Episode #8 - Mr. Spock and Homer Simpson: The Two Sides of Human Economic Behavior

Ed and Ron discussed the two sides of human action: rationality and irrationality on the August 22nd show, and why economists (such as Steven Landsburg, David Friedman, Steven Levitt, and many others) cling to this assumption even though it’s been challenged by behavioral economists such as Dan Ariely, Richard Thaler, and others. The assumption of rationality has come under attack in recent decades, mostly from within the economics profession itself. The idea that “Economic Man”––Homoeconomicus––has unbounded rationality, self-interest, free-will, is selfish, self-maximizing, and entirely efficient in his decisions and choices, has sometimes been proven false by a new school of economics: Behavioral Economics.

Rather than man being a completely rational calculator, similar to Mr. Spock of StarTrek fame, it seems in many areas of life we act more like Homer Simpson of TheSimpsons. It’s doubtful a Mr. Spock would need Alcoholics or Gambling Anonymous, or the idea of a self-control credit card that in advance voluntarily limits one’s spending in various categories automatically.

Mr. Spock: The Assumption of Rationality

Most of economics can be summarized in four words: “People respond to incentives.” The rest is commentary

–Steven Landsburg, The Armchair Economist: Economics & Everyday Life

Critics charge that the assumption of rationality turns the average person into a cold, calculating individual whose only interest is to maximize their wealth (or utility, or power, or whatever). Yet simple observations of human behavior reveal all sorts of activities that would not be deemed rational. We can all think of “irrational” acts that most people commit daily:

•  We pay higher prices for goods and services endorsed by celebrities;

• We routinely vote in elections even when we know our one vote won’t decide the outcome;

• We leave tips in restaurants to strangers, in locations we will never visit again.

Given these realities, it appears as if the assumption of rationality is false, and this doesn’t seem to concern professional economists. But here is how Steven Landsburg explains this assumption in his textbook, Price Theory and Applications:

But the fact of the matter is that all assumptions made in all sciences are clearly false. Physicists, the most successful of scientists, routinely assume that the table is frictionless when called upon to model the motions of billiard balls. All scientists make simplifying assumptions about the world, because the world itself is too complicated to study.

To a large extent, the assumption of rationality is nothing more than a commitment to inquire sympathetically into people’s motives. [When we observe what at first appears to be irrational behavior] we have a choice. Either we can remark––wistfully or cynically, according to our temperament––on the inadequacy of human nature, or we can ask, “How might such behavior be serving someone’s purposes?” The first option offers the satisfaction of exempting oneself from the great mass of human folly. The second offers an opportunity to learn something.

David Friedman, in Hidden Order: The Economics of Everyday Life, explains the assumption of rationality this way:

…the assumption describes our actions, not our thoughts. If you had to understand something intellectually in order to do it, none of us would be able to walk.

Economics is based on the assumption that people have reasonably simple objectives and choose the correct means to achieve them. Both assumptions are false––but useful.

Suppose someone is rational only half the time. Since there is generally one right way of doing things and many wrong ways, the rational behavior can be predicted but the irrational cannot. If we assume he is rational, we predict his behavior correctly about half the time––far from perfect, but a lot better than nothing. If I could do that well at the racetrack I would be a very rich man.

…rationality is an assumption I make about other people. I know myself well enough to allow for the consequences of my own irrationality. But for the vast mass of my fellow humans, about whom I know very little, rationality is the best predictive assumption available.

Examples of Rationality Ed and Ron Discussed

• Why do we have .99 cent pricing?

• Why are Coke vending machines far more elaborate, and costly, than newspaper racks, where it’s quite easy to take more than one paper?

• The four ways we can spend money.

Homer Simpson: Irrational?

Nobel Economist Herbert Simon believed that man did not maximize utility, but rather attempted to “satisfice”––that is, do good enough. He believed man had a “bounded rationality,” and often used shortcuts––hueristics––to make decisions that although not perfectly optimal were good enough.

The recent work of Behavioral Economists is fascinating, often challenging and falsifying the traditional economists’ assumption of rationality. Books such as Predictably Irrational, Revised and Expanded Edition: The Hidden Forces That Shape Our Decisions and The Upside of Irrationality: The Unexpected Benefits of Defying Logic at Work and at Home, by Dan Ariely; Nudge: Improving Decisions About Health, Wealth, and Happiness, by Richard Thaler and Cass Sunstein; The Mind of the Market: Compassionate Apes, Competitive Humans, and Other Tales from Evolutionary Economics, by Michael Shermer, among many others, are fascinating looks at human behavior that conclude that man certainly has the capacity in some functions to be a Mr. Spock, but that a lot of the time we are more like Homer Simpson, a Homer Economicus, if you will.

Here are just some of the anomalies that argue in favor of man’s irrationality:

• Loss-Aversion Effect. We are more adverse to loss than gain of size. It takes $2 of gain to offset $1 of loss, psychologically.

• Endowment Effect. We value something much more as soon as it’s ours, which is why a lot of manufacturers (and pet stores) will grant a 30-day return policy.

• Confirmation Bias. Once we form a belief, or vision of the world, we pay no attention to evidence that disproves it.

• Anchoring Effect. We give undue weight to anchors from the past, even if they are no longer relevant. Depression babies remember .05¢ candy bars, we recall $1.50 per gallon gas, we sometimes spend $100 for an omelet after being shown one for $1,000. Campbell’s soup sold twice as many cans when a sign on the shelf read “Limit of 12 per Person,” then when the sign read “No Limit per Person.”

• Better-Than-Average Bias. We’re all above-average drivers, more rational voters than our neighbors, etc. Also known as the Lake Woebegone Effect.

• Relative vs. Absolute Thinking. We tend to think in relative, not absolute terms. If you’re purchasing a $25 pen and someone in the store tells you it’s on sale for $18 at another 10 minutes away most people would leave for the other store. However, if you were buying a $455 suit and could save $448 at another store 10 minutes away, most wouldn’t bother. But it’s a $7 savings no matter what.

• Zero Price Irrationality. Nothing is as exciting as “FREE!” even if we don’t need it, which is why we load up with useless knick-knacks at conventions, and spend more at Amazon.com than we otherwise planned to get the FREE shipping.

• Framing Effect. How information is presented can evoke different emotions and comparisons. “The odds of survival one month after surgery are 90%” is more reassuring than the equivalent statement that “mortality within one month of surgery is 10%. Cold-cuts described as “90% fat-free” are more attractive than when they are described as “10% fat.”

Critiques of Behavioral Economics

Not all economists are convinced by the research that man is not rational, let alone willing to forego the assumption of rationality (the endowment effect and confirmation bias in action?).

Ludwig von Mises refused to call bad decision making “irrational.” He stated:

Error, inefficiency, and failure must not be confused with irrationality. He who shoots wants, as a rule, to hit the mark. If he misses, he is not ‘irrational,’ he is a poor marksman.

This is why Richard Thaler and Cass Sunstein, in their book Nudge: Improving Decisions About Health, Wealth, and Happiness, are arguing that people need to be nudged to make the correct decisions, especially when decisions are complex and have long-term consequences, such as retirement planning.

They’ve experimented with 401(k) plans being automatically opt-in, so that employees have to fill out paperwork to opt-out. Participation rates quadrupled. They did the same with having employees pledge to increase their participation percentage as they receive future raises, which most did, compared to increasing contributions after receiving the pay raise. Since it’s easier to forgo future raises that you don’t have yet.

But as Tim Harford points out in his book, The Logic of Life: The Rational Economics of an Irrational World, since a lot of behavioral economic theories are based on laboratory experiments––albeit very cleverly designed and executed––we can’t extrapolate from them “unless we are confident that the conditions of the experiment––which are necessarily contrived––resemble the kind of situations we face in real life.

That is far from certain, as an economics professor named John List has been discovering. On several occasions, List has taken a deeper look at the laboratory discoveries of irrationality and found that rational behavior isn’t far beneath the surface after all.”

Let the debate and research continue, since science and understanding progresses by dissent, not consensus.

Other books and resources mentioned

"That's a problem for future Homer"

Miton and Rose Friedman’s book, Free to Choose: A Personal Statement

The television series Free to Choose with Milton Friedman, with both the 1980 original series and the 1990 updated version at http://www.freetochoose.tv/

Steven Levitt’s books, Freakonomics Rev Ed: (and Other Riddles of Modern Life) and Think Like a Freak: The Authors of Freakonomics Offer to Retrain Your Brain

Rory Sutherland’s Zeitgeist talk, wherein he shows the $300 million effect by changing a web etailers button from “sign-in” to “continue.”

Herbert A. Simon's book, Models of My Life, where he discusses the concepts "bounded rationality" and "satisficing."

Episode #7 - Everyday Ethics: Doing Well and Doing Good

It’s not easy to be a good citizen in a bad society.

–Aristotle

Ed and Ron start out by discussing the classic trolley thought experiment, a branch of ethics now known as Trolleyology.

Spike

Fat man push

Fat man trap door

An excellent book by David Edmonds, Would You Kill the Fat Man?: The Trolley Problem and What Your Answer Tells Us about Right and Wrong, along with a two-part video series on YouTube: Part I and Part II.

Fat Man Book

Why Study Ethics?

Ethics––originating from the Greek word ethos, meaning habit––is the study of morality. Morality is concerned with social practices defining right and wrong. It exists prior to the acceptance by any one individual.

In other words, morality is not a personal choice but a social construct. Ethical theory is a reflection on right actions.

After all, you would not need to study morality or ethics if you were stranded on an island, since there would be no one to be “just” or “unjust” to.

The Josephson Institute of Ethics defines ethics:

Ethics is about how we meet the challenge of doing the right thing when that will cost more than we want to pay. There are two aspects to ethics: The first involves the ability to discern right from wrong, good from evil, and propriety from impropriety. The second involves the commitment to do what is right, good and proper. Ethics entails action; it is not just a topic to mull or debate.

Normative Ethical Theory

There are many normative ethical theories. Theory is important because it enables us to control, predict or explain human behavior. Some of the most common normative ethical theories will be discussed below.

Utilitarianism

To do as one would be done by, and to love one’s neighbor as one’s self, constitute the ideal perfection of utilitarian morality.

–J.S. Mill, Utilitarianism (Illustrated), II, 1863

Utilitarianism is one of the leading consequentialist ethical theories––that is, the morality of an act should be judged only based on its consequences.

At Glasgow University, Adam Smith’s inspiring teacher Francis Hutcheson (1694-1746) coined the phrase “The greatest happiness of the greatest number.” Jeremy Bentham (1748-1832) in particular made this the cornerstone of his utilitarian philosophy as outlined in his Introduction to the Principles of Morals and Legislation, published in 1789.

According to Bentham, the battle in life is not between good and evil, or between reason and passion, but between pleasure and pain: “Nature has placed mankind under the governance of two sovereign masters, pain and pleasure. He proposed we weigh up the net pleasure against the net pain (what he termed “felicific calculus”).

The goal of society should be the “greatest happiness principle”––that is, “the greatest happiness of the greatest number.” The concept of utility (utils), cost-benefit analysis, and the progressive income tax (e.g., an extra dollar to Bill Gates is worth less than to a homeless person), has its origins in this theory.

Some refer to utilitarians as hedonistic since they believe that any act that maximizes pleasure or happiness is right.

Kantian Ethics

Always recognize that human individuals are ends, and do not use them as means to your end.

–Immanuel Kant

Rather than analyzing the consequences of actions, another philosophical theory holds that one should do what is right. This is known as deontology, a Greek term meaning duty.

Deontologists believe in universal principles (thou shall not steal, etc.) and consequences should not be the only criteria used to judge moral behavior. The leading deontologist is the German Philosopher Immanuel Kant (1724-1804).

In other words, one should do what is right, for the right reasons. If one is honest only because they believe honesty pays, it’s not as moral as those who are honest because it is the right thing to do.

Virtue Ethics

Virtue is its own reward.

–Cicero, De finibus, III, c. 50 B.C.

Greek philosophers spoke of good habits and bad habits. The good habits were called “virtues” and the bad habits “vices.” Every person develops a unique combination of both habits, known as character. This formulation allows us to predict human behavior, as is done, for instance, when we say someone acted “out of character.”

The Greeks thought that character was destiny.

Rights Theories

Rights theorists hold that human rights are independent of citizenship in a state or any other social organization, unlike legal rights that may vary from place to place. As formulated by John Locke, David Hume, and Edmund Burke––among others––natural rights consist of rights to be free from state interference.

Of course, with these rights come certain obligations, or duties, not to interfere with the rights of others. These are known as negative obligations, meaning one does not interfere with the liberty of others. Positive obligations, on the other hand, require some persons (or institutions) to provide for others (medical care, or welfare, for example).

True rights exist simultaneously among people. The exercise of a right by one person does not diminish those held by another and imposes no obligations on others.

For example, my right to free speech does not inhibit yours, nor does it oblige you to listen to my views. Furthermore, natural rights theorists believe that without freedom there is no virtue, since a coerced virtue is no virtue at all.

Other Ethical Considerations

Morality and Law

I have spent my whole life under a Communist regime, and I will tell you that a society without any objective legal scale is a terrible one indeed. But a society with no other scale than the legal one is not quite worthy of man, either.

– Alexander Solzhenitsyn, commencement address, Harvard University, 1978

The University of Pennsylvania’s motto is: Leges sine moribus vanae, “Laws apart from moral habits are empty.”

Just because a particular law is voted on by a majority does not make it moral. Apartheid, Nazism, and the Fugitive Slave Act of 1850 were all supported by a majority. Legal remedies can sometimes preclude ethical remedies. For example, how would you be able to tell what is the right thing to do without a legal precedent?

What About “Business Ethics”?

It is common today to speak of “medical ethics,” “bio ethics,” “accounting ethics,” and so forth.

In his 1981 article in The Public Interest, “What is Business Ethics”?, management thinker Peter Drucker challenges the concept of a separate ethics for business:

What difference does it make if a certain act or behavior takes place in a “business,” in a “non-profit organization,” or outside any organization at all? The answer is clear: None at all.

 …”business ethics” may be good for politics and good electioneering. But that is all. For ethics deals with the right actions of individuals.

Altogether, “business ethics” might well be called “ethical chic” rather than ethics––and indeed might be considered more a media event than philosophy or morals.

Summary and Conclusions

Character is ethics in action, it is what and who you are. Reputation is what people say you are.

Abraham Lincoln likened character to a tree and reputation to its shadow.

The Josephson Institute of Ethics lists Six Pillars of Character:

1. Trustworthiness

2. Respect

3. Responsibility

4. Fairness

5. Caring

6. Citizenship

Other books and resources mentioned

Arthur Andersen’s Website. Oscar Wilde warned: “No man is rich enough to buy back his past.”

The Rule of Nobody, the book mentioned by Ron. It’s an excellent read!

Also highly recommended in Michael Novak’s <Business as a Calling. Novak compellingly assets that business is a moral serious enterprise, and we believe he’s right.

Charles Murray’s book, Human Accomplishment, names ethics as one of the fourteen meta-inventions.

Capitalism: The Unknown Ideal, Ayn Rand explains and defends natural rights.

Episode #6 - Interview with Distinguished Professor of Economics, Deirdre McCloskey

We were honored to have as our first guest the Distinguished Professor of Economics, History, English, and Communication at the University of Illinois at Chicago, Deirdre McCloskey. A well-known economist and historian and rhetorician, she has written sixteen books and around 400 scholarly pieces on topics ranging from technical economics and statistics to transgender advocacy and the ethics of the bourgeois virtues. She is known as a "conservative" economist, University-of-Chicago style (she taught for 12 years there), but protests that "I'm a literary, quantitative, postmodern, free-market, progressive Episcopalian, Midwestern woman from Boston who was once a man. Not 'conservative'! I'm a Christian libertarian." Her latest book, Bourgeois Dignity: Why Economics Can't Explain the Modern World, which argues that an ideological change rather than saving or exploitation is what made us rich, is the second in a series of four on The Bourgeois Era. The first was The Bourgeois Virtues: Ethics for an Age of Commerce(2006), asking if a participant in a capitalist economy can have an ethical life (briefly, yes).

"We fans of innovation and markets have done enough preaching to the choir," she says. "We need to speak to our beloved critics on the left and right who do not think that the Age of Innovation was the best thing to happen since the invention of language."

What caused the Industrial Revolution?

Economist Deirdre McCloskey, in Bourgeois Dignity, has looked at the possible causes from every conceivable angle. This is the second book in a series (the first was Bourgeois Virtues, which sets out to answer this question:

What caused the spectacular growth in the economy from the late 18 century to the present day, going from an income of approximately $3 per day to $137 today?

It’s even larger than that if you take into account the quality of goods and services available today versus then. One simple example is antibiotics. Simple infections that once killed incredibly wealthy people can now be cured with five dollars and a trip to the drugstore. Estimates put the growth in the quality of goods and services at a factor of 40 to 190—I believe even that is an understatement.

In 1875, the average family spent 74% of its income on food, clothing and shelter. In 1995 they spent 13%. This is one reason why Ed Kless says he’d rather be poor anywhere in the world today than in 1800.

This is an incredible accomplishment, and historians, economists, sociologists, poets, along with many others, have offered a plethora of explanations to explain it. McCloskey explores them all, but she reaches a totally different conclusion than most economists. In fact, the subtitle of the book is “Why economics can’t explain the modern world.”

All Transformation is Linguistic

McCloskey believes that economic change depends on what people believe—their talk, their ethics, and their ideas, especially as related to dignity and innovation. It’s what Alexis de Tocqueville called “habits of the mind.”

Yet “ideas about ideas are unscientific” and ignored by economists who naturally gravitate towards materialist explanations for growth and dynamism. McCloskey writes:

To be able to detect the dark matter we will need a new, more idea-oriented economics, which would admit for example that language shapes an economy.

One of my favorite lines discovered recently is Werner Erhard’s “All transformation is linguistic. If we want to change our culture, we need to change our conversation.”

McCloskey’s argument is this statement on steroids. In other words, our conversations about dignity and liberty changed, launching the Industrial Revolution. Here’s how McCloskey expresses this phenomena:

A big change in the common opinion about markets and innovation, I claim, caused the Industrial Revolution, and then the modern world. The change occurred during the seventeenth and eighteenth centuries in north-western Europe. More or less suddenly the Dutch and British and then the Americans and the French began talking about the middle class, high or low—the “bourgeoisie”—as though it were dignified and free. The result was modern economic growth.

That is, ideas, or “rhetoric,” enriched us. The cause, in other words, was language, that most human of our accomplishments.

McCloskey here is using the word rhetoric in its ancient sense, “the means of [unforced] persuasion,” which includes logic and metaphor, fact and story. She’s written many books on this topic, criticizing economists for not telling better stories, two of which I thoroughly enjoyed: The Rhetoric of Economics (Rhetoric of the Human Sciences), and If You're So Smart: The Narrative of Economic Expertise.

In the spirit of words being crucial, she’s attempting to rid the world of the dreaded “Capitalism,” preferring “Innovation” instead to explain the wonders of a free market.

Rhetoric Over Matter

Most causes of the Industrial Revolution rely on a materialist explanation, from natural resources and climate to geography, transportation and foreign trade. Yet in chapter after chapter, McCloskey definitively falsifies the following list of reasons often cited as the cause of the Industrial Revolution:

• The Weber Thesis—The Protestant (particularly Calvinism) ethic

• Michael Porter’s thesis of competitive strategy of nations (this is deftly ripped apart by McCloskey, and R.I.P. as far as I’m concerned)

• Rise of rationality

• The exchange of ideas. Ideas having sex, in Matt Ridley’s phrase from The Rational Optimist P.S. - It helps, but it’s simply not large enough to have caused the Industrial Revolution

• Education. In fact, too much education can impair growth. An interesting discussion is provided by McCloskey, and in Thomas Sowell’s work as well.

• Thrift (savings accumulation)

• Investment (capital accumulation)

• Economies of scale

• Division of labor

• Greed

• Expropriation or imperialism

• Human capital. Not that this is unimportant, but McCloskey would argue that social capital—specifically, our conversations and beliefs—are more important

• Transportation

• Foreign trade. This simply reshuffles goods and services, it doesn’t discover or lead to innovation

• Geography. Jared Diamond’s thesis is thoroughly shot down

• Natural resources. McCloskey believes there’s no such thing as a natural resource, except the imagination of man

• Unions

• Eugenics

• Institutions. No doubt important, but no way did they cause the spectacular growth, and mostly were formed afterwards

• Property rights. Again, they are important, but they existed in all sorts of places prior to Great Britain (China, e.g.)

• Science. This is more a result, not a cause

Thankfully, she also takes down the happiness literature that’s beginning to sprout up in economics, which is just so much hokum.

One discussion that runs through the narrative is the “California School”—why so many scholars (who tend to be disproportionately located in California universities) believe that numerous discoveries were originally from China, giving error to the idea of European exceptionalism. McCloskey is more and more convinced of the findings of this school of thought, and so will you after reading about it.

In the final chapter, she summarizes the “Bourgeois Deal”:

Give a woman some rice, and you save her for a day. Give a man some seed and you save him for a year. That’s the plan of investment in capital, tried for decades in foreign aid, without much success. But give a man and a woman the liberty to innovate, and persuade them to admire enterprise and to cultivate the bourgeois virtues, and you save them both for a long life of wide scope, and for successively wider lives for their children and their grandchildren, too. That’s the Bourgeois Deal, which paid off in the Age of Innovation.

We find McCloskey’s work compelling, and it certainly has changed our worldview on the causes of the Industrial Revolution. It truly gives weight to the saying “all transformation is linguistic.”

Conclusion

Professor, thank you again for appearing today and sharing your wisdom.

Author and educator William Arthur Ward wrote:

The mediocre teacher tells. The good teacher explains. The superior teacher demonstrates. The great teacher inspires.

You have certainly inspired Ed and me, and for that we will be eternally grateful.

Other books and resources mentioned

Ron’s LinkedIn blog post that reviews Bourgeois Dignity: Why Economics Can’t Explain the Modern World. Be sure to read some of the comments.

Cato Unbound, a discussion on Professor McCloskey’s book Bourgeois Dignity: Why Economics Can’t Explain the Modern World.

Bourgeois Equality: How Betterment Became Ethical, 1600-1848, and Then Suspect, the final book in the series, to be published later this year.

Episode #5 - Replacing the Annual Appraisal Agony

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Appraisal is not the system that drives pay, careers, and status; it is an incidental effect of those dynamic systems. Appraisal is primarily the paper-shuffling that sanctifies decisions already made. –Tom Coens and Mary Jenkins, Abolishing Performance Appraisals

Human capital determines the performance capacity of any organization. Today’s knowledge workers, unlike the factory workers of the Industrial Revolution, own the means of production. Ultimately, knowledge workers are volunteers, since whether they return to work is completely based on their volition.

Consequently, it is difficult to understand the continued reliance on the “annual agony" —the performance-appraisal apparatus. According to Tom Coens and Mary Jenkins, in their seminal book Abolishing Performance Appraisals: Why They Backfire and What to Do Instead, over 50 years of academic studies reveal scant empirical evidence of the effectiveness of performance appraisals at actually improving performance.

Despite these facts, organizations cling to it in an uninformed belief that there is no suitable replacement. Where did this ritual come from?

The Origins of Performance Appraisals

The modern antecedent of the appraisal process was explained by Peter Drucker in his book, The Effective Executive:

Appraisals, as they are now being used in the great majority of organizations, were designed by the clinical and abnormal psychologists for their own purposes. He is legitimately concerned with what is wrong, rather than with what is right with the patient. The clinical psychologist or the abnormal psychologist, therefore, very properly looks upon appraisals as a process of diagnosing the weaknesses of a man.

The appraisal tends to focus on weaknesses, not strengths—what psychologists call the “presenting problem.” But good leaders—like good coaches—design performance processes and tasks around a person’s strengths, and ignore—or make irrelevant—their weaknesses.

What about the Law?

Two primary defenses for maintaining performance appraisals are that they are required by law, and that they are required documentation to terminate an employee. Both assertions are false. Most workers in the United States are employees at will; they can be fired for any reason, or no reason at all, with or without warning. There are exceptions to this doctrine, and they have grown over the years, yet there is no explicit legal reason to perform performance appraisals.

Tom Coens, coauthor of the definitive book, Abolishing Performance Appraisals, is a labor and employment lawyer with thirty years of experience. He dispels the myths surrounding the effectiveness of performance appraisals from a legal perspective.

Jay Shepherd is another unapologetic management-side lawyer who practiced for 17 years. In his indispensable book, Firing at Will: A Manager's Guide, Jay explains why he, too, is a critic of performance appraisals, labeling them “the dumbest managerial tool,” and explains how they can actually hurt your chances in court.

Deleterious Effects of Performance Appraisals

Performance appraisals have become, to borrow a term from the medical profession, an iatrogenic illness—that is, a disease caused by the doctor. An estimated ten percent of all hospital patients suffer from this type of disease. We need to apply the Hippocratic principle of primum non nocere (“first, do no harm”) to the performance appraisal process.

The following are some of the more serious negative effects of the performance appraisal (PA):

• PAs are counterproductive to “driving out fear,” the one emotion that Dr. Edwards Deming believed needed to be eliminated to improve human performance;

• PAs focus on the weaknesses of the worker rather than his or her strengths;

• Learning is overshadowed by the evaluation and judgment inherent in the PA;

• Even if PAs convey both strengths and weaknesses, it is human nature for negative feedback to drown out positive feedback;

• Effective feedback should occur as needed, not on an arbitrary date on a calendar;

• PAs are a symbol of a paternalistic boss-subordinate relationship based on command and control rather than the knowledge worker being responsible for his or her own development;

• PAs impose a one-size-fits-all approach that impedes relevant, authentic feedback to different individuals;

• Too much “noise” surrounds the PA process: discipline or termination, pay raises, bonuses, promotions, and the like, lessening the focus on performance improvement;

• Ranking people against each other does not help them do a better job. Ranking people, also, by definition, creates “bottom performers,” regardless of the absolute value of their work;

• PAs devote far too much scarce leadership attention to underperforming employees rather than top performers;

• PAs are extremely costly to administer relative to their meager benefits;

• PAs provide no effective method for holding people accountable for future results, since they focus on the past;

• Any self-acknowledged weakness by a team member can be used against them, deterring learning and self-development;

• PAs confuse delivering effective feedback with filling out bureaucratic forms and check-the-box administrative activities that have no connection to strategic purpose or value creation;

• PAs reinforce a requirement for human-resources departments to keep KGB-like dossiers on team members;

• PAs create a false impression that a scientific and objective process is being applied to measure individual performance. Yet all PAs, in the final analysis, are subjective and based on judgment;

• PAs obscure the fact that a firm is an interdependent system, and what matters is the performance of the whole, which is not merely the sum of its components;

• PAs provide the illusion of protection from lawsuits and allegations of wrongful termination, when in fact they rarely offer that protection—and often backfire in litigation.

• According to author Daniel Pink in “Think Tank: Fix the workplace, not the workers” (November 6, 2010), “Performance reviews are rarely authentic conversations. More often, they are the West’s form of kabuki theatre—highly stylized rituals in which people recite predictable lines in a formulaic way and hope the experience ends very quickly.”

Replacing the Performance Appraisal

It is time to move to a model where courage is valued over caution, and command and control is replaced with connect and cultivate. Ultimately, it is the intensity of interactions with intelligent people, along with great ideas, that attracts and develops talent—not the efficiency of a firm’s administrative processes.

Three strategic resources replace the performance appraisal system:

1. Key Predictive Indicators for Knowledge Workers

2. The Manager’s Letter

3. After-Action Reviews

Key Predictive Indicators for Knowledge Workers

A critical distinction is being made between a key performance indicator and a key predictive indicator. The former is merely a measurement—such as the number of patents filed, or new clients—but lacks a falsifiable theory. The latter, by contrast, is a measurement, or judgment, guided by a theory, which can be tested and refined, in order to explain, prescribe, or predict. It is the search for cause and effect.

Knowledge work is not defined by quantity, but quality; not by its costs, but results. The traditional tools of measurement need to be replaced by judgment. And there is a difference between a measurement and a judgment: a measurement requires only a scale; a judgment requires wisdom.

So many firm leaders worry that if they get rid of objective measures, they will introduce subjective bias into the decision-making process. So what? To get rid of bias we would have to give up emotions and discernment, which is too high a price to pay. Neurologist Antonio Damasio has studied brain-damaged patients, demonstrating that without emotion it is impossible to make decisions.

Admittedly, the following KPIs raise rather than answer questions, but at least they raise the right questions. Better to be approximately relevant rather than precisely irrelevant. Enlightened organizations allow their team members to decide which of the following KPIs are most important to track and develop.

• Client Feedback - What are the customers saying—good and bad—about the team member? Would you trade some efficiency for a team member who was absolutely loved by your customers? How does the firm solicit feedback from its customers on team-member performance?

• Effective Listening and Communication Skills - It is easier to teach reading and writing, which are solitary undertakings, than to teach listening and speaking, which always involve human interactions. But how do you measure listening and communication skills?

• Risk Taking, Innovation, and Creativity - How often do employees take risks or innovate new ways of doing things for customers or the company? Do they engage in creative thinking in approaching their work?

• Knowledge Elicitation - Aristotle said, “Teaching is the highest form of understanding.” Knowledge elicitation is the process of assisting others to generate their own knowledge. Note that this encompasses more than simply learning new things; it involves educating others so that they are able to generate their own knowledge. One of the most effective techniques for knowledge workers to learn any subject—especially at a very deep level—is to teach it. How often do the team members facilitate a “lunch and learn” about an article or book they have read or seminar they have attended? How good are they at educating their customers and colleagues?

• Continuous Learning - What do team members know this year that they did not know last year that makes them more valuable? This is more than simply logging hours in educational courses; it would actually require an attempt to judge what they learned. How many books have they read this year? More important, what did they learn from them? One of the objections we hear to investing more in people’s education is “they will leave, and possibly become an even stronger competitor.” This is no doubt true, although a company faces the risk of their leaving anyway. But what if you do not invest in their education and they stay?

• Effective Delegator - Peter Drucker believed that up to one-quarter of the demands on an executive’s time could be consigned to the wastebasket without anyone noticing. Does your organization encourage its knowledge workers to become effective delegators?

• Pride, Passion, Attitude, and Commitment - If you thought some of these other KPIs were hard to measure, how would you measure pride? Although not a substitute for actual talent, pride in one’s work, customers, colleagues, employer, and values are critical to operate with passion and commitment.

• High-Satisfaction Day - I am indebted to John Heymann, CEO, and his Team at NewLevel Group, a consulting firm located in Napa, California, for this KPI. An HSD is one of those days that convinces you, beyond doubt, why you do what you do. It could mean landing a new customer, achieving a breakthrough on an existing project, or receiving a heartfelt thank-you from a customer. Sound touchy-feely? John admits that it is. But he also says that the number of HSDs logged into the firm’s calendar is a leading indicator—and a barometer—of his firm’s morale, culture, and profitability.

We can’t measure a doctor’s beside manner—it has to be experienced. Efficiency metrics cannot count all the energy, enthusiasm, and commitment that employees decide not to contribute.

The Manager’s Letter

Another practical suggestion to hold people accountable for their future contribution is what Peter Drucker called the manager’s letter, as explained in John Flaherty’s book, Peter Drucker: Shaping the Managerial Mind:

[Setting objectives] is so important that some of the most effective managers I know go one step further. They have each of their subordinates write a “manager’s letter” twice a year. In this letter to his superior, each manager first defines the objectives of his superior’s job and of his own job as he sees them. He then sets down the performance standards that he believes are being applied to him. Next, he lists the things he must do himself to attain these goals––and the things within his own unit he considers the major obstacles. He lists the things his superior and the company do that help him and the things that hamper him. Finally, he outlines what he proposes to do during the next year to reach his goals. If his superior accepts this statement, the “manager’s letter” becomes the charter under which the manager operates.

Procter & Gamble utilizes what it calls the Work and Development Plan, in lieu of performance appraisals, which lays out the work to be achieved in the upcoming year, how it links to the business plan, the measures and timing for success, and expected results.

What makes the manager’s letter so valuable is its focus on opportunities, results, output, and value, rather than problems, inputs, costs, and activities. Performance appraisals can only report on the past, revealing problems, never opportunities.

After-Action Reviews (AARs)

The U.S. Army’s use of AARs began in 1973, not as a knowledge-management tool but as a method to restore the values, integrity, and accountability that had diminished during the Vietnam War.

Reflection without action is passive, but action without reflection is thoughtlessness. Combine experience with reflection, and learning that lasts is the result. What percent of your firm’s time is devoted to improving the work, not just doing the work?

The objective is not just to correct things, but to correct thinking, as the Army has learned that flawed assumptions are the largest factor in flawed execution.

But perfectionist cultures, however, resist this type of candid introspection, as they tend to be intolerant of errors, and they associate mistakes with career risk, not continuous learning. The medical world has an appropriate axiom for mistakes made: forgive and remember. AARs should not be used for promotions, salary increases, or performance appraisals.

For more information on AARs, the book Hope is Not a Methodby Gordon R. Sullivan and Michael V. Harper, is an excellent resource.

Confronting People with Their Freedom

You can’t keep on doing things the old way and still get the benefits of the new way.

––Thomas Sowell

Because knowledge workers are volunteers, we could learn a lot from the not-for-profit sector. They know how to leverage people’s gifts, whereas performance appraisals are more concerned with people’s weaknesses.

Management thinker Charles Handy has spent his career arguing that organizations are living communities of individuals, not machines. He offers a splendid metaphor in his autobiography, Myself and Other More Important Matters, which I believe is applicable to knowledge workers and the performance appraisal process: the theater.

“There’s no talk of “human resources,” everyone is listed on the playbill, and managers are for things (stage, lighting, etc.), not people. The talent is directed, not managed, by someone who departs after the project commences. The audience feedback is immediate, not one year after the performance.”

Author and consultant Peter Block says, “The real task of leadership is to confront people with their freedom.” Performance appraisals inhibit autonomy and responsibility; they are the buggy whip of the knowledge era—an example of yesterday holding tomorrow hostage. Do we have the courage to replace such an ineffective process?

Performance appraisals are, after all, an iatrogenic illness, which means: physician, heal thyself.

Other books and resources mentioned

Ron's LinkedIn blog post, Appraising the Performance of Performance Appraisals. Be sure to read some of the 170 comments.

Ron's LinkedIn blog post, Replacing the Performance Appraisal. See some of the 488 comments.

A two-part interview Ron gave on Replacing Performance Appraisals for LocalJobNetwork.com, from LinkedIn.