Episode #4 - The Economy in Mind

How much does the economy weigh? Believe it or not, it weighs the same as in 1950, even though output is roughly five times larger. We are increasingly an economy driven by mind, not matter. Thomas Sowell explains how in his fantastic book, Knowledge And Decisions

After all, the caveman had the same natural resources at their disposal as we have today, and the difference between their standard of living and ours is a difference between the knowledge they could bring to bear on those resources and the knowledge used today.

Peter Drucker explained it this way:

We know that the source of wealth is something specifically human: knowledge. If we apply knowledge to tasks that we already know how to do, we call it productivity. If we apply knowledge to tasks that are new and different, we call it innovation. Only knowledge allows us to achieve these two goals.

Ed and Ron discussed the following topics during the show. For more information on this topic, see Ron’s book, Mind Over Matter: Why Intellectual Capital is the Chief Source of Wealth.

Five stages in society:

1. Hunters & gatherers economy

2. Agrarian economy

3. Industrial economy

4. Service economy

5. Knowledge economy—often referred to as the “Information economy,” but this is a misnomer.

There’s an enormous difference between information and knowledge. Ever since Stewart Brand, founder of the Whole Earth Catalog quipped, “Information wants to be free,” commentators have confused information with knowledge.

Again, Thomas Sowell explains why knowledge, far from being free, is enormously expensive, and the most severe constraint facing societies:

… [T]he most severe constraints facing human beings in all societies and throughout history––inadequate knowledge for making all the decisions that each individual and every organization nevertheless has to make, in order to perform the tasks that go with living and achieve the goals that go with being human.

Data, Information and Knowledge

1. Data. Factual information (as measurements or statistics) used as a basis for reasoning, discussion or calculation. There is no judgment, interpretation, context, or basis for action. It knows nothing of its own importance or irrelevance.

2. Information. Root in Latin is formare, meaning “to shape.” Peter Drucker said information is “data endowed with relevance and purpose.” It has to have a sender and a receiver, and it is the receiver, not the sender, who decides if the message is information or not. “We add value to information in various ways: Contextualized; Categorized; Calculated; Corrected; Condensed.”

3. Knowledge. The fact or condition of knowing something with familiarity gained through experience or association. To turn information into knowledge we need: “Comparison; Consequences; Connections; Conversation.

SCA_Slides_pptx

The Physical Fallacy: 

Brains trump brawn and Bits are more valuable than atoms.

Merv Griffin has made “close to $70 million to $80 million” in royalties from the Jeopardy! theme song, which he wrote in less than a minute.

YouTube was purchased by Google for $1.65 billion.

Disney’s Snow White video release generated $800 million in revenue, $500 million to the bottom line, from a movie made in the 1930s. Compare these supposedly ephemeral products to the value of an automobile from the same decade

Disney bought Pixar in January 2006 for $7.4 billion (Steve Jobs originally paid $10 million for it in 1986). One analyst talked about the importance of retaining two key individuals from Pixar, otherwise:

If two key people leave, Disney just bought the most expensive computers ever sold.

George Gilder likes to say that knowledge is about the past, while entrepreneurialism is about the future. Albert Einstein would have agreed:

I am enough of an artist to draw freely upon my imagination. Imagination is more important than knowledge. Knowledge is limited. Imagination encircles the world.

Self Sufficiency = Poverty

One professor of economics assigns his student the class project of building something they normally purchase. Many choose beer, or electronic devices.

What they discover is it’s incredibly expensive, takes an awful amount of time, and doesn’t taste or work as well as what you can buy for a lot less.

Two works we highly recommend illustrate just how dependent we are on dispersed knowledge, in the heads of literally billions of people around the world. It takes millions just to make a simple pencil.

See I, Pencil, as told by Leonard E. Read. Also, The Toaster Project: Or A Heroic Attempt to Build a Simple Electric Appliance from Scratch, by Thomas Thwaits.

The Philosopher Alfred North Whitehead wrote: “Civilization advances by extending the number of operations we can perform without thinking about them.”

Think how much easier it is do perform many tasks that our ancestors spent far more time on.

Rival vs. Non-Rival Assets

Alvin and Heidi Toffler define characteristics of knowledge in their book Revolutionary Wealth:

1. Knowledge is inherently non-rival

2. Knowledge is intangible

3. Knowledge is non-linear

4. Knowledge is relational––ideas having sex

5. Knowledge mates with other knowledge

6. Knowledge is more portable than any other product

7. Knowledge can be compressed into symbols or abstractions

8. Knowledge can be stored in smaller and smaller spaces

9. Knowledge can be explicit or implicit, expressed or not expressed, shared or tacit

10. Knowledge is hard to bottle up. It spreads

Knowledge is like the dark matter of the cosmos—we know it is out there, but we cannot see, touch, or measure it.

Again, Thomas Sowell:

Many of the products that create a modern standard of living are only the physical incorporation of ideas––not only the ideas of an Edison or Ford but the ideas of innumerable anonymous people who figure out the design of supermarkets, the location of gasoline stations, and the million mundane things on which our material well-being depends. It is those ideas that are crucial, not the physical act of carrying them out. Societies which have more people carrying out physical acts and fewer people supplying ideas do not have higher standards of living. Quite the contrary. Yet the physical fallacy continues on, undaunted by this or any other evidence.

Three Components of Intellectual Capital (IC)

IC = Knowledge that can be converted into profits (or value); it’s an entity, not a process.

IC was classified into three categories by Karl-Erik Sveiby, in 1989:

1. Human capital (HC). This comprises your team members and associates who work either for you or with you. As one industry leader said, this is the capital that leaves in the elevator at night. The important thing to remember about HC is that it cannot be owned, only contracted, since it is completely volitional. In fact, more and more, knowledge workers own the means of your company’s production, and knowledge workers will invest their HC in those organizations that pay a decent return on investment, both economic and psychological. In the final analysis, your people are not assets (they deserve more respect than a copier machine and a computer), they are not resources to be harvested from the land like coal when you run out; ultimately, they are volunteers and it is totally up to them whether or not they get back into the elevator the following morning.

2. Structural capital. This is everything that remains in your company once the HC has stepped into the elevator, such as databases, customer lists, systems, procedures, intranets, manuals, files, technology, and all of the explicit knowledge tools you utilize to produce results for your customers.

3. Social capital. This includes your customers, the main reason a business exists; but it also includes your suppliers, vendors, networks, referral sources, alumni, joint venture and alliance partners, reputation, and so on. Of the three types of IC, this is perhaps the least leveraged, and yet it is highly valued by customers.

There is such a thing as negative human capital, negative structural capital, and negative social capital. Not everything we know is beneficial.

Think of the IC a thief possesses; social loss they impose is a societal negative.

Examples of negative intellectual capital in an organization: cost-plus pricing, Industrial Age efficiency metrics, Taylorism, focusing on activities and costs rather than results and value, and other forms of negative IC that have embedded themselves into the culture.

Knowledge Workers

Knowledge workers are unique:

• They own the means of production

• Firms need them more than they need firms—balance has shifted

• KWs have unique value, not jobs

• Office is their servant, not their master

• Effectiveness is far more important than efficiency

• Judgments are more important than measurements

• •Ultimately, they are volunteers

The World Bank: in two reports, Where is the Wealth of Nations (2006) and The Changing Wealth of Nations (2010) report that 80% of the developed world’s wealth resides in human capital.

Other books and resources mentioned

The Rational Optimist (P.S.), by Matt Ridley

Dear Reader: The Unauthorized Autobiography of Kim Jong Il, by Michael Malice

Ronald Reagan, speech at Moscow State University, 1988

Text here. Ron believes this is one of his all-time best speeches. He’s basically telling the students, in a very polite way, their economy is headed for the ash heap of history, due to what he calls the information economy, but we are calling the knowledge economy.

Email us at: tsoe@verasage.com

Twitter: @edkless @ronaldbaker #tsoe

Episode #3 - The Second Law of Marketing: All Prices are Contextual

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In our July 11th show we discussed The First Law of Marketing: The Value of Value. The Second Law of Marketing is just as critical to help your organization communicate value, and help convince your customers to pay for that value.

One of the most customer-centric strategies your company can deploy is to offer an array options to your customers. It is very “outer-directed,” rather than just offering a one-size-fits-all, take-it or leave-it option.

Customers prefer options, especially in today’s world where they face a plethora of choices regarding who, when, what, and how to patronize a business. Contemplate these examples:

• Universal Studios Theme Parks standard admission price is $80, but for $139 you can get a “Front of the Line Pass” and for $299 a “VIP Experience,” giving guests behind-the-scenes access.

• When the final book in the Harry Potter series was released, the publisher offered the regular version for $34.99 and the deluxe version for $65. They were ranked number one and two, respectively, on Amazon and Barnes and Noble websites.

• Tourists in New York can avoid the long lines to get to the observation deck of the Empire State Building for double the regular admission price, guaranteed to take no longer than 20 minutes.

We simply must get over the false idea that there is one optimal price for a customer. There is a range of optimal prices, commensurate with the value being created. Dutch psychologist Peter van Westendorp developed the van Westendorp Price Sensitivity Meter (PSM) by posing these five questions:

1. At what price would this service be so expensive the customer would not consider buying it?

2. At what price would the service be expensive, but the customer would still buy it?

3. At what price would the service be perceived as inexpensive?

4. At what price does the service become so inexpensive the customer would question its value?

5. What price would be the most acceptable price to pay?

The Magic of Three––Goldilocks Pricing

There is strong empirical evidence—from both the rational and behavioral schools of economics—that offering customers at least three options can often times result in them purchasing more, at a higher price, than merely offering one take-it or leave-it option.

In his book, Predictably Irrational, Revised and Expanded Edition: The Hidden Forces That Shape Our Decisions, behavioral economist Dan Ariely illustrates the utility of offering options by illustrating The Economist magazine’s offerings. First, he presented the following two options to 100 students at MIT’s Sloan School of Management:

1. Economist.com subscription $59: One-year subscription to Economist.com, including access to all articles from The Economist since 1997—68 students chose this option.

2. Print & web subscriptions $125: One-year subscription to the print edition of The Economist and online access to all articles from The Economist since 1997—32 students.

Now compare those results to the actual ad that The Economist offered, which contained three options, not two:

1. Economist.com subscription $59: One-year subscription to Economist.com, including access to all articles from The Economist since 1997—16 students chose this option.

2. Print subscription $125: One-year subscription to the print edition of The Economist—0 students.

3. Print & web subscriptions $125: One-year subscription to the print edition of The Economist and online access to all articles from The Economist since 1997—84 students.

Ariely concludes that there is nothing rational about this change in choices. The mere presence of an option that was not desired—known as the decoy or dominated option—affected behavior, leading to a potential 42.8% increase in incremental revenue for The Economist.

When two options are presented, the decision is mostly made on price, yet when three options are offered it becomes a decision based on value.

The Anchor and Framing Effects

Offering options creates the anchoring effect, whereby the customer is now comparing prices to your highest offering. This is why Victoria’s Secret offers a diamond ornamented bra for $6.5 million that no one probably ever bought; and Prada stores always display one incredibly high-priced article that acts as an anchor for all the other products.

All of these high priced items act as an anchor, even if the customer never buys them—throwing a halo effect over the other offerings, allowing for prices to be higher, while increasing average per customer sales.

The first lesson from the above is if you do not offer a high-end premium package, how could you customers ever select one? Second, list your most expensive option first. The third lesson is that by offering three options, you almost always sell more of the middle option, and less of the cheapest offering.

This confirms what most pricing experts know: people are not price sensitive; they are value conscious.

Another behavioral phenomenon is the framing effect. What you compare something to will determine an acceptable price to pay. If I offered to sell you my Unicorn, you’d have no idea what to pay since no one has ever purchased one. But you’re happy to pay for coffee in little pods—which are more expensive than coffee purchased in bulk—because you are comparing it to Starbucks.

This is why brands pay so much attention to what you’re comparing their offerings to: Red Bull is packaged in a skinny can so it will not be compared to a Coke or Pepsi, and Woolite is in a bottle so it’s not compared with Tide, but rather dry cleaning.

When you present three options to the customer, you are also subtly changing their psychology. Rather than thinking about whether or not they will do business with your company, the options nudge them in the direction of thinking about how they are going to do business with your company.

Pay close attention to the context in which your prices are anchored and framed. It will have an enormous impact on your profitability.

Additional Resources and Books Mentioned

For more on why are we in business, Peter Drucker’s Marketing Concept, and the role of profit, see Pricing on Purpose: Creating and Capturing Value, by Ronald J. Baker.

Minding the Store: A Memoir, by Stanley Marcus. Ron believes this is the best book ever written on customer service.

Positioning for Professionals: How Professional Knowledge Firms Can Differentiate Their Way to Success, by our VeraSage Institute colleague Tim Williams, who will be a guest on a future show.

Ed mentioned Harry Gordon Selfridge and Amazon's Kindle Unlimited.

We referred to Rory Sutherland TED.com talk, and his example the breakfast cereal Shreddies. Here is the video. Rory will be a guest on our August 29th show.

The infamous Wendy’s commercial from the Cold War era, about offering choices.

Email us at: tsoe@verasage.com

Twitter: @edkless @ronaldbaker #tsoe

Episode #2 - The First Law of Marketing: The Value of Value

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On this show, Ron and Ed contrast and compare the labor theory of value and the subjective theory of value starting out with the “Diamond-Water Paradox.” Listen to the show at VoiceAmerica.com, here.

 The Diamond-Water Paradox

Adam Smith was confounded. One of the greatest economic and social thinkers in the history of ideas struggled with the so-called “diamond-water paradox.”

None of us would be able to live beyond a couple of weeks without water, yet its price is relatively cheap compared to the frivolous diamond, which certainly no one needs to stay alive.

Most people resolve this paradox by replying the supply of diamonds is scarce compared to water. But this theory lacks explanatory power. If it did, those drawings by your kids on your refrigerator would be worth a few mortgage payments. Just because something is scarce does not make it valuable.

The Labor Theory of Value

Karl Marx had a theory, too. The labor theory of value still wields enormous influence over our present-day concept of value and price. Marx explained his theory in Value, Price and Profit, published in 1865:

"A commodity has a value, because it is a crystallisation ofsocial labour. The greatness of its value, or its relative value, depends upon the greater or less amount of that social substance contained in it; that is to say, on the relative mass of labour necessary for its production."

This sounds reasonable, but if Marx’s theory were correct, a rock found next to a diamond in a mine would be of equal value, since each took the same amount of labor hours to locate and extract.

If you have pizza for lunch today, under Marx’s theory, your tenth slice would be just as valuable as your first, since each took the same amount of labor hours to produce.

One glaring flaw in Marx’s theory was it did not take into account the law of diminishing marginal utility, which states the value to the customer declines with additional consumption of the good in question.

The Marginalist Revolution of 1871

Fortunately, three economists developed the theory of marginalism and created a revolution: William Stanley Jevons from Great Britain, Leon Walras from France, and Carl Menger from Austria.

There were forerunners to the marginal theory, but it was not until these three came together that the theory was accepted as valid in the economics profession. The idea that all value is subjective seems obvious is retrospect, given how consumer preferences and tastes can change on a whim.

So what made this new theory so revolutionary? As Menger explains in his book Principles of Economics, written in 1873:

"Value is…nothing inherent in goods, no property of them. Value is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. Hence value does not exist outside the consciousness of men…[T]he value of goods…is entirely subjective in nature."

Value is like beauty—it is in the eye of the beholder. This theory has enormous explanatory. Philip Wicksteed, a British clergyman, wrote scientific critique of the Marxian labor theory of value in 1884, where he explained:

"A coat is not worth eight times as much as a hat to the community because it takes eight times as long to make it….The community is willing to devote eight times as long to the making of a coat because it will be worth eight times as much to it."

Still, cause and effect is confused constantly on this principle in businesses to this day. I remember taking a wine tour of Far Niente in Napa where the guide was explaining how one particular vintage had to be bottled by hand, which was why it was more expensive—due to the extra labor this entailed.

I could not help thinking: No, you are willing to invest in the labor necessary to bottle the wine by hand because some customers find it valuable (and delicious!) enough to cover the extra labor costs.

If one were to lay the two theories of value––labor and subjective––side by side, it would look like this:

Cost-Plus Pricing––Labor Theory of Value

Product » Cost » Price » Value » Customers

Pricing On Purpose––Subjective Theory of Value

Customers » Value » Price » Cost » Product

Notice how value pricing turns the order of cost-plus pricing inside-out, by starting with the ultimate arbiter of value––the customer. Goods and services do not magically become more valuable as they move through the factory and have costs allocated to them by cost accountants.

The costs do not determine the price, let alone the value. It is precisely the opposite; that is, the price determines the costs that can be profitably invested in to make a product desirable for the customer, at an acceptable profit for the seller.

Why Are Diamonds More Expensive Than Water?

The German economist Hermann Heinrich Gossen developed what is known as Gossen’s Law: The market price is always determined by what the last unit of a product is worth to people.

While the first several gallons of water may be vital for your survival, the water used to shower, flush the toilet, and wash the dishes is less valuable. Less valuable still is the water used to wash your dog, your car, and hose down your driveway.

On the other hand, the marginal satisfaction of one more diamond tends to be very high.

If water companies knew you were dehydrated in the desert they would be able to charge a higher price for those first vital gallons consumed, and then gradually adjust the price downwards to reflect the less valuable marginal gallons.

Since they do not possess this information—the cost of doing so would be prohibitive—the aggregate market price for water tends to be based upon its marginal value.

Old Fallacies Die Hard

Thomas Sowell explains in his book, Economic Facts and Fallacies: Second Edition, how the economics profession finally overcame the labor theory of value:

"By the late nineteenth century, however, economists had given up on the notion that it is primarily labor which determines the value of goods. This new understanding marked a revolution in the development of economics. It is also a sobering reminder of how long it can take for even highly intelligent people to get rid of a misconception whose fallacy then seems obvious in retrospect. It is not costs which create value; it is value which causes purchasers to be willing to repay the costs incurred in the production of what they want."

That all value is subjective is difficult for many business people to accept, but it does explain how we humans spend money.

Wrong Theory, Suboptimal Results

As John Maynard Keynes said, “The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds,” to which philosopher Bertrand Russell added, “The resistance to a new idea increases as the square of its importance.”

Yet when people hear the subjective theory explained, they intuitively understand it, because it comports to human behavior. And isn’t this what learning is all about—understanding something you have known all along, but in a new way?

Despite this lesson, we return to our offices and fall back to pricing our products and services using a cost-base formula.

As John Kenneth Galbraith said, “There are many misfortunes that can befall an economist. The worst, by far, is to have a theory in which he devoutly believes, and which is wrong, put into practice.”

Additional Resources and Books Mentioned

LinkedIn Blog post: The First Law of Marketing: All Value is Subjective, which also explains the tale of two automobiles, and the problems with cost-plus pricing, which Ron and Ed discussed.

LinkedIn Blog post: Car Guys vs. Bean Counters. This is Ron’s book review of the book by Bob Lutz, a diagnostic book on the demise of General Motors: Car Guys vs. Bean Counters: The Battle for the Soul of American Business. Since we discussed the problems General Motors is currently having, this book provides more detail on why they are having these issues.

Milton Friedman’s book, Money Mischief: Episodes in Monetary History (Harvest Book).

Lee Iacocca’s autobiography: Iacocca.

More about Yap: the island of stone money and the diamond planet.

Video: Penn & Teller’s Bottled Water Segment, from their Showtime TV Show, Bullshit.

Episode # 1 - Declaring Independence from the Tyranny of Taylorism

Time Clock Old

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What is Taylorism?

On our premiere show, Ed and I tackle the ghost and gospel of efficiency, as made popular by Frederick Winslow Taylor, author of The Principles of Scientific Management in 1911.

Taylor was the world’s first business consultant, at $35/day and a classic example a thinker Justice Oliver Wendell Holmes, “a hundred years after he is dead and forgotten, men who never heard of him will be moving to the measure of his thought.”

Taylor set out to prove that management is “a true science” with “laws as exact, and as clearly defined…as the fundamental principles of engineering.” Taylorism can be defined as follows:

The application of scientific methods to the problem of obtaining maximum efficiency in industrial work or the like.

In the past the man has been first. In the future the System must be first.” Taylor separated the doing from the thinking.

One of his disciples: Frank Gilbreth, Cheaper by the Dozen, the book by two of his children, as well as the movie made based on the book starring Clifton Webb.

A lot of efficiency experts died young, leading to the question: why were they saving all that time?

Efficiency vs. Effectiveness

Efficiency is always a ratio: outputs/inputs. It’s not about “doing things right,” as efficiency metrics make no judgment about right vs. wrong.

Effectiveness, by contrast, is doing the right thing.

Was Einstein efficient? How would you know? Who cares?

We can be efficient at doing the wrong things—nothing more wasteful, or useless.

No Such Thing As Generic “Efficiency”

Efficiency cannot meaningfully defined without regards to purpose, desires, preferences, and what we are willing to pay.

We can be efficient with things, but must be effective with people.

Peter Drucker didn’t write The Efficient Executive, but The Effective Executive.

McKinsey Maxim: “What You Can Measure, You Can Manage”

Peter Drucker didn’t write this, nor did he believe it.

It’s false: We can’t change our weight by having a more accurate scale, or weighing ourselves more frequently.

According to Peter Drucker in People and Performance:

Efficiency means focus on costs. But the optimizing approach should focus on effectiveness.

Effectiveness focuses on opportunities to produce revenue, to create markets, and to change the economic characteristics of existing products and markets.

…It then asks, To what results should, therefore, the resources and efforts of the business be allocated so as to produce extraordinary results rather than the “ordinary” ones which is all efficiency can possibly produce?

This does not deprecate efficiency. Even the healthiest business, the business with the greatest effectiveness, can well die of poor efficiency. But even the most efficient business cannot survive, let alone succeed, if it efficient in doing the wrong things, that is, if it lacks effectiveness. No amount of efficiency would have enabled the manufacturer of buggy whips to survive.

Effectiveness is the foundation of success—efficiency is a minimum condition for survival after success has been achieved.

Efficiency concerns itself with the input of effort into all areas of activity. Effectiveness, however, starts out with the realization that in business, as in any other social organism, 10 or 15 percent of the phenomena—such as products, orders, customers, markets, or people—produce 80 to 90 percent of the results.

The other 85 to 90 percent of the phenomena, no matter how efficiently taken care of, produce nothing but costs (which are always proportionate to transactions, that is, to busy-ness).

Business is an Art, Not a Science

Taylor “became famous for the idea of what he was supposed to have achieved—not for what he actually achieved.” In short, Taylor was a fraud, according to Matthew Stewart, author of the seminal book, The Myth of Management:

One can go grocery shopping with a scientific attitude. But it does not follow that there is a science of grocery shopping.

Rather than being a falsifiable theory, Taylorism was a tautology: “An efficient shop is more productive than an inefficient shop.”

In a skillful twist of the McKinsey Maxim—If you can measure it, you can manage it—Stewart says management consultants’ motto might as well be, “If you can’t manage it, measure it!”

Better still, organizations should strive for efficaciousness—that is, having the power to produce a desired effect.

Additional Resources:

Book Review: Frederick Taylor: The One Best Way

Book Review: The Management Myth

Blog post: Efficiency vs. Effectiveness

Blog post: Pigs, Productivity, and Purpose

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