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.

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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