I’m not sure if Economic Thinking Thursday will become a series or not, but I’ve been looking for opportunities to write about the role that basic economic thinking can play in looking at society and the firm. Today’s example comes from this article, namely the following quote:

“We recognize that moral hazard is a real and significant concern” in the Troubled Asset Relief Program, Timothy Massad, acting assistant secretary for financial stability, said in a hearing before a House Oversight Committee panel today. “But to suggest that it is TARP’s main legacy is to ignore the facts, and to confuse the response to a crisis with the need to address the causes of the crisis.”

Moral Hazard “occurs when a party insulated from risk behaves differently than it would behave if it were fully exposed to the risk.”  Critics of TARP often allege that it created an environment in which financial institutions are insulated from risk.

The purpose of this post is not to determine whether or not TARP creates moral hazard.  Instead, I want to focus on how exposure to risk–and being shielded from it–can affect organizational behavior.  Taking too much (or unprincipled) risk can destroy value.  However, taking too little risk leaves value on the table.  It seems that people are more likely to sacrifice value (perhaps because the unseen loss appears better than one that is seen).

Firms, by their very nature, shield employees from risk.  If an employee makes a bad deal, they are unlikely to be personally liable for the losses related to that deal (assuming that the deal was legal and that the employee was authorized to make the deal).  Aware that employees still tend to be too risk averse, some firms take extra steps to shield employees from risk.  They encourage experimentation, forgive disciplined failure, and give disproportionally large incentives for risks that pay off.

Your Challenge: Using the definition of moral hazard, the example from the article, and your knowledge of the subject, discuss the role of moral hazard in understanding how firm might encourage and/or discourage risk aversion.

I’m starting a new series each Wednesday in which I’ll ask you to use MBM to assess an advertisement. Please take a minute to watch this week’s ad:

I’m sure that there are a lot of ways that MBM can shed light on this ad. I’m thinking about one model in particular. The Human Action Model. The Science of Success–drawing upon the work of Ludwig von Mises–notes that “three requirements must be present for individuals to take action. These are: (1) unease or dissatisfaction with the present state of affairs, (2) a vision of a better state, and (3) belief that they can reach the better state.”

How does this ad make use (probably accidentally) of the Human Action Model?

Frequent reader Dave sent along this series of videos.  He says–and I have to agree with him–that, “every time I see this commercial I think of Fulfillment.” 

In the videos, you see a couple of carpet cleaners who genuinely (as actors, at least) love what most of us probably think would be a boring, unfulfilling job: cleaning someone else’s carpet.  Colin Powell famously said that “all work is honorable,” even mopping the floor.    I’ve found that–where possible–if I can (a) find something meaningful about a job or task (somehow tie it to a the ‘big picture’ of the organization, or tie it to my long-term goals even if it’s simply “impress my boss with my good work today”) or (b) find someway to be excellent at it, I get a lot more out of it than viewing it as “just mopping” or “just cleaning” or “just working on that spreadsheet.” 

Ideally, we find those roles that we’re good at, that we enjoy, and that are valued by someone–I think that’s what we mean by “fulfillment.”

cleaning, Fulfillment, mopping, Stanley Steemer

Notice that the title of this post doesn’t say “inaction….”  Too often, that is exactly the problem most of us face [read: me] when using RR&E thinking.

Below is an example from my experiences with this tool, but first let me explain what “RR&E Thinking” means to me (and check out the bottom of the post for a nerdy MBM discussion of why we fundamentally care about this stuff).

I don’t think it’s revolutionary to claim that if each employee understands her roles (the different “hats” she wears at an organization), what she’s responsible for, and what expected results she is to achieve, then we’d have a lot better chance of success.  RR&E thinking suggests that we (the employee and the supervisor together) clarify these three things for each employee, and then we go back to them frequently enough to make sure things are getting done and that those are still the ‘right’ things to be focused on.  These are usually written down and look something like “here are my 2-4 roles; for role 1, I am responsible for these handful of things, and for each of these I have a few responsibilities.  For role 2…” etc.

A Few Examples

As a supervisor, I’ve had successes and failures using RR&Es with my direct reports.  I’ve found that two things usually trip me up (or, if done well, help a lot).  First, spending time to get the expectations clear is very helpful.  For example, in my role I do some mentoring.  At first, my expectations were to “be a good mentor” (not that helpful…).  After a few quick meetings where I brought in more specific expectations and got feedback, we landed on a “constellation” of measures for this role, including “positive feedback from mentees, meet with mentees enough to be aware of and help them deal with issues, and most of the mentees improve their performance in specific areas (depending on the person).”  Not perfect, but it helps guide my behavior month to month.   A good trick to use to clarify what your boss is looking for is to ask, “When you think of this responsibility, what does ‘good’ look like to you?  What else?  What else?  Anything else?  Of these, how would you prioritize their importance?”  Seriously: try it.

The second thing that trips me up is inaction.  Write-it-and-forget-it behavior limits the power of this tool significantly.  True, there is a lot of value generated by simply sitting down once with your direct reports to clarify expectations.  A lot.  But, to constantly adjust to an ever-changing world and to provide clarity to your employees, it’s important to check in frequently to make sure the RR&Es still make sense and that we’re advancing the ball down the field.  For example, when I manage folks, I use their RR&Es in our weekly (or monthly) meetings.  I can quickly skim the document to remind myself “OK, these are the 3-5 big things Joe should be focused on–what progress are we making on these fronts?”

Back to Basics

In MBM, we try to find managerial best practices by looking at how prosperous societies achieve prosperity.  Assuming that the accountability that comes along with ownership of property in society leads to people making good use of resources, and assuming that entrepreneurs who own property are constantly re-evaluating where their best opportunities are, we want to find ways for individuals in firms to feel a similar sense of “ownership,” accountability, responsibility and excitement over the projects they have, while making sure we’re constantly asking the question “is each person–today–in the role that is their comparative advantage?” 

We are—at the risk of oversimplification–trying to replicate the benefits of ownership by giving a sense of responsibility and accountability to individual employees, and then asking everyone to constantly search for where they can best help the organization succeed.

Comparative Advantage, Decision Rights, RR&E, Theory to Practice

Aaron stormed out of the wilds of Alaska, hung up his gun and fishing rod, and took to that book learnin’. His opportunity to repent on his law degree came during the 2009-2010 KAP class, and now he works at the Mercatus Center at George Mason University translating academic economics into public policy. He still eyes that fly-rod from time to time.

In my first post, we examined the results and challenge of making success more than simply random. The last post explored the idea that human ignorance is far more pervasive, or radical, than we tend to admit. Ignorance is fundamental. It’s the basic building block of all of our knowledge. If that’s true, what does it imply for our conception of failure?

Consider restaurants. The industry is known for high failure rates, sometimes (erroneously) reported at 90% (it’s actually closer to two-thirds). Even the most optimistic estimates put business failure at 61% within three years.  Consider baseball, once the American pastime. In Ted Williams’ best season, he still failed six out of ten times. That was 1941, and no one has come close to his success in seven decades.

Failure is a necessary part of a functioning market, and of a functioning society. As Isreal Kirzner explained, markets exist to facilitate discovery:

The “process” view suggests that the appropriate criterion should be sought in the capacity attributed to the market process, of serving as a “discovery procedure” (the phrase is Hayek’s). What occurs during the market process of interacting individual decisions, Hayek argues, is that participants tend to discover relevant aspects of each other’s abilities and desires. Here, then, we have a relevant conceptual yardstick by which to assess both the operation of a market economy and policy recommendations made to modify its operation. Our question need never be: Are the results of the market process such that there is nothing remaining yet to be discovered, or even reasonably close to such a state? Rather, we must ask: Can the institutional structure (or proposed modifications to it) stimulate a reasonably steady and significant flow of (correct) mutual discoveries?

If we buy the Austrian view of knowledge, in which learning is inescapably imperfect, divorced from perfection or a priori direction, it becomes clear that failure is a feature, not a bug. What does that mean for our view of organizations or risk-taking ventures? A firm, or a team within a firm, acts (or could act) as hyper-specialized market; a discreet discovery process. And yet this market is hardly efficient. We have emotional attachment to our ideas, and an aversion to failure. Could any society operate otherwise?

But individuals, teams, and firms which can master this aversion to failure, and divorce their ideas from their personalities and brands have a distinct advantage. Tyler Durdensaid “you are not your job”; maybe Hayek agreed? No matter your role, how do you separate your personality and ideas from your role? Isn’t the most damming critique of capitalism that it turns free workers into drones? Is there a difference between ‘divorcing’ and ‘subsuming’ one’s personality?

Thanks to Aaron for this guest post. If you’d like to submit a potential guest post, please email any of the regular bloggers.

Thanks to David for passing on a great story about “The Dirty Little Secret of Successful Companies.” The author writes, “What these people don’t tell you in those interviews and books — and I’ve read quite a few — is that great companies may be great at a lot of things, but they do not always hire the right people.”

Bob Sutton offers up “The Power of Observing and Talking to Real Humans.” He writes, “…the best bosses go to great lengths to develop empathy for both the people they lead and the customers served by their teams and organizations.”

The Consumerist has two interesting posts up this week. First, they are having a contest for their readers to “Tell Us About Your Never Again Moment.” I rarely pass along posts for their comments, but some of the comments provide some good insight into why customers leave places of business. Most of the comments focus on bad customer service, not the more subtle “better product” reasons. The second post from The Consumerist gives an example of complementary goods: “No NFL Season Could Clip Chicken Wing Industry.”

Some other economic concepts can be found in “The Pros and Cons of a Flexible Movie Ticket Price System.”

For your economic history kick, I give you “10 Most Bizarre Economic Bubbles in History.”

Learning and applying any new set of concepts can be difficult.  MBM is no exception.  The Science of Success points to personal knowledge, not just “conceptual or procedural understanding,” as the key to applying MBM:

For this reason, before an organization can successfully apply MBM, its leaders must gain personal knowledge through a dedicated commitment to understanding and holistically applying MBM to achieve results.  Gaining this personal knowledge involves self-modification that starts with understanding the underlying concepts.  It also requires seeing how the concepts contribute to long-term profitability, and then repeatedly applying them over time.  (p. 160).  (Emphasis mine.)

I submit that this paragraph encapsulates the journey that many of the readers (and writers) of this blog have undertaken.  I emphasize understanding the underlying concepts as the *starting point* for this journey.  Two “bad habits” can emerge with respect to this starting point:

1. Being satisfied with understanding the concepts, and failing to move to application.
2. Skipping over the process of understanding the concepts and moving directly to application.

I want to focus on #2.  The Science of Success seems to concede that it is possible to get some value out of MBM without having personal knowledge.  We can talk the talk, and even take a few of the right steps just by observation or being told what to do.  But, how do we learn *when* to put certain tools or skills to work?  How do we learn to adapt thing to f it specific scenarios?  I believe that a deep understand of the underlying principles of MBM, and the subsequent personal knowledge that comes from grappling with the challenge of applying those principles, opens the door to the successful application of MBM over time.

Failure is all the rage right now.  This month’s Harvard Business Review is called, “The Failure Issue.”  I’ve always heard failure discussed in the context of failing small now in order to avoid bigger failures in the future.  This article from HBR.org–along with making some really interesting political observations–introduces some additional nuance.  Why fail small when you can (cheaply) fail big?

Now, I realize that some of this is just semantics.  When we say “fail small” we may just mean “fail cheaply.”  But I wonder if there isn’t more to the author’s idea?  I think he is suggesting that minimizing the cost of an experiment is different than minimizing the risk.  The resources put at risk in an experiment are only part of what’s at stake.  I think the author is pushing us to test as much as possible with the amount of resources we’re willing to invest.  Shrinking the scope of an experiment is different than shrinking the budget.

What do you think?

failure

I’ve recently been trying to come up with a metaphor for how the five dimensions are interrelated and holistic.  For a time I was considering a Jenga-like stack of interrelated blocks. The various levels would correspond to each dimension, and the individual blocks would correspond to the various mental models that comprise each dimension.

Fortunately, my friend Fawna happened to have a super-sized version Jenga set (which I call “Danger Jenga,” since a section of 2-by-4 falling on your head is a real risk in this game) which will help illustrate what I was thinking of here.

What I liked about that this was that it showed the interrelated and mutually reinforcing nature of the various concepts that collectively make up “MBM.”  I liked how if you took out too many blocks (mental models), or too much of one layer (a dimension) the structure would collapse.

What I didn’t like is that the blocks/models at the top would have less structural importance–so, if all of the incentive blocks were on top one might assume they’re less important, which in my opinion isn’t true.  For that reason, I ultimately decided against using this.

Maybe another way to do it would be to make each block represent a dimension; so, you would have V’s and DR’s and KP’s, etc., all over the structure reinforcing one another, but that has its problems, too….  Other non-Jenga metaphors?

However we conceive of it, MBM is basically just a collection of a bunch of ideas about what allow socieites to prosper and how those might help your organization prosper, and the dimensions just help us organize those concepts in a useful way.

Five Dimensions, Jenga, Mental Models

What types of posts would you like to see more of on the blog?

What topics are you curious to learn more about, or what issues would you like to discuss?

What changes would you suggest?

In short, we want your ideas and feedback!  If the fancy strikes you, leave an idea or two in the comments.