eliminate Muda
Muda is the Japanese term for waste. Specifically any human activity which absorbs
resources but creates no value: mistakes which require rectification, production of items no
one wants so that inventories and remaindered goods pile up, processing steps which aren't
actually needed, movement of employees and transport of goods from one place to another
without any purpose, groups of people in a downstream activity standing around waiting
because an upstream activity has not delivered on time, and goods and services which don't
meet the needs of the customer.
Design Pull
Letting the customer 'pull' the product to them. This means order then manufacture, as
opposed to the 'push' system that has manufacture, inventory and then sale.
The Process
Applicable for both manufacturing and service industries.
1.!
Place linked processes near one another
2.!
Standardize procedures
3.!
Eliminate loop-backs
4.!
Setting a common tempo
5.!
Balancing loads
6.!
Segregating complexity
7. Posting performance results - including customer focused metrics.
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Surf a Wave
The idea of a large business force that developed, which a company was
able to ride. The metaphor is explained in 'Poor Charlie's Almanack', by
Charles Munger:
!
There's a tire store chain in the Northwest that has slowly succeeded over the last fifty
years, the Les Schwab tire store chain. It started competing with the stores that were owned
by the big tire companies that made all the tires, the Goodyears and so forth. And, of course,
the manufacturers favored their own stores. Their 'tied stores' had a big cost advantage.
Later, Les Schwab rose in competition with the huge price discounters like Costco and
Sam's Club and before that Sears, Roebuck and so forth. And yet, here is Schwab now, with
hundreds of millions of dollars in sales. How did he do it? Well, let's think about it with some
microeconomic fluency.
!
Is there some wave that Schwab could have caught? The minute you ask the
question, the answer pops in. The Japanese had a zero position in tires, and they got big. So
this guy must have ridden that wave some in the early times. So, he had to get a wave in
Japanese tire invasion, the Japanese being as successful as they were. And then a talented
fanatic had to get a hell of a lot of things right and keep them right with clever systems.
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Technology
Technologys doubled edged sword is described by Charles Munger in
'Poor Charlie's Almanack':
!
The great lesson in microeconomics is to discriminate between when technology is
going to help you and when it's going to kill you. And most people do not get this straight in
their heads. But a fellow like Buffett does.
!
For example, when we were in the textile business, which is a terrible commodity
business, we were making low-end textiles, which are a real commodity product. And one
day, the people came to Warren and said, 'They've invented a new loom that we think will do
twice as much work as our old ones.' And Warren said, 'Gee, I hope this doesn't work because if it does, I'm going to close the mill.' And he meant it.
!
What was he thinking? He was thinking, 'It's a lousy business. We're earning
substandard returns and keeping it open just to be nice to the elderly workers. But we're not
going to put huge amounts of new capital into a lousy business.'
!
And he knew that the huge productivity increases that would come from a better
machine introduced into the production of a commodity product would all go to the benefit of
the buyers of the textiles. Nothing was going to stick to our ribs as owners.
!
That's such an obvious concept - that there are all kinds of wonderful new inventions
that give you nothing as owners except the opportunity to spend a lot more money in a
business that's still going to be lousy. The money still won't come to you. All of the
advantages from great improvements are going to flow through to the customers.
!
Conversely, if you own the only newspaper in Oshkosh and they were to invent more
efficient ways of composing the whole newspaper, then when you got rid of the old
technology and get new, fancy computers and so forth, all of the savings would come right
through to the bottom line.
The need for continuing technology investment just to stand still is a component
of maintenance capital expenditures. As technologies progress, the major trends
seem to be
increasing
increasing
increasing
increasing
increasing
increasing
efficiency
capacity
compactness
accuracy
size range
complexity
85
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Business Metrics
Logistics Benchmark
Setting and measuring the appropriate metrics to drive the company forward profitably.
Benchmarking within the industry, and outside of it, in order to obtain
productivity information.
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Intrinsic Value
Whats It Worth?
88
This is the discounted cash flow model, where factors of inherent stability allow
one to use past and current data as a guide to future business prospects. The
major problem occurs when there's a secular change, where the fundamental
economics of the business, or the industry, are changing.
Alternatively, one can think of valuation in terms of the replacement cost of
assets. For example, a mobile phone company could be worth the cost of building
its network and acquiring its customers; remembering, of course, that what was
recently created is often most easily reproduced.
The Austrian School of Economics, however, states that the value of an asset is
determined solely by the quality of plans for its use.
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Mr. Market
90
Reversion-to-mean
There is a strong tendency in many areas of the financial market, due to the
action of economic forces, for results to revert to their long-term mean.
If a certain company, or industry, earns large profits for a period of time, then
more companies, or capital, will enter and the increased competition will likely
drive the exceptional profits down to a lower level. If a certain commodity goes
up in price, producers will be encouraged to produce, or find, more and the extra
supply will drive the price down.
The Dow's historical return on equity has been around 11% and book value
growth in the order of 5%. Will the future be significantly better, or worse?
The $24 real estate investment by the Dutch to buy the island of Manhattan
would today, by some estimates, be roughly equivalent to $3 trillion. Over 378
years, that's about a seven percent annual compound rate of return.
91
Scandal
Warren Buffett has used this model for American Express (salad oil scandal),
GEICO and more recently USG (asbestos litigation). Essentially, there is a big, onetime mess of some kind, but the enduring competitive advantage of the
underlying business is still in tact.
92
It Really Is Magic
93
94
Nature of Goods
A Complementary Good
95
Maslows Triangle
Self Actualization
(Truth, justice, wisdom & meaning)
Esteem Wants
(Self-respect, achievement, attention, recognition,
reputation, knowledge &
aesthetics)
Social Needs
(Friendship, group belonging, giving & receiving love)
Safety Needs
(Free from the threat of physical & emotional harm)
Physiological Needs
(Air/water/food/sleep)
For any business, consider whether its product/service acts as a painkiller or as a vitamin
tablet.
96
Total Utility
A Utility Vehicle
Everyone tries to maximize his utility, i.e. get most bang for buck. This may
include money, time, physical effort, social reward, pleasure reward, satisfaction
reward etc.
97
Value
A Great Value
98
Decision Models
Margin of Safety
"
"
"
A Small Margin
This model is based on the idea that the
future is uncertain and, therefore, if one
makes a choice with a sufficient margin of
safety, then even if the outcome is not as
predicted it should still be satisfactory.
Hence it has broad application.
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Pr O A C T
100
Process v Outcome
Good Judgement
You just made a great decision, but was the outcome due to...
Luck Skill Judgement
Review the decision making process, as that is the thing which can be controlled.
Often the outcome is out of our hands.
101
My Brokers Yacht
102
Trade-offs
103
104
105
Bayes Theorem
The conditional probability of the event A given that the event B has occurred is
described by Bayes Theorem (first developed by the English Reverend Thomas
Bayes):
Pr (A \ B) = The probability of A, given that B has occurred:
!
Pr (B \ A) * Pr (A)
Pr (B \ A) * Pr (A) + Pr (B \ not A) * Pr (not A)
106
Contrast Principle
Contrasting Principles
107
Correlation or Causation
'Asking The Right Questions', by Neil Browne and Stuart Keeley discusses
this problem:
!
We have an inherent tendency to 'see' events that are associated, or that 'go together', as
events that cause one another. That is, we conclude that because characteristic X (e.g.,
amount of TV viewing) is associated with characteristic Y (e.g., performance in school), that X
therefore causes Y.
The following are examples of such reasoning:
1. States with low speed limits tend to have a lower rate of highway death than states with
higher speed limits; thus, low speed limits deter highway death.
2. Absence of a father in the home occurs at a higher rate with juvenile delinquents than with
non-delinquents; thus, father absence is a cause of juvenile delinquency.
When we think this way, we are, however, often very wrong. Why? Usually, because multiple
hypotheses can explain why X and Y 'go together'.
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Doubt Avoidance
No Doubt
109
Extrapolation
People have a tendency to take the most recent, or the most easily available
information and project the 'trend' into the future in a linear fashion extrapolation.
Extrapolation is a dangerous game. Consider the following examples:
A linear extrapolation in 2004 of the global creditdefault swap market would have missed the
subsequent exponential rise.
110
Lets Spend It
From 'Why Smart People Make Big Money Mistakes and How to Correct
Them', by Gary Belsky & Thomas Gilovich:
!
This idea, developed and championed by the University of Chicago's Richard Thaler,
underlies one of the most common and costly money mistakes - the tendency to value some
dollars less than others and thus to waste them. More formally, mental accounting refers to
the inclination to categorize and treat money differently depending on where it comes from,
where it is kept, or how it is spent.
!
The notion of mental accounts is anathema to traditional economics, which holds that
wealth in general, and money in particular, should be 'fungible'. Fungibility, at its essence,
means that $100 in roulette winnings, $100 in salary, and a $100 tax refund should have the
same significance and value to you, since each [dollar could buy the same thing].
!
... the easiest-to-explain instance of mental accounting's harmful effects is the
different value people place on earned income as opposed to gift income. That is, we'll
spend $50 from Mom with less thought than $50 we've earned on the job.
!
Imagine that you go to a store to buy a lamp, which sells for $100. At the store you
discover that the same lamp is on sale for $75 at a branch of the store five blocks away. Do
you go to the other branch to get the lower price?
!
Now imagine that you go to the same store to buy a dining room set, which sells for
$1,775. At the store you discover that you can buy the same table and chairs for $1,750 at a
branch of the store five blocks away. Do you go to the other branch to get the lower price?
!
Credit card dollars are cheapened because there is seemingly no loss at the moment
of purchase, at least on a visceral level. Think of it this way: If you have $100 cash in your
pocket and you pay $50 for a toaster, you experience the purchase as cutting your pocket
money in half. If you charge that toaster, though, you don't experience the same loss of
buying power that emptying your wallet of $50 brings.
111
Groupthink
Groupthink
Gentlemen, I take it we are all in complete agreement on the decision here... Then I propose
we postpone further discussion of this matter until our next meeting to give ourselves time to
develop disagreement and perhaps gain some understanding of what the decision is all
about. - Alfred P. Sloan, Jr.
In 'Thinking and Deciding', by Jonathan Baron, the major errors that can
arise from Groupthink are highlighted The Group overestimates its abilities
!
Because there is an illusion of invulnerability
!
Due to a belief in the inherent morality of the group
The Group is Closed-Minded
!
Because there is a collective rationalization
!
Members hold stereotypes of out-groups
There is Pressure(s) Toward Uniformity
!
Self-censorship of members
!
There is an illusion of unanimity
!
Direct and indirect pressure is applied to dissenters
The behavior of a group may be completely different from the traits of the individuals
comprising the group.
By contrast, when good thinking occurs in groups, there is a commitment of the group to a
friendly (and sometimes not so friendly) interchange of arguments pro and con, not to a
decision already tentatively made. Loyalty to the group is defined in terms of loyalty to the
process of making the best decision, not loyalty to a decision already made.
112
Ideology
A Matching Ideology
A tendency to ignore facts and dismiss analyses that do not conform to a political
viewpoint.
The judgement is often reinforced by the 'commitment and consistency' principle,
especially when made in the presence of others.
113
Information Bias
114
115
Over-optimism
From 'Why Smart People Make Big Money Mistakes and How to Correct
Them', by Gary Belsky & Thomas Gilovich:
!
The core idea... is not particularly uplifting: You're probably not as smart as you think
you are. Overconfidence is pervasive, even among people who presumably have good
reason to think highly of themselves.
!
The classic example of this tendency is a 1981 survey of automobile drivers in
Sweden, in which 90 percent of them described themselves as above average drivers.
Clearly a large number of the respondents were giving themselves the benefit of what should
have been a very large doubt.
!
... what research psychologists have discovered about overconfidence is that most
people - those with healthy egos and those in the basement of self-esteem - consistently
overrate their abilities, knowledge, and skill, at whatever level they might place them.
!
... one financial consequence of overconfidence [is] under-preparedness. Another is
the willingness with which most people spend large amounts of money for products and
services about which they know very little.
!
To quote Odean and Barber: 'We argue that the well-documented tendency for
human beings to be overconfident can best explain the high trading levels and the resulting
poor performance of individual investors. Our central message is that trading is hazardous to
your wealth.'
116
Overweighting Numbers
Not everything that can be counted counts, and not everything that counts can be counted.
- Albert Einstein
A widely used management phrase is 'if you can measure it you can manage it'.
There is, however, a tendency to attach too little importance to things that cannot
be measured.
In part this can be attributed to the 'man with a hammer syndrome' - if the only
tool that a man has is a hammer, then every problem will look like a nail. So, for
example, an individual with great proficiency in numbers will tend to bias an
analysis towards data and its subsequent manipulation. And numbers may not be
the heart of the issue.
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Statistics
In a normal distribution, the
data is distributed around the mean
and 68% of the observations fall
within 1 standard deviation of the
mean, 95% fall within 2 standard
deviations and 99.7% within 3
standard deviations.
A series of numbers can be represented by the mean (average), the mode (most
frequent) and the median (middle number).
The mean is the most commonly used everyday statistic, but sometimes the
median provides
greater insight. For example, the median house price is a
better gauge than the average price as the nature of housing stock units across
the whole economy tends to remain the same and therefore the middle number
better represents the state of housing.
The normal distribution is the most important distribution in statistics. This
distribution called the 'central limit theorem', states that if a random variable X is
the sum of a large number of random increments, then X has the normal
distribution.
Consider the examples The daily turnover of a large store is the sum of the purchases of all the individual
customers. The height of a 50-year old oak tree can be thought of as the sum of
each year's growth - which itself is a variable affected by sunshine, temperature,
rainfall, etc. So one expects the heights of 50-year old oak trees to obey a normal
distribution. Similarly, an examination mark is the sum of the scores in a large
number of questions. Thus, by the central limit theorem, one expects daily
turnover, the heights of trees and examination marks (approximately, at least) to
be normally distributed.
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Economic Models
Animal Spirits
119
... individual initiative will only be adequate when reasonable calculation is supplemented and
supported by animal spirits, so that the thought of ultimate loss which often overtakes
pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts
aside the expectation of death.
In estimating the prospects of investment, we must have regard, therefore, to the nerves and
hysteria and even the digestions and reactions to the weather of those upon whose
spontaneous activity it largely depends.
We are merely reminding ourselves that human decisions affecting the future, whether
personal or political or economic, cannot depend on strict mathematical expectation, since
the basis for making such calculations does not exist; and that it is our innate urge to activity
which makes the wheels go round, our rational selves choosing between the alternatives as
best we are able, calculating where we can, but often falling back for our motive on whim or
sentiment or chance.
The idea is further developed and its impact on the broader economy
discussed by George A. Akerlof and Robert J. Shiller in 'Animal Spirits:
How Human Psychology Drives the Economy, and Why It Matters for
Global Capitalism ' ... there have been no principles in conventional economic theories regarding animal spirits.
Conventional economic theories exclude the changing thought patterns and modes of doing
business that bring on the crisis.
They even exclude the loss of trust and confidence. They exclude the sense of fairness that
inhibits the wage and price flexibility that could possibly stabilize an economy. They exclude
the role of corruption and the sale of bad products in booms, and the role of their revelation
when the bubbles burst. They also exclude the role of stories that interpret the economy.
All of these exclusions from conventional explanations of how the economy behaves were
responsible for the suspension of disbelief that led out to the [2007 to 2009] crisis.
120
Asymmetric Information
Its a Lemon
When one party to a transaction has more relevant information than the other. For
example: The insurance deductible is a tool for teasing out private information.
121
Bubbles
A Bubble Prayer
The recurring nature of market extremes provide some examples - Japanese real
estate and stocks in the 1980s; the internet mania of 1999 & 2000; and more
recently global property markets.
122
feedback to even greater optimism. It's 'Japan as Number One' or the 'East Asian Miracle'
or 'The New American Economy' - a new sense of more profound optimism about the
economic environment.
!
Minsky noted that 'euphoria' might develop at this stage. Investors buy goods and
securities to profit from the capital gains associated with the anticipated increases in the
prices of these goods and securities. The authorities recognize that something exceptional is
happening in the economy and while they are mindful of earlier manias, 'this time it's
different', and they have extensive explanations for the difference.
!
A follow-the-leader process develops as firms and households see that others are
profiting from speculative purchases [and the envy principle goes to work]. More and more
firms and households that previously had been aloof from these speculative ventures begin
to participate in the scramble for high rates of return. Making money never seemed easier.
!
If the eagerness of the outsiders to buy is stronger than the eagerness of the insiders
to sell, the prices of the assets or securities continue to increase. In contrast if the sellers
become more eager than the buyers, then the prices will decline.
!
As the buyers become less eager and the sellers become more eager an uneasy
period of 'financial distress' follows...
!
As the decline in prices continues, more and more investors realize that prices are
unlikely to increase and that they should sell before prices decline further; in some cases this
realization occurs gradually and in others suddenly. The race out of real or long-term financial
securities and into money may turn into a stampede.
!
The specific signal that precipitates the crisis may be the failure of a bank or of a firm,
the revelation of a swindle... or a sharp fall in price.
Magazine covers are a useful money-management tool because they indicate the
point in time when public awareness of a financial subject has reached maximum
saturation and by extension, the point in time when prices within the subject
market are likely to be at, or near, a major extreme.
123
Comparative Advantage
124
Creative Destruction
Creatively Destroying
U.S. Rubber! !
!
North American!
!
Tennessee Coal & Iron!
125
126
Diminishing Returns
127
Equilibrium
Perfect Equilibrium
128
Externalities
A Negative Externality
Sometimes our actions do not have costs. These actions can affect others and yet
we do not suffer any consequences. A good example of just such a negative
externality would be pollution - the pollution from a car, or even noise pollution
from loud music.
On the other hand, an externality could be positive. If the exterior of a house is
particularly beautiful, both passersby and neighbors alike will receive a benefit
from its appearance.
The inability to charge for externalities (positive and negative) may be a problem
and is therefore an opportunity for better resource allocation.
129
Markets
The Market Looks Great Today
130
Moral Hazard
Describes a situation where one party does not bear the true costs associated
with its actions, and is therefore likely to behave in a reckless fashion.
Moral Hazard issues can occur at any level - for example, government insurance
subsidies allowing homeowners to build near vulnerable coastlines; a teenager's
car insurance incorporated under the parent's accident free policy etc.
131
Price Discrimination
132
Property Rights
Our Fish
133
Public/Private Goods
A Public Good
Public Goods are available to everyone and people cannot easily be prevented
from using them. Examples include clean air and the protection of the Military.
Using a Public Good does not hinder, or diminish, another's access to that good.
Public Goods can have the problem of the Free Rider - a person who receives the
benefit of a good but avoids paying for it.
Private Goods, on the other hand, can be charged for.
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Sunk Costs
135
Switching Costs
High Switching Cost
Contractual commitments
Durable purchases !
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Switching Costs
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Brand-specific training!!
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Specialized suppliers!
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Loyalty programs!
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136
Transaction Costs
Every exchange incurs some kind of transaction cost. Consider electronic share
trading, which has sharply lowered the cost of buying and selling shares, both in
terms of commissions and the spread between bid and offer.
But money may not be the only consideration. Time is also a component in a
transaction. The large range of products under one roof in a supermarket is a
convenience for many people as it reduces the time transaction costs associated
with buying groceries and household essentials.
On a macro level, transaction costs can play an even bigger role: The time to set
up a business corporation; to prepare and file taxes; the costs in resolving
business contract disputes etc.
Lowest
Suriname
694
Australia
Guinea-Bissau
233
Canada
Haiti
203
Denmark
Iceland
United States
Laos
163
Singapore
Congo
155
Puerto Rico
137
System Models
Back-up/Redundancy
138
Bottlenecks
139
Natural Complexity
In systems such as economies, stock markets etc., behavior often changes as a
result of the behavior of others and experiential learning (feedback loop). These
systems therefore become difficult to predict as unexpected (emergent)
properties may emerge.
A complex system involves large numbers of interacting elements. Interactions
are non-linear. Consider a steady stream of sand grains that randomly pile up on
top of each other. At some point the pile of sand reaches a critical state. The next
grain of sand causes the pile to topple over and one has to start again. In this
way, the sand grains are similar to a number of other systems, in that when they
have reached the critical state the slightest change (shock) will cause the system
to malfunction. Further, the smallest change can produce the most radical
malfunction and this change may be unavoidable and unforeseeable.
The system is dynamic, the whole is greater than the sum of its parts, and
solutions can't be imposed; rather they arise from the circumstances emergence.
The system has a history, and the past is integrated with the present; the
elements evolve with one another and with the environment; and evolution is
irreversible.
Though a complex system may, in retrospect, appear to be ordered and
predictable, hindsight does not lead to foresight because the external conditions
and systems constantly change.
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Complexity Economics
Traditional Economics
Dynamics
Agents
Networks
Emergence
Evolution
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Evolution
The Explanation?
If some individuals have a trait that allows them to better compete in a given
environment, then they are more likely to survive into adulthood and produce
offspring. And the offspring are likely to carry the same trait. The organism acts,
and has evolved, to further the interests of its genes.
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Feedback Loops
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Momentum
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Newtons Laws
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Power Law
Mark Buchanan, describes how some systems can be represented by the
Power Law in his book 'Ubiquity - why catastrophes happen':
In terms of energy, it turns out that the Gutenberg-Richter law boils down to one very simple
rule: If earthquakes of type A release twice the energy of those of type B, then type A quakes
happen four times less frequently. Double the energy, that is, and an earthquake becomes
four times as rare. This simple pattern - a power law - holds for quakes over a tremendous
range of energies.
!
Remarkably, Bak and his colleagues found a similar relationship for avalanches in the
sandpile game. Counting up how frequently avalanches of each size happened, they found
that avalanches toppling anything from a few up to a few million grains follow a regular
pattern: Double the number of grains involved, and the avalanche becomes just a bit more
than twice as unlikely (more precisely, about 2.14 times as unlikely).
!
...their data for 4,284 fires on U.S. Fish and Wildlife Service lands between 1986 and
1995 reveals a remarkably strong power law. Once again we find the same geometric
pattern: double the area covered by a fire, and it becomes about 2.48 times as rare, and the
pattern holds for fires varying in size by a factor of a million. In other words, despite the
immensely complex picture of how fires spread, a startlingly simple pattern emerges when
you look at how often you find fires of different sizes - a kind of Gutenberg-Richter law for
ecological conflagration.
!
Using data for the twenty-four hundred largest cities in the United States, Zanette and
Manrubia counted up how many cities there are with populations of around one hundred
thousand, two hundred thousand, three hundred thousand, and so on... The numbers reveal
that for every city such as Atlanta, Georgia, population four million, there are four cities having
populations half that size. Cincinnati, Ohio, is one such city, and for every Cincinnati there are
in turn four cities just half as large again, and so on down the line. This perfect geometrical
pattern continues down to the smallest cities of just ten thousand people or so.
!
Things that live in critical states tend to show similar kinds of organization, and this
organization arises not from specific details of those systems and the elements that make
them up, but from the far deeper skeleton of basic geometry and logic behind these details.
The critical form wells up in things regardless of what they are. When something is
recognized to be in a critical state, its essential character can be understood even by
ignoring most of the details.
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Reflexivity
Interacting Observers
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Six Degrees
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previous ones. Hence, an initial shock can propagate throughout a very large system, even
when the shock itself is small.
!
As a result, the primary feature of the cascade model - that apparently stable
systems can suddenly exhibit a very large cascade - can also be interpreted as a statement
about the inherent fragility of complex systems, even those that seem robust.
[Alternatively this sudden change of state can be imagined as...]
!
Phase transition - driven by the addition of a small number of links right near the
critical point that have the effect of connecting many very small clusters into a single giant
component, which then proceeds to swallow up all the other nodes until everything is
connected.
[Bringing these two concepts together one can see, as the author explains, how...]
"
In 1997, the decoupling of the Thai bhat from the U.S. dollar triggered a real estate
crisis in Thailand that led to the collapse of its banking system... within months, financial
distress had spread to the other Asian Tigers prompting a depression in the prices of
commodities. Russia, meanwhile, was heavily dependent on its oil exports. A Russian
budgetary crisis ensued, and the government was forced to default on its sovereign debt...
the shock to the world debt markets caused investors to flee bonds of any kind other than
those of the U.S. government.
[Thus completing the link from the distressed Thai real estate investor to the holder of U.S.
treasuries.]
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System Boundary
The idea of drawing a system boundary around the area to be studied is not only
valid in engineering, but also in business.
The most common boundary is that of the organization, which is represented by
the company's profit/loss; but the boundary could be drawn around all the
companies from the raw material to the final customer, which would represent the
profit/loss of the supply chain; or, alternatively, the boundary could be drawn
around the individual production process within the company to determine the
product's profit/loss.
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We commonly consider hair to be part of the body, because it is attached to it. When we are
thinking of thermal problems, parasite problems, or swimming problems, it is useful to
consider the hair in such a way. But this accepted mode of thought blinds us to the
possibility that, for some purposes, hair is better thought of as being outside of the body.
Unlike the material in body cells, material once secreted into the hair no longer participates in
the body's physiological processes. Since material in the hair was once inside the body's
physiological system and is now outside, it is useful for the physiologist to think of hair as
excrement - just like perspiration, urine, feces, and, for that matter, toenails.
These examples could be multiplied endlessly to demonstrate how our built-in
notions of 'natural' boundaries may make a difference in the effectiveness of our
thought.
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Thermodynamics
Impromptu Cooling
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