TCS Daily


Decisions, Decisions

By Nick Schulz - January 5, 2006 12:00 AM

Nick Schulz: David Henderson is Professor of Economics at the Naval Post Graduate School in Monterrey, California. And he's a research fellow with the Hoover Institution at Stanford University. He was a senior economist with President Regan's Counsel of Economic Advisors.

He is the co author of a new book called Making Great Decisions in Business and Life (Chicago Park Press, $28.50). And David joins us today to talk about his new book. David, thanks for joining us.

David Henderson: Thanks, Nick.

Schulz: What prompted you and your co author Charles Hooper to write a book on this subject?

Henderson: Starting around the mid '90s, when my friend Charlie Hooper had started his consulting firm and was starting to see the kinds of decisions various firms were making in the sector of the economy he was dealing with, which is pharmaceuticals and biotech, he had some hilarious stories about bad decisions, and also some good stories about good decisions. At some point we thought we should jot these down and we might get something out of them.

And then we did that over a few years, and realized there was a book forming there. And basically the idea was to have each chapter of the book be on some basic principal of good decision making. And we noticed that a lot of them were just ability to apply basic economics, or inability to apply basic economics, and that's where I came in. He got his masters degree in engineering and economic systems and there was a lot of decision theory in those courses, and he saw ability or inability to apply decision theory. And then there was a third category just plain common sense, which we've learned over the years is not very common.

And so that's what got us writing it. And then, we would just notice various things, not just in his business consulting stories, but in our own lives, in some of the stories, some of the encounters I'd had, some of the things I had observed. And so that's kind of how it happened.

Schulz: The title of the book implies that decision making, whether it's in the business sphere, or in the personal sphere, might have some things in common. Now is that what you discovered in doing your research for this book and putting it together?

Henderson: I would have to say we discovered that way earlier than when we wrote this book. I mean one of the ways I've always taught economics courses is to apply the principals not just to a business firm, but to my student's own lives. Consider the whole idea of thinking on the margin. When should you quit studying? What's the optimum amount of studying? It isn't all of the time.

Schulz: What did your students say to that?

Henderson: They like that. They relax. They realize, hey this professor doesn't expect us all to get A's, that for some students, a C might be an optimal grade. And so that whole way, that's always how I've taught, and that's what we notice is also how people learn. If people can learn about how to make decisions in their own personal lives, they can often carry that over to their business lives.

Schulz: The two of you write in your book that "clear thinking" is a problem for both businesses and individuals. Now what exactly do you mean by that? What's the distinction that you're trying to highlight here?

Henderson: Well I guess it is true that the word "clear" is redundant, but sometimes redundancy is very valuable as airline pilots and lawyers can tell you. And so to say clear thinking really doesn't add anything to thinking but a lot of people do think they're thinking, but you can get them to rethink that if you remind them they ought to be thinking clearly.

So let me give you an example. Someone in a firm says we want our firm to grow from a five million in revenue a year firm to a 10 million revenue a year firm. And if that's all they do, if that's all they say, and that starts guiding their decisions, they're going to be making a lot of bad decisions. Because they're going to be looking for ways to increase revenue without thinking about what they probably really meant to say which is we want our profits to increase. And you can easily get from a five million a year firm making $200,000 in profit, to a $10 million a year a firm making $300,000 in losses, and that's not good. And so there's an example where they just blindly follow some precepts, some idea that someone had without thinking, is that really what we want?

So one of our principals is think clearly first about what you really want.

Schulz: We write a lot at TCS about innovation. And part and parcel of that in our view is risk, and the risk that goes into innovation. Now, you tackle risk as a subject in your book. Is it your view that individuals and businesses today are too risk averse?

Henderson: I wouldn't say they're too risk averse. I would just say that they often don't think clearly about risk. And I'll just tell you the most complicated chapter in our book is the one on risk. We actually get a little into some math, but we also guide the readers through the parts that don't require that.

Schulz: Can you illustrate how somebody may not think clearly about risk?

Henderson: Sometimes people will look at expected values, and that is taking the probability of each outcome times the value of that outcome. And then saying, well, if the expected value exceeds the cost, let's do it. Well, that doesn't necessarily make sense. If there's a 10 percent probability of a huge gain, and a 90 percent probability of a medium loss, and the expected value is positive, that might just be too much of a risk to take.

And in fact, that's why we buy insurance. Insurance in an expected value sense is always a bad deal because we not only have to pay the expected loss in our premium, but we have to pay for the transaction cost, and the cost of operating the insurance firm and so on.

And so if you went with straight expected values, as we point out in the book, you would advise people never to buy insurance.

Schulz: But that's not something you're advising folks.

Henderson: Right. We're saying you have to. In fact, we introduce the concept called your risk tolerance -- given your particular place in the world, your income, your wealth, your age, your attitudes to risk, what is the maximum amount you'd be willing to lose in a given situation. And then if the amount is greater than that, don't do it.

So for example, when we were working on this book, Charlie, presented me with an opportunity to be one of the early investors in a drug company. And it looked as if the minimum investment would be $100,000. And I thought through it and just decided I wasn't comfortable with that. Well, we actually persuaded the drug company to let me invest $25,000 and I figured the $25,000 was my risk tolerance, I could lose that given the particular probabilities, and it wouldn't have a huge effect on my life.

Schulz: Is there a way that you can will yourself to change your risk tolerance, or does it have to be a function of thinking clearly through the entire range of options before you, before making a decision?

Henderson: Yes. I don't see those as mutually exclusively alternatives. You do need to think things through carefully. You have to think through everything because you might not do anything but you have to think through the major issues.

Certainly I see this in myself in looking at how I've grown in various ways is to kind of try to push the edge a little more each time. For example, I invested 25,000 in this drug company. Next time something came along like that, now that I've done it and I've gotten comfortable with that, if it were the same kind of investment with the same probabilities -- and by the way the probability was about 50 percent of a huge gain and 50 percent of losing everything, but the gain was so huge -- If that came along again I think I might invest $40,000 because I got comfortable with $25,000.

It's like when you're a 19-year-old trying to ask out a girl and it's actually easier to ask the second girl after the first rejection than it was to ask the first girl. And one night I was very proud of myself, I had just moved into this new city, I was 20 years old, and I asked out all of the seven women I had met. Unfortunately I asked them on a Thursday night for Friday night which wasn't a lot of notice, but they all said no. And I felt great at the end.

Schulz: You have a chapter in your book where you discuss arbitrage. Now, some people don't know exactly what arbitrage is much less how it could be useful to them personally. So can you talk a little bit about arbitrage and why it's so important?

Henderson: Arbitrage is extremely valuable for society. The reason arbitragers make money is they're actually doing good for society, so let me just explain what it is.

Arbitrage means buying something in one market at a certain price. Reselling it in another market at a higher price. And for it to be arbitrage, as opposed to speculation, it must be the case that those prices are known. So you know there's a sure gain from buying on the low price market, and reselling on the high price market, after you've subtracted your holding cost, your transaction costs, your shipping costs, there's a sure gain.

It's socially valuable because the person doing the arbitrage is reallocating resources from lower valid uses, to higher valid uses. It's valuable to the individual because he's making money. And that's the neat thing as (Adam Smith) pointed out 230 years ago, that we, in doing good for ourselves in a market, we're doing good for others too. So the arbitrager, his only goal is to make money. But notice that what he does is he helps society by reallocating resources to higher valued uses.

The example we give is of a retired colleague of mine, who when he was 17 was sitting becalmed in a sail boat and it occurred to him, this was in 1947, the price controls from the war time had just come off, and lead prices shot way up. And he realized that his lead keel was worth more than the whole boat. So he took off the lead keel, sold it to someone, put on an iron keel and it took some fashioning to do that, and he resold that to someone with full information telling them it was an iron keel and it wouldn't work as well, but telling them that. And then he thought, I could do this again. And so he bought dozens of boats through the summer at age 17 and resold them and made, in those days, I don't have the number handy, but I believe he made something like $20,000 in 1947 dollars which is close to a quarter-of-a-million dollars today -- and he was arbitraging.

Schulz: Not bad for a summer job.

Henderson: Yes. He's an unusual man.

Schulz: This is interesting, the idea of getting resources to people who may have better use for them because in recent months we've had several natural disasters, and then with price spikes in certain commodities, such as in the energy sector, we have complaints from people of price gouging, or, in the energy sector, questions about windfall profits. But what you're suggesting is that the situation may be a little more complicated because if people respond to these price shifts there may be some social utility there. It's not just that it's a terrible thing that people may be paying more for something.

Henderson: Well I would make it much stronger. It's not that there may be some social utility, there is social utility.

When these things happened, say in Florida, a few years ago, when there was the big hurricane people were lined up in Georgia and so on, waiting to come down with all kinds of lumber to rebuild. And they would not have been so excited about coming down if price controls had been slapped on them for what they could charge. And so if the price is allowed to go up, it just sucks resources from lower value uses around the country into that part of the world. And it's extremely useful. And by the way, it's very hard to find an economist who will say that price controls in that kind of situation are a good idea.

Schulz: Actually, just on a personal note, a couple of years ago, I looked into the prospect of building a new wooden fence at my house on our property and I talked to a fence contractor. The biggest input was going to be the cost of wood, and I was asking why it seemed so expensive. And he said, well, all of the wood that was available was going to all of these rebuilding efforts down in Florida and other regions.

Henderson: Exactly.

Schulz: So I ended up putting off building the fence...

Henderson: Yes, because it wasn't that valuable to you.

Schulz: Yes. So maybe that was the right thing to have the market work that way.

Henderson: Yes.

Schulz: Now is not a political book by any means.

Henderson: It's not.

Schulz: But in putting this together and your research into it, and looking at decision making, do you think that it has any sort of political implications, at all, broadly understood? And what might those be?

Henderson: I do. It's funny that's a question I haven't been asked about this book, because I'm usually interviewed by people who are just thinking of the business angle. So let me just think a minute.

Clear thinking is useful in every part of life, including thinking about politics. And as you pointed out, we just talked about an issue where there's a clear cut political aspect, mainly the whole idea of windfall, profits, taxes, and price controls, which distort, which prevent resources from flowing to their highest value uses. So there's one right there.

Another one is we -- our last chapter is on ethics. And we approach it very differently from the way many books do. We aren't trying to hammer people over the head about what's making them feel bad. We're going to try to tell them that if they really think through their self interest, they will find that it virtually always pays to be honest, for example.

And we have a section there, where we talk about kind of your own personal constitution. And to have a constitution that reins me in is a good idea. For example, let's say I'm on a business trip and -- I'm married, by the way -- and a very attractive woman approaches me. I'm tempted, but if I remember my constitution and part of my constitution is clear cut in my brain that I don't cheat on my wife, that's very helpful to go to that.

Well now think about the political system and how much more important it is to have a constitution when there really are separate people. So it's not someone cheating on himself, not someone violating his own constitution, but someone taking power to himself that he isn't allowed under the constitution and just using it and all of the potential for abuse that is there. One of the implications is it's very important to have a constitution to rein in government power. And it's important to enforce it. It's important to somehow sanction people who violate it, and so there's one big implication.

Schulz: Who are your heroes?

Henderson: I've got many. But I've changed my term over the years. When I used to have heroes, I would always find myself being disappointed and let down because they're human. And so they do things that disappoint me. So instead, I shifted back in my late 20s to the idea of whom do I admire a lot, OK, and that's what I'm going to answer.

Schulz: OK.

Henderson: Warts and all. All of these people have warts. And the first one really had warts, Ayn Rand. Reading her just literally changed my life. I read her novels starting when I was 17. I wouldn't be talking to you if I hadn't read them because it just effected all kinds of major life choices I made over the next five years roughly.

Milton Friedman is another. I went and knocked on his door at the University of Chicago when I was 19 years old. I had just graduated from college and he gave me 10 minutes of his time and gave me a bunch of advice, some of which I took. And he was just - he's always - what I've always liked about Milton is his ability to be kind of relatively pure, and yet work within the mainstream. That's a very hard thing to pull off, and I think he's done that very well.

John Stossel at ABC News is another. I just think it's very neat what he's doing there. I know the kinds of criticism he gets. In a speech I saw him give he said he knows he'll never get another Peabody again. And yet it's worth it for laying out these important truths that he's laying out when he does his shows.

Schulz: David, thank you so much for taking some time to talk to us.

Henderson: You're welcome.

Schulz: And congratulations on what is a fascinating and stimulating book.

Henderson: Thank you.

Click here to listen to an excerpt from this interview.
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3 Comments

Katrina Price Gouging
Your post-hurricane lumber example makes sense, but I have trouble understanding the economic utility of raising gasoline prices as people tried to flee Katrina (for exampe), even though I have heard many economists defend it.

When EVERYONE, including those with limited resources, needs approximately the same amount of the same commodity NOW, how does raising the prices improve the efficiency of distribution or provide any social benefit?

Sharon

Katrina Pricing
The problem isn't the need, but the supply. If I have a vehicle with two large gas tanks, the temptation is to fill them both. Also, if I have a nearly full tank, I will be tempted to top it off. If prices go up, I will think twice. This way, the limited supply is distributed to those who actually need the gas to get somewhere. A person running on fumes will pay more than one with half a tank, and the supply is more likely to make it to those who need it most. If you left the price low, people would top off their tanks, and gas stations would run out of fuel.

Katrina Pricing
That all seems logical, but in reality it seems that "topping off" happens when prices are high, not when they are low. Obviously this is because there is an expectation that prices are going even higher, or that gas will become completely unavailable, a prediction which becomes self-fulfilling - a positive feedback loop. I'm sure this fits into a basic economic model, but does it not argue for some sort of rationing or price controls in certain situations?

Sharon

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