The E Myth Revisited
Blue Ocean Strategy: How To Create Uncontested Market Space And Make The Competition Irrelevant
The Know-It-All: One Man’s Humble Quest to Become the Smartest Person in the World
When I went to school in the Dark Ages, we were taught in Economics that there is such a thing as Homo economicus, a purely rational human who makes all economic decisions based on “What’s in it for me” — sounds a lot like Chicago aldermen, but I digress. In many ways, this short cut made economics much easier. We didn’t have to worry about things like people’s desire for respect or willingness to impose “fairness” into our negotiations. But it was also a bit like physics, where we were told to ignore the effects of friction in some of our equations – a shortcut than didn’t really help our understanding of the world we live in.
As time moved on, economists and psychologists started to research whether the Homo Economicus was real or a fallacy. Scholars like Amos Tversky, Daniel Kahneman, Ian Ayres, Dan Ariely and Richard Thaler ran scientific experiments to see if people really did act rationally when it came to economic decisions. What they all found, in various ways, was that we are not rational at all when it comes to buying, negotiating, selling, responding to advertisements and even going to the movies. In fact, to steal the title from Dan Ariely’s most famous book, we are Predictably Irrational.
I have recently completed reading the book Priceless: The Myth of Fair Value (and How to Take Advantage of It) by William Poundstone. I had read a number of Poundstone’s books before. He wrote books on secrets and puzzlers like How Would You Move Mount Fuji?, but I wasn’t prepared for the level of detail and research that he had completed to write this book.
The book is structured into 53 chapters. Each chapter takes a specific pricing case and talks about the specifics of the deal. There is also a description of a scientific experiment that describes the psychology of the participants. I had read about a lot of the experiments before, but this book allowed you to tie the results of the experiment with the results of a pricing decision in a very real way.
Poundstone opens the book by retelling of the McDonald’s hot coffee lawsuit, where the attorney for the plaintiff in the case employed a simple scheme to raise the amount of the jury award — he simply asked for an astronomical award from the jury. This raised the anchoring point for the jury so that while they awarded much less than the asked for judgment, they awarded much higher than any rational person would have considered the case to be worth. Anchoring also works in the grocery aisle. Not too long ago, the standard size for ice cream was a half-gallon. Consumers had in their minds what they normally paid for a half-gallon of ice cream. Manufacturers wanted to raise prices (their costs had increased) but were concerned that if they raised prices, people would notice and either change brands or even more worrisome, consider alternative dessert items. So, now if you go into the grocery store, most ice cream is sold in 1.5 or 1.75 quart sizes (a reduction of 12-25%), but the pricing is kept in the same familiar range. The average consumer doesn’t realize that they are getting less for the same price and the market share of ice cream as a portion of the dessert market is safe. Anchoring at its best.
One of the experiments that gets a lot of play in the book is the ultimatum game. In this game, one person is given $10 and is told that they can give any part of the $10 to another player. If the other player agrees, then the deal is done. If the other player does not agree, neither party receives any money. This simple game uncovers a lot of different outcomes. Men perform differently from women, Type A’s perform differently from Type B’s, Liberals perform differently from Conservatives, sober people perform differently from those more tipsy. Is the proposer most rational when he proposes $1 to be given to others while keeping $9 for himself? Is the receiver rational when rejecting a deal that would make them $1 richer in order to punish the unfairness of the proposer? The best example in the book of the ultimatum game in real life is the story of Jack Welch’s divorce negotiation. While we normally think of Neutron Jack as a most savvy businessman, it was fun to read the story how of his former wife turned the tables on him using the precepts of the ultimatum game.
Each of the chapters talks about ways that we as consumers are manipulated to paying more or selling for less than our mythical ancestor Homo Economicus would have been expected to. This is certainly important to consumers, because a savvy consumer who is aware of the psychological tricks can make smarter purchasing decisions. As business people, it is helpful to understand how to price your products and services in order to reduce price resistance.
This book was a pretty easy book to get through with enough concrete examples to catch your attention. In the 1-5 star rating category, I would give this book a solid 4 star rating.
How many times have you made the statement to yourself (or to your significant other) “Man, they just don’t get it.”? Maybe it’s because I am getting older, but it seems like those “Get off my lawn!” moments are happening more and more frequently to me. Let me give you a couple of examples from this week.
I read an article from Slate today about the plight of airline pilots, written from the point of view of a airline pilot. In this rant, he blames the consumer for looking for $99 fares causing airline executives to: look for less experienced (cheaper) pilots, for diverting flights from big planes to commuter jets, for the decrease in pilot pay and even for the company not providing the pilots with free food.
We all know that the airline business is a tough one to be in. It has been estimated that the US airline industry in all of its years of operation has not posted a cumulative profit. Be that as it may, the pilots for a long time ruled the roost. Their unions have provided the most senior of these pilots with salaries well into the 6 digits. The author of the article talks about new pilots making “welfare wages”. In fact, first year pilots make in the low $30K range across many of the major carriers. Not big bucks, but it is based on a half time flying schedule. They are limited by Federal Law (FAR 121.481) to a maximum of 1000 hours flying time per year, which is considered half time in my book. Yes, they have to get to the job, but so do a lot of commuters. I don’t know about you, but $32K is not welfare wages. In fact, it is right at the median for wages across the whole US. The picture changes as the pilot gets more experience. With the larger carriers, within 3 years, the salary will double or almost triple. With the regional airlines, the initial salaries are lower and the rate of increase is also lower. The pilots’ union for these carriers have had less success in negotiating the higher salaries than their brethren at the majors.
The author claims that safety is compromised by hiring younger, less experienced pilots at the regional airlines. These pilots must meet the same qualifications, mandated by the FAA, as at the bigger carriers. His conclusion that the safety of passengers is threatened has not been verified by the actual events. Flying in a commercial jet (of any size) is safer than most other modes of transportation.
But the most laughable point was that despite flying a full day, the pilots were not given free food. Now, other than Google (and a few other non-traditional companies), where else do you, as an employee, expect to be fed while on the job? Heck, even at Burger King, employees are not given free food, only discounted meals. Get off my lawn!
Well, let’s see… I haven’t talked about health care in about 12 hours, so let’s hit that one as well…
The AMA, Big Insurance and Big Pharma are against any major reformation of health care in our country. And why not. They are all making a ton of money at our expense. I read an article by Abraham Verghese in the Wall Street Journal about the health care debacle from a doctor’s perspective. In his article, he decries preventive medicine and electronic medical records (EMR) as not helping to solve the problems of our age. In my opinion, both preventive medicine and EMR provide critical advantages to our populace. Preventive medicine will allow doctors to get more information on the tracking of conditions. This will provide the benefit to aggressively treat a risk factor and hopefully shortcut the critical issues that cost the most amount of money. If the doctor was tracking the coronary heart disease over a period of time, the doctor and the patient together could plan for a treatment that was gradual and effective, rather than waiting for the heart attack and then starting treatment. From both the cost standpoint and the quality of life standpoint, the patient would be in a better position. EMR, if implemented correctly, will allow doctors to have the wisdom of the crowds to gather information on conditions and how others have successfully treated them, in much closer to real time. Today we wait for articles to appear in medical journals to get our information. We can and must do a better job here. Dr. Varghese, you just don’t get it. The world has changed and the medical community needs to change as well.
So, the former Labor Secretary, Robert Reich writes regarding the health care crisis that the only way that we will get out of this mess is to look to cost containment, or even cost reduction. Those doctors, hospitals, insurance companies, drug companies and their friends will need to reduce the costs of providing their products and services. The best way to do that is through the free market system and a mandate from the government to implement changes in our medical systems. President Obama needs to have a strong hand and force the issue.
Earlier this week I posted about the health care mess and talked about some of the causes. In thinking about this a bit more, I feel the need to expand upon one particular group of participants. Over time I may go over some of the others, but for right now, my ire is with the health insurance industry.
These are presented as separate musings, all related to the same topic.
Insurance is a funny thing. Many people believe that insurance should cover all medical costs. In my world view, this is playing with OPM – Other People’s Money. If the insurance policy will pay for everything, where is my responsibility to evaluate the costs and benefits of my health care needs? I firmly believe in high deductible medical policies — where the insured pays for the regular charges and uses the insurance to cover the risk of a costly medical event. In this way, you can determine if you should go to the emergency room with that sprained ankle or whether it is better to wait to go to an urgent care center where the costs are less. You need to take control of your health care and the best way to do that is through the lens of your wallet.
I read an interesting article from Nate Silver, from fivethirtyeight.com, the statistical blogger who correctly predicted the last presidential race. He talks about a George Will opinion article that describes the President’s wish to include a public insurance option as a folly. Nate (and I) believe that the addition of a public option will provide some competition to the ingrained insurance cabals.
One of George’s thoughts is that the government can undercut the insurance companies because it does not need to make a profit. Nate brought a good point to the discussion – the fact that profits are not earned by providing better service, just by adding additional people to the pool. Therefore, the government can provide serious competition to the insurance companies. Last year, Aetna earned $1.3B in profits, UnitedHealthCare returned $2.977B and CIGNA had a bad year, only $297M in profits down from $1.1B the prior year. We should not cry for these companies; we need to ask how they are going to help us address the health care crisis in our country.
In any case, the logic that the insurance companies use is flawed. For example, let’s say that someone has an insurance policy through an employer. No problem, the insurance company takes a history but, in general, accepts everyone in the group. All is fine until the employee loses his job. Not a big deal, because there is COBRA, which allows the employee to continue coverage, by paying the entire premium. Now, this is only the law for companies that have 20 or more employees, but let’s not pick on details. So, the former employee is now paying the full premium, but is covered under the same terms and conditions as when he was employed. But COBRA runs out 18 months (yes, there are some exceptions and temporary extensions, but bear with me…). At this point, former employee needs to get other insurance. Hopefully he will have gotten a new job that include health insurance benefits. But let’s take the story one more step. He is unable to get a new job. He tries to get an individual policy that will cover his insurance needs. So, he goes back to the company that provided his insurance coverage while he was employed and during his COBRA period. Note that nothing has changed: same company, same person, same health experience, no health changes. The company denies him insurance because of a medical issue. They claim that his risk is too high. But nothing has changed! The risk is the same as when he was employed. The insurance company claims that because the group is now small (1), they have different underwriting standards. Instead of looking at their entire pool of policyholders, they focus on the risks associated with a single participant, which negates all of the reasons for having insurance in the first place.
There are many problems with the insurance system today. George Will elaborated on some of them. OPM even raises its head here because a significant portion of the employee’s insurance premium is paid for by the company with tax deductable dollars. But as Nate Silver so adeptly points out, you can’t just start up a health insurance company anymore. The only entity that has the ability to do so is the Federal Government and I sure would like to see some innovation that might be spurred on by new competition.
The one thing that the general public doesn’t have that all of the other constituencies have is a lobbyist. The doctors and the AMA have one. The insurance companies have one. Big Pharma has one. The hospitals have them. Right now, the President has the responsibility for lobbying for the general public. He has claimed that he wants bipartisan support for health care reform, but it is clear that the only way to get both parties to agree is to have no real change. President Obama needs to use his bully pulpit and put together a program that will work to reform healthcare, despite the opposition party and the lobbyists. This is his opportunity to put his stamp on ensuring the future of the American health care system.
The thing about this health care crisis is that no one is going to come out of this with the status quo. Each constituent is going to have to make a change: it could be to their process, procedures, reimbursement, staffing, equipment, expectations etc. The insurance companies need to take the initiative to strive for new ways of doing business so that they have some say in how it all comes out. Otherwise, they might just be forced by competition from the government and by force of law to react to a very different world view.
I read an interesting article on health care that debunks many of the commonly stated reasons for our health care crisis in this country. It seems that we don’t have more hospital beds, doctors or CT Scanners than the rest of the world. Malpractice insurance and tort reform are a problem, but not a huge problem. Why in the world are we spending 2.4 times the amount of money per capita and 70% more as a percent of GDP than the rest of the world on our health care system?
My quick answer is OPM – Other People’s Money. Just like its homonym, OPM (opium) is a narcotic that can induce people to misuse it.
Lets take a few examples and see where this leads. Insurance companies pay the bulk of the medical bills in this country. In most cases, they negotiate with providers (hospitals, physicians, etc.) to pay from a price list. That is, even though a hospital may charge $1000 for a procedure, the insurance company has negotiated a rate of $600 and will pay that $600 to the hospital. The hospital writes off the $400 negotiated credit. But what happens if you don’t have insurance… You will be billed $1000 and be expected to pay that. The hospital is not taking a loss at $600, but there is no incentive for them to accurately price their services. In fact, they may not even know their true costs to offer services. That to me, as a business and numbers guy, is truly scary.
The patient, in most cases, has insurance. Do most patients shop around for services based on cost? Actually, most people pay more attention to the pricing of their cell phone plan or auto body repair than they do for health care. Why is this? OPM. They know that their insurance company will pay according to the terms of their policy and this gives them the freedom to be blind and dumb when it comes to their healthcare. Do whatever the doctor recommends, no matter the cost. This has the additional unfortunate side effect of people not having the data to accurately determine the competence of their health care provider. If you are not going to check on price, you probably aren’t going to see if the doctor or hospital has significant experience and positive results with your type of condition.
Ah, then, the answer is to get the insurance companies involved. Well, not so fast. The insurance companies by definition, assess and reduce risk. The usual answer is that they do this by combining risk for many people to reduce the harm that an individual’s loss could cause. In auto insurance and home insurance, they do this pretty well. In health insurance, unless you are part of a huge group, say a Fortune 1000 company, insurance companies will weed out anyone who shows even a glimmer of a future problem, either through direct denial or increased rates. Rather than look at their entire portfolio of insureds and combine risks, they focus on the micro level of each individual subscriber. But the only data that they have is based upon doctor records. So, if you know you are sick but haven’t been to a doctor, you are more likely to get insurance coverage than if you have been doing the preventive medicine routine with regular checkups and preemptive care. Totally backwards, but somehow it makes sense to the insurance companies.
Well, then the problem must be solved by the doctors. Again, OPM raises its ugly head. Doctors also buy insurance — in their case it is malpractice insurance. They are scared senseless by the threat of huge lawsuits, so they overtest. Sure don’t want to be that guy who gets asked “Why didn’t you order an MRI to determine for sure the extent of the problem?” on the witness stand. All of this testing costs money and the patients, in general, don’t make a fuss — if the doctor requests it, it must be the right thing. This leads into a long discussion about tort reform, another OPM — insurance companies paying off litigants and their attorneys, but I am not going to go there. The thing about overtesting is that the doctors have wised up. They have seen the amounts of money going to testing, imaging and minor surgical procedures. They too are taking advantage of the OPM gravy train by starting up centers to do imaging, diagnostic testing and minor surgery. They can then take a piece out of the insurance dollars on both sides of the transaction. There is nothing in the AMA charter that disallows this practice. Does it equal more unnecessary tests? You would have to think so.
Solving the health care crisis is not solving a simple problem. It will require many small steps to help to corral the runaway train that is OPM. But nothing is more important to the future of our country than the process of reining in health care costs and improving medical outcomes. We as a country need to step back and say that we didn’t have the optimal solution and look at how other countries have attacked the problem to help us find our right path.
Behind the Scenes: The cloud in cloud computing requires extensive data centers. Most of us don’t think about the infrastructure of how Google can get search results to your desktop in 0.15 seconds multiplied by millions of users every minute.
Economics: Alex discusses idiot taxes and the price of HDMI cables. I have been surprised by the same phenomenon with regard to Apple iPod chargers and headphones. Deals can be found online sometimes, but almost never in retail stores. Why is that?
Big Picture: Innovation is a hot topic in business circles for a while now. Jeff Jarvis writes thoughtfully about how the innovations of the last few years have acted differently from innovations in prior years. Previously, business innovations created increases in GDP, things like the Personal Computer and the ShamWow that consumers bought and companies derived income from. Lately, some of the most important innovations, Craigslist and Google included, reduced corporate income (macro), but increased personal wealth (micro). This is critical because reporting on our economic progress have been focused on macro trends for many years. We need to develop alternative measures to accurately report on our progress.
We are definitely living in difficult economic times. According to the the Bureau of Labor Statistics, from January 2009 through May 2009, we have lost a total of 3.4 million jobs; a staggering average of over 680,000 per month. Why that is like the entire population of Memphis, Tennessee losing their jobs… for 6 months straight. And appropriately we focus on the people behind the job losses. The personal stress, the family concerns, health insurance, retirements, downsizing, mortgages, college funding. All important concepts.
I am not an economic prognosticator, but I don’t believe that we have seen the end of job losses. Heck, GM, Chrysler and the Boston Globe haven’t figured out if they are going to be in business a month from now.
But one area that we really haven’t focused a lot of attention on are those people who are still working. Now what our large corporations have done is cut jobs – that is clear from the BLS statistics. My guess is that they did what they always do and cut way deep. Now, I learned the lesson from a mentor back in my corporate days, that you want to cut deep and cut once to keep morale of the remaining staff as positive as possible. You don’t want your staff to be continually wondering when the other shoe is going to drop and the next round of layoffs is announced. I am not sure that our current corporate leaders learned from the great John McCarron.
Generally speaking, the team that has remained is stressed because they don’t know if their job is next. They feel resentful because they now have to do their work plus that of workers that have left. They feel ashamed to be feeling resentful because they have a job and a paycheck and health insurance. All of this mental stress is not helping our corporations get what they need, which is to start selling, delivering, servicing, writing, producing again.
I have stated it before – someone in Big Corporate America needs to stand up and say that we won’t lay anyone off this year. In fact, we are going to start a limited hiring campaign to ensure that we can still deliver the best products to the marketplace. Now is the time for some American Executive to make his mark. Will it be someone you know?
Economics: Wonder how the local governments are going to handle the reduction in tax income? Some places have it figured out… If you haven’t gotten the ticket yet, it seems you will.
Big Picture: I am reading a very interesting book, The Numbers Game: The Commonsense Guide to Understanding Numbers in the News, in Politics, and in Life, by Michael Blastland and Andrew Dilnot. The idea is that we need to have some sense of numbers before we can make rational decisions. The book is broken up into chapters like Count, Size and Average. In each, the authors try to show how a little thinking can help us understand what we read and how people can use numbers to confuse. On a related point, the Freakonomics blog today talks about why it may be better for us to move to an SUV rather than a Prius. How could this be? Well, it has to do with our understanding (or lack thereof) of the most common statistic related to fuel economy, miles per gallon.
Fun: There is this group called Improv Everywhere. They stage fun, surprising scenes. For the past 8 years, they have staged the No Pants Subway Ride, where their teams (in 22 cities this year, with over 1200 participants in New York alone) get on the subway wearing only their undies. No harm, no fuss, just bringing fun to the world. Their latest escapade was to provide a wedding reception to a couple who had just been married by a judge in New York City. What a great gift. The world needs more Improv.
Economics: The Freakonomics blog points us to Al Roth of the Harvard Business School. He talks about the opposite of repugnance. These are things that we as a society promote, even though there are no good financial or political reasons. They include: monogamous marriage between a man and a woman, home ownership and donating to charity.
Technology: Lots of talk about this new product that Google introduced (not released) at their IO Conference, called Google Wave. A good overview article can be found at Techcrunch, but if you have an hour and a half to spare, I heartily recommend you watch the keynote speech where the development team demonstrated the tool. Wave solves some of the problems that we have today with out communications products, by providing a single repository for waves that can contain multi-media and can be edited by a specified group. The good news is that Google is planning to release Wave as an open source product, so developers can use common interfaces to build new features, much like the Firefox browser. This also means that Google will probably not be using this as an advertising vehicle. Lots of whiz bang stuff has been included like real time search, context sensitive spell check, easy two way integration with blogs and real time translation.
Behavior: My most popular column to date is the one I entitled “The Young Entrepreneur“. Tomatonation wrote a version that was more life centered and less business life centered. But it belongs on the reading list for any 25 year old.
Big Picture: There is no more pressing issue in our financial lives than Health Care. If we continue on the current path, we will be spending more than 40% of our GDP on health care issues with no better outcomes than the average country. An indepth article in the New Yorker by Atul Gawande talks about the medical services provided in a high cost county and a low cost county. The differences may surprise you.
Behavior: Micah muses about the greatest time of your life. It is interesting to think that you might live your life one way if you think that you have already had your greatest time of your life and another entirely if you are waiting for it.
Behind the Scenes: Here is a story of the New York Times Economics reporter who is on track for foreclosure on his house and the story of how he got there. An eye-opening view of the loan practices (and unwise spending habits) of our times.
Economy: James Surowiecki, writing in the New Yorker notes that for the first time in many years, the size of the financial industry has declined. What does this mean for us?
Behind the Scenes: Nicholas Felton makes me feel like a voyeur. But I just can’t help myself. He writes and designs an awesome annual report of his life every year (2008, 2o07). Now he has made the software available for others to journal their life and chart what is important to them at Daytum.com. Interesting… Don’t think I am going to start charting myself, but I like the end result a lot.
Entrepreneurship: April Lane, Associate Director of the Coleman Entrepreneurship Center at DePaul University wrote a good article today on the habits that owners of service companies need to practice to achieve success. I might have mentioned one or two of them before, but it never hurts to have a reminder.