Category: Mental Models

Gresham’s Law: Why Bad Drives Out Good As Time Passes

Whenever coins containing precious metals have been used along with base metal coins of the same denomination, both legally accepted as tender, the bad coins have driven the good coins out of circulation.

Gresham’s Law is named after Sir Thomas Gresham (1519-1579), an English financier in the time of the Tudors.

However, the original principle had been stated at least forty years before by Nicolaus Copernicus and has been credited to Christian and Islamic scholars even before that. In some parts of the world (mostly Central and Eastern Europe) the law is still known as the Copernicus Law.

The idea may practically date back as far as the Athenian playwright Aristophanes. In his play The Frogs, Aristophanes compares the degradation of great politicians to the introduction of bad coinage.

I’ll tell you what I think about the way

This city treats her soundest men today:

By coincidence more sad than funny,

It’s very like the way we treat our money.

The noble silver drachma, which of old

We were so proud of, and the one of gold

Coins that rang so true

Throughout the world have ceased to circulate.

Instead the purses of Athenian shoppers

Are full of phoney silver-plated coppers.

Just so, when men are needed by the nation,

The best have withdrawn from circulation.

The coinage problem is mostly obsolete in the modern age, but the practical problems are as large as ever.

The outcome described by Aristophanes is common in competing human groups or organizations: When bad behavior has taken root, and that bad behavior has a “survival advantage” against good behavior, it becomes difficult, and occasionally impossible, to drive out the bad behavior; a process akin to natural selection.

In fact, one might call Gresham’s Law something of a special case of natural selection itself.

Forms of human behavior survive because they have a competitive edge against other behaviors. Self-interested groups naturally tend towards what works, so bad drives out good (in a moral sense) if it causes superior practical effects. This is one large reason why forms of regulation and policing are needed in human systems, to prevent the Law from working its magic.

Thomas Gresham, famous for Gresham's Law

In a wonderful illustration of this tendency, Charlie Munger applied Gresham’s Law to 1980s savings and loan banking practices in his 1984 Letter to Wesco Shareholders:

Although interest rates have subsided from the 1981-82 peak, the low and slowly changing interest rates of former years are plainly gone with the wind, as are the former government-decreed limits on interest rate competition for savings accounts and the favouritism for savings and loan associations over banks. But an agency of the U.S. Government (…) continues to insure savings accounts in the savings and loan industry, just as it did before. The result may well be bolder and bolder conduct by many savings and loan associations. A sort of Gresham’s Law (“bad loan practice drives out good”) may take effect for fully competitive but deposit-insured institutions, through increased copying by cautious institutions of whatever apparent-high-yield loan and investment strategies seem to allow competitors to bid away their savings accounts and yet report substantial earnings. If so, if “bold conduct drives out conservative conduct,” there eventually could be widespread insolvencies caused by bold credit extensions come to grief.

This can be common in some business fields. Take two drug salespeople – one willing to bribe doctors in order to make sales, and one not willing to do so. If the industry functions such that fraudulent business practices are not punished, and the bribery goes uncovered by the buyer’s organization, then bribery obviously gains a sustainable competitive advantage over non-bribery. Clearly, the deceptive practice will take hold, as salespeople unburdened by morals are promoted and compensated better than the high-roaders. It’s a clear form of Gresham’s Law.

Take also sub-prime mortgage lending practices in the lead up to the 2008 financial crisis. If two banks are competing for borrowers and one lets their standards slide to zero (or less), which is likely to prevail? Even if the practice is a “long-term loser,” it can still take hold in systems where short-term incentives provide encouragement to the actual decision makers.

Canadian Prime Minister Mackenzie King once described the origins of Gresham’s Law and its effects in a similar fashion, dubbing it the Law of Competing Standards.

In the reign of Queen Elizabeth, an official named Gresham observed that where different metals were in circulation as coinage and some were better than others of the same nominal value, the coins made of the inferior metal tended to drive the better out of circulation. The better coins were either hoarded or melted down and sold as bullion, were used in the fine arts, or were absorbed in the foreign exchanges. In other words, what Gresham discovered was that cheaper money tends to drive out dearer; that when people begin to discriminate between two coinages, they will invariably pay out the inferior and hoard the better, thus removing the better from circulation. This phenomenon once generally observed came to be described as a “Law,” and was identified with Gresham’ s name, since it was Gresham who was first successful in drawing public attention to it. Amongst money-changers, Gresham’ s Law of the precious metals is better known than the Ten Commandments.

Something analogous to Gresham’s Law will be found to obtain in the case of competing standards in Industry. Assuming there is indifference in the matter of choice between competing commodities or services, but that in the case of such commodities or services the labor standards involved vary, the inferior standard, if brought in this manner into competition with a higher standard, will drive it out, or drag the higher down to its level. This is effected by the opportunity of under-selling which comes, where in such cases human well-being is sacrificed to material ends. The superior standard, not being recognized or demanded, is unable to hold its own, and in time disappears. This Law is just as real and relentless in its operation in Industry as Gresham’s Law of the precious metals is with respect to money and the mechanism of exchange. Indeed, a more accurate exposition would describe both as manifestations of one and the same law, which I propose to call the Law of Competing Standards. I see no reason why economists should not recognize the existence of such a law, and incorporate it immediately in economic science as being quite as significant as the Law of Supply and Demand, the Law of Diminishing Returns, or any other Law accorded a place in its nomenclature.

The Law of Competing Standards is doubtless a part of the general Law of Competition, under which the cheaper of two commodities gains in competition a preference over the dearer. What Gresham discovered was an important sequence of the Law of Competition as applied to coinage; namely, the disappearance, in the course of time, of the superior metals. Observance of a like sequence in the case of standards in Industry is highly desirable. As respects labor standards, I believe that recognition of the operation of the Law of Competing Standards over ever-widening areas would do more than aught else to clear up the most baffling problems with which Industry is confronted, and to point the way to a solution of many situations which hitherto have seemed incapable of solution.

***

Perhaps the most important application of Gresham’s Law is to avoid becoming part of systems where good beahviour cannot win. Certain industries and activities lack the “policing” necessary to keep systems free from bad behaviour. While it’s admirable to be the “cleanest shirt” in a pile of dirty laundry, certain areas of human life do not allow the clean shirts to win.

On the flip side, you’ll occasionally find situations where the good money drives out bad, and the cleanest shirts end up being worn the most. Those are the areas to aim your focus.

Gresham’s Law is one of Farnam Street’s Latticework of Mental Models.

The Murder of Kitty Genovese and The Bystander Effect

Catherine “Kitty” Genovese, a New York City woman who was stabbed to death near her home in the Kew Gardens section of Queens, New York on March 13, 1964.

Genovese was buried in a family grave at Lakeview Cemetery in New Canaan, Connecticut.

The circumstances of her murder and the supposed lack of reaction of numerous neighbors were reported by a newspaper article published two weeks later; the common portrayal of neighbors being fully aware but completely nonresponsive has later been criticized as inaccurate. Nonetheless, it prompted an investigation into the social psychological phenomenon that has become known as the bystander effect (seldom: “Genovese syndrome”) and especially diffusion of responsibility.

Social Proof: Why We Look to Others For What We Should Think and Do

“Where all think alike, no one thinks very much.”
Walter Lippmann

“The five most dangerous words in business are: ‘Everybody else is doing it.'”
Warren Buffett

***

The Basics

Consider a university freshman, attempting to navigate the adult world for the first time. They are convinced that all the other students around them somehow know more about adulthood. Perhaps they imagine that everyone else was handed a manual they somehow missed. Everyone else seems to know where to go, how to make new friends, what to do. Except, of course, the majority of their peers feel equally unsure and are doing the exact same. We never quite leave behind that tendency to look at others for clues.

When we feel uncertain, we all tend to look to others for answers as to how we should behave, what we should think and what we should do. This psychological concept is known as social proof. It occurs as a result of our natural desire to behave in the correct manner and fit in with others. It can be easy to assume that everyone else has a better grasp of what to do in a given situation. Social proof is especially prevalent in ambiguous or unfamiliar conditions, or in big groups. It affects us both in public and in private.

In The Power of Positive Deviance, Richard Pascale explains social proof:

A well-known principle of chemistry establishes that active ingredients can be mixed together with little effect until a third ingredient- often an innocuous catalyst- triggers a chemical synthesis. Analogously, the social system is the catalyst between all the stuff we know versus what actually alters our behavior and mental maps. Social proof? Simple idea, really: it boils down to ‘seeing is believing.’… We use social proof to decide how to dispose of an empty popcorn box in a movie theater, how fast to drive on a highway, or whether to tackle that fried chicken or corn on the cob with our hands at a dinner party. At the more consequential end of the spectrum, we rely on social proof to inform moral choices- whether to assist an inebriated football enthusiast who falls on the sidewalk or step forward as a whistleblower.

Social proof can be problematic for two main reasons. Firstly, groups of people can reach conclusions which are suboptimal or even outright wrong. This is also known as groupthink or herd behavior. Secondly, social proof can be manipulated to guide us towards choices we would not otherwise make. In extreme cases, it can lead to groups of people becoming violent or antisocial. We will look at one of the worst examples further on in this post.

No one likes to be confused about what to do in a situation where other people are around to witness any blunders. The more uncertain we feel, the more susceptible we are to social proof.
A further key factor is the similarity we see between ourselves and the people around us. When people relate to those around them (due to gender, class, race, shared interests, and other commonalities) they mimic each other’s behavior with greater care. This is known as implicit egotism and linked to the mirror neurons in our brains.

In Private Truths, Public Lies, Timur Kuran writes of the influence on social proof on groups:

A phrase like ‘the American way’ when uttered on behalf of a particular agenda, signals that most Americans, or at least most respectable Americans agree on what is appropriate. Of course, the claim embodied in such a phrase may harbor much exaggeration. Other methods of exaggeration include dwelling on biased polls [e.g. a political poll only completed by white males] and overstating the size of a demonstration. All such methods constitute direct appeals to social proof. ..the softness or hardness of a belief must not be confused with its power, which is its potential influence over behaviour. A belief based solely on social proof -one that is extremely soft- may generate wild passions, as when a student participates fervently in a revolutionary movement whose program she has never read. By the same token, a belief formed through extensive personal experience- one that is very hard may elicit little action. An educator convinced that schools are in decline will not necessarily act on this information fearing objections.

No matter how individual we think we are, we all have an inherent desire to conform. Psychologists call this the bandwagon effect- ideas, beliefs, trends, and concepts are spread between people. The more people adopt them, the more people are influenced to do so.

In The Negotiator’s Fieldbook, an example of how social proof is used by lawyers is provided:

A lawyer… might exhibit certain behaviors at the bargaining table (e.g. she can attempt to frame the negotiation as a search for jointly desirable outcomes) and thereby model the behaviour for her counterpart. This, in turn, could induce her counterpart to conduct herself in a similar manner. Likewise, a lawyer might use evidence from similar cases…showing how often- even perhaps for what amounts- litigants in similar cases have settled. By demonstrating that similarly situated others have settled, the lawyer may be able to persuade her counterpart that settlement is appropriate for her as well.

Robert Cialdini and the Science of Persuasion

According to Robert Cialdini, social proof is one of the six key principles of persuasion. When combined with reciprocity, consistency, authority, liking, and scarcity, it can be used to influence people’s actions.

In one study, researchers from New York City university planted a man on a busy sidewalk. Amongst crowds of people, he stopped and looked upwards for a minute. The experiment by social psychologists Milgram, Bickman, and Berkowitz was designed to test the power of social proof. When just one man gazed at the sky, just 4% of passersby also looked up. When the experiment was repeated with five men looking upwards, 18% of passersby followed suit, and for 15 the figure was 40%. This experiment is cited by Cialdini as an illustration of how social proof persuades people to behave in certain ways.
Another study cited by Cialdini concerned charitable donations, finding that showing people a list of their neighbors who had donated to a charity led to a substantial increase in funds raised. The more names on the list, the more people donated. Cialdini also explains how the use of social proof can backfire. Campaigns to reduce drug and alcohol consumption which cite high rates of abuse can have the opposite effect. People subconsciously seek to comply with the many others who are engaging in this behavior.

Cialdini writes:

The principle of social proof says so: The greater the number of people who find any idea correct, the more the idea will be correct…We will use the actions of others to decide on proper behavior for ourselves, especially when we view those others as similar to ourselves…When we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd…First, we seem to assume that if a lot of people are doing the same thing, they must know something we don’t…Social proof is most powerful for those who feel unfamiliar or unsure in a specific situation and who, consequently, must look outside themselves for evidence of how best to behave there… Since 95 percent of the people are imitators and only 5 percent initiators, people are persuaded more by the actions of others than by any proof we can offer.

Examples of social proof

“Lack of skepticism is often the result of our social beliefs. No one would believe such absurd nonsense as a moon made of cheese or a flying teapot when it is proposed in such an unfamiliar way. However, when we encounter equally absurd belief systems in socially or historically-familiar contexts, they seem to have a measure of proof and be established or valid. In other words, a lot of people believing some total bullshit creates a form of social proof.”
— Sia Mohajer

***

An unfortunate fact of life is that some people desperately seek opportunities, while others are bombarded with them. One person struggles to find a job, sending their CV everywhere. Another person has an impressive role already and yet is constantly offered others. One book proposal is fought over by publishers. Another is relegated straight to the bin. One person never manages to find anyone willing to go on a date, while another receives non-stop propositions despite being in a relationship. Why does this happen? The answer is social proof.

When someone is regarded as successful, talented, or attractive that view spreads. When social proof is absent, others are more dismissive and attentive to flaws. Two people could be equally qualified, but the one with a high-ranking job already seems like a fail-safe choice for a key role. Two writers could be equally talented, but the one whose previous book was a bestseller will have much less trouble getting their next published. And so on.

The Arizona Petrified Forest
A classic example of social proof occurred in the Arizona Petrified Forest. The theft of unusual petrified wood by visitors was becoming a serious issue, depleting the ancient woodland. Staff put up a sign stating: ‘Many past visitors have removed the petrified wood from the park, destroying the natural state of the Petrified Forest.’ This was intended to deter theft, but it had the opposite effect. The depletion of the petrified wood tripled. Experts who looked at the case determined that the signs had served as social proof, making people feel the act was justified.

Claquers
Another example of social proof is a claque. A claque is a group of professional applauders, positioned in theaters or opera houses. Claqueurs (members of a claque) have been used since Emperor Nero, whose performances were applauded by five thousand soldiers. In the 16th century, claqueurs became a common part of theater and opera performances. Their job was to applaud a performance, encouraging others to do the same. Social proof meant that once a few people began to applaud, the rest did the same. Audience members saw that others appeared to enjoy the piece and went away with a more positive view of it. Whilst clacquers are now rare, their existence shows how social proof can distort reality.

The Jonestown Massacre
The 1978 Jonestown Massacre is one of the most shocking, terrifying examples of the dark side of social proof. Under the leadership of religious fanatic Jim Jones, 918 people died in a commune in Georgetown. Although the event was technically a mass suicide, the degree of duress and force under which the deaths happened and the fact that 1 in 3 were minors mean that massacre is more accurate. Nearly a thousand members of the cult drank poison, including infants. Within a matter of minutes, all were dead.

In the aftermath of this tragedy (the worst loss of American lives on a single occasion until 9/11), the world struggled to make sense of how it could have happened. One important element which emerged upon study was that of social proof. Isolated from the rest of the world, the commune had no outside influences and no one to emulate save each other. At the head of the cult was the self-appointed messiah Jim Jones who manipulated and controlled his followers. Force was used to squash any dissent, meaning people had no option but to comply. Cult members were encouraged to inform Jones of anyone who felt rebellious, and families were broken up to give him total control. If someone did object, they had no allies to side with and reinforce their change of heart. The few people who survived were mostly couples who managed to stay together and had the social proof provided by each other necessary to retain their opinions. Deborah Blakey, a survivor later said:

Any disagreement with [Jones’] dictates came to be regarded as “treason.” ….Although I felt terrible about what was happening, I was afraid to say anything because I knew that anyone with a differing opinion gained the wrath of Jones and other members.

Jones’ final, harrowing speech which manipulated his followers into committing suicide can be heard here. It provides a clear example of how people succumbed to social proof. Throughout the tape, a number of people are heard dissenting, only to be forced back into submission by their peers.

How marketers use social proof

“Social proof is a flame to the human mind moth,
and it leaves a fire trail of destruction across the path of enough.”
— Will Jelbert (The Happiness Animal)

***

Marketers love using social proof to encourage people to spend more money. If you ever feel the strange urge to buy something you don’t need, this could be down to social proof.

Marketers achieve this in a number of ways:

  • Using influencers and famous people. A phenomenon known by psychologists as the ‘halo and horns effect’ means we see a product/service as more desirable if it is associated with someone we like. On a subconscious level, we imagine their good qualities rubbing off on the item advertised. Likewise, if we wish to be like someone, we may think anything they endorse will make us more like them.
  • Implying popularity. Night clubs and bars often make patrons wait outside, even when the venues are not full. This creates an aura of desirability
  • Reviews/ratings. 70% of people look at these before making a purchase, to see what others think about a product or service. Even though these can be biased, anecdotal or even fake, we judge people ‘like us’ as more trustworthy than the companies. For example, if someone is planning on buying a certain vacuum cleaner, just one negative review can sway them away from it- never mind that said reviewer may have used it incorrectly.
    Social proof is part of the Farnham Street latticework of mental models. To read more on the topic look to Cialdini’s Persuasion, Gladwell’s Tipping Point, or Kuran’s Private Truths, Public Lies.

Social Proof is in the Farnam Street Latticework of Mental Models.

Mental Model: Anchoring

We often pay attention to irrelevant information. This happens because we develop estimates by starting with an initial anchor that is based on whatever information is provided and adjust from the anchor (sometimes our adjustments are not sufficient). This is called anchoring.

More problematic perhaps is that the existence of an anchor leads people to think of information consistent with that anchor (commitment and consistency) rather than access information that is inconsistent with that anchor.

Anchoring is commonly observed in real estate and the stock market. Many BUYERS tend to negotiate based on the listed price of a house — and many SELLERS tend to determine the list priced based on adjusting their purchase price.

Some interesting points on anchoring: (1) Experts and non-experts are affected similarly by an anchor; (2) Anchoring-adjustment may occur in any task requiring a numerical response, provided an initial estimate is available; and (3) One study of particular importance for investors, by Joyce and Biddle (1981), found support for the presence of the anchoring effect among practicing auditors of major accounting firms.

* * *

Anchoring and adjustment was first theorized by Tversky and Kahneman. The pair demonstrated that when asked to guess the percentage of African nations which are members of the UN, people who were first asked “was it more or less than 35%” guessed lower values than those who had been asked if it was more or less than 65%. Subjects were biased by the number 45 or 65 and this had a meaningful influence on their judgment. Over time this bias has been shown in numerous experiments. Interestingly, paying participants based on their accuracy did not reduce the magnitude of the anchoring effect.

The power of anchoring can be explained by the confirmation heuristic and by the limitations of our own mind. We selectively access hypothesis-consistent information without realizing it. Availability may also play a role in anchoring.

There are numerous examples of anchoring in everyday life:

  • Children are tracked by schools that categorize them by ability at an early age and based on this initial “anchor” teachers derive expectations. Teachers tend to expect children assigned to the lower group to achieve little and have much higher expectations of children in the top group (for more info see Darley and Gross, 1983). Malcolm Gladwell talks more about anchoring in his book outliers.
  • First impressions are a form of anchoring.
  • Minimum payments on credit card bills.
  • Posted interest rates at Banks.
  • Prices on a menu in restaurants.
  • Race can also be an anchor with respect to our expectations (Duncan, 1976)

* * *

Heuristic and Biases: The Psychology of Intuitive Judgment offers:

“To examine this heuristic, Tversky and Kahneman (1974) developed a paradigm in which participants are given an irrelevant number and asked if the answer to the question is greater or less than that value. After this comparative assessment, participants provide an absolute answer. Countless experiments have shown that people’s absolute answers are influenced by initial comparison with the irrelevant anchor. People estimate that Gandhi lived to be roughly 67 years old, for example, if they first decided whether he died before or after the age of 140, but only 50years old if they first decided whether he died before or after the age of 9.

Anchoring effects have traditionally been interpreted as a result of insufficient adjustment from an irrelevant value, but recent evidence casts doubt on this account. Instead, anchoring effects observed in the standard paradigm appear to be produced by the increased accessibility of anchor consistent information.

* * *

In Judgment and Decision Making, David Hardman says:

Anchoring effects have been observed in a variety of domains including pricing, negotiation, legal judgment, lotteries and gambles, probability estimates, and general knowledge. In one of these studies, Northcraft and Neale (1987) demonstrated anchoring effects in the pricing estimates of estate agents…

Despite the robustness of the anchoring effect, there has been little agreement as to the true nature of the underlying processes. One theory that has been proposed is that of selective anchoring (Mussweilier and Strack, 1997). According to this account, the comparative question task activates information into memory that is subsequently more accessible when making an absolute judgment….

Epley (2004) listed four findings that are consistent with the selective memory account: (1) People attend to shared features between the anchor and target more than to unique features; (2) Completion of a standard anchoring task speeds identification of words consistent with implications of an anchor value rather than words inconsistent with it; (3) The size of anchoring effects can be influenced by altering the hypothesis tested in the comparative assessment (for example, asking whether the anchor is less than a target value has a different effect to asking whether it is more than a target value); (4) People with greater domain knowledge are less susceptible to the effects of irrelevant anchors.

* * *

In Fooled by Randomness, Nicholas Taleb writes:

Anchoring to a number is the reason people do not react to their total wealth, but rather to differences of wealth from whatever number they are currently anchored to. This is in major conflict with economic theory, as according to economists, someone with $1 million in the bank would be more satisfied than if he had $500 thousand but this is not necessarily the case.

* * *

Tversky and Kahneman (1974)

In many situations, people make estimates by starting from an initial value that is adjusted to yield the final answer. The initial value, or starting point, may be suggested by the formulation of the problem, or it may be the result of a partial computation. In either case, adjustments are typically insufficient (Slovic & Lichtenstein, 1971). That is, different starting points yield different estimates, which are biased toward the initial values. We call this phenomenon anchoring.

* * *

Russell Fuller writes:

Psychologists have documented that when people make quantitative estimates, their estimates may be heavily influenced by previous values of the item. For example, it is not an accident that a used car salesman always starts negotiating with a high price and then works down. The salesman is trying to get the consumer anchored on the high price so that when he offers a lower price, the consumer will estimate that the lower price represents a good value. Anchoring can cause investors to under-react to new information.

Anchoring is a Farnam Street Mental Model.

The Principles of Comparative Advantage: Why Tiger Woods Shouldn’t Mow Your Lawn

In economics, comparative advantage refers to the ability of a person or nation to produce a good or service at a lower opportunity cost than another person (or nation). This is why trade can create value for both parties—because each person can concentrate on the activity for which they have the lower opportunity cost. It also explains why Tiger Woods shouldn’t mow your lawn.

The term “comparative advantage” is usually attributed to David Ricardo. In his 1817 book On The Principles Of Political Economy And Taxation, Ricardo used the example of trade between England and Portugal.

Portugal could produce both wine and cloth with less labor than it would have taken to produce the same output in England. However, the relative costs are different (currencies have different values). From Ricardo’s point of view, England had difficulty producing wine and very little difficulty producing cloth. Portugal, however, could easily produce both wine and cloth. Ricardo concluded that while it was cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine and trade this for English cloth. England would benefit from this trade because its cost of producing cloth has not changed but it can now get wine at a lower price. Thus, each country can gain by specializing in the good that has a comparative advantage.

One of the drawbacks of trade in this way is that it creates increasing interdependence among people or nations. In Ricardo’s example, England and Portugal relied on each other for certain goods. This is possible as long as it is in the self-interest of each nation and there are no disruptions.
comparative advantage

In the leading economics textbook, Principles of Microeconomics, Greg Mankiw offers the following:

Differences in opportunity cost and comparative advantage create the gains from trade. When each person specializes in producing the good for which he or she has a comparative advantage, total production in the economy rises, and this increase in the size of the economic pie can be used to make everyone better off. In other words, as long as two people have different opportunity costs, each can benefit from trade by obtaining a good at a lower price than his or her opportunity cost of that good.

 

Real Life Examples

Should Tiger Woods Mow His Own Lawn?

Tiger is a great athlete. One of the best golfers to have every lived. Most likely he is better at other activities too. Tiger is probably in better shape than most: He can run faster, lift more, and work quicker. For example, Tiger can probably mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should?

To answer this question we can use the concepts of opportunity cost and comparative advantage. Let’s say that Tiger can mow his lawn in 2 hours. In the same two hours he could film a television commercial for golf clubs and earn $100,000. By contrast, Joe, the kid next door can mow Tiger’s lawn in 4 hours. In that same 4 hours he could work at McDonald’s and earn $24.

In this example, Tiger’s opportunity cost is $100,000 and Joe’s is $24. Tiger has an absolute advantage in mowing lawns because he can do the work in less time. Yet Joe has a comparative advantage because he has the lower opportunity cost. The gains in trade from this example are tremendous. Rather than mowing his own lawn, Tiger should make the commercial and hire Joe to mow his lawn. As long as Tiger pays Joe more than $24 and less than $100,000, both of them are better off.

(Another example, this one from wikipedia)

Two men live alone on an isolated island. To survive they must undertake a few basic economic activities like water carrying, fishing, cooking and shelter construction and maintenance. The first man is young, strong, and educated. He is also, faster, better, more productive at everything. He has an absolute advantage in all activities. The second man is old, weak, and uneducated. He has an absolute disadvantage in all economic activities. In some activities the difference between the two is great; in others it is small.

Despite the fact that the younger man has absolute advantage in all activities, it is not in the interest of either of them to work in isolation since they both can benefit from specialization and exchange. If the two men divide the work according to comparative advantage then the young man will specialize in tasks at which he is most productive, while the older man will concentrate on tasks where his productivity is only a little less than that of a young man. Such an arrangement will increase total production for a given amount of labor supplied by both men and it will make both of them richer.

Hindsight Bias: Why You’re Not As Smart As You Think You Are

hindsight bias

Hindsight bias occurs when we look backward in time and see events are more predictable than they were at the time a decision was made. This bias, also known as the “knew-it-all-along effect,” typically involves those annoying “I told you so” people who never really told you anything.

For instance, consider driving in the car with your partner and coming to a T in the road. Your partner decides to turn right and 4 miles down the road when you realize you are lost you think “I knew we should have taken that left.”

Hindsight bias can offer a number of benefits in the short run. For instance, it can be flattering to believe that our judgment is better than it actually is. And, of course, hindsight bias allows us to participate in one of our favorite pastimes — criticizing the decisions of others for their lack of foresight.

“Judgments about what is good and what is bad, what is worthwhile and what is a waste of talent, what is useful and what is less so, are judgments that seldom can be made in the present. They can safely be made only by posterity.”

— Tulvings

Aside from helping aid in a more objective reflection of decisions, hindsight bias also has several practical implications. For example, consider someone asked to review a paper but knows the results of the previous review from someone else? Or a physician asked for a second opinion after knowing the results of the first. The results of these actions will likely be biased by some degree. Once we know an outcome it becomes easy to find some plausible explanation.

Hindsight bias helps us become less accountable for our decisions, less critical of ourselves, and over-confident in our ability to make decisions.

One of the most interesting things I discovered when researching hindsight bias was the impact on our legal system and the perceptions of jurors.

* * *

Harvard Professor Max Bazerman offers:

The processes that give rise to anchoring and overconfidence are also at play with the hindsight bias. According to this explanation, knowledge of an event’s outcome works as an anchor by which individuals interpret their prior judgments of the event’s likelihood. Due to the selective accessibility of the confirmatory information during information retrieval, adjustments to anchors are inadequate. Consequently, hindsight knowledge biases our perceptions of what we remember knowing in foresight. Furthermore, to the extent that various pieces of data about the event vary in support of actual outcome, evidence that is consistent with the known outcome may become cognitively more salient and thus more available in memory. This tendency will lead an individual to justify a claimed foresight in view of “the facts provided.” Finally, the relevance of a particular piece of that may later be judged important to the extent to which it is representative of the final observed outcome.

In Cognitive Illusions, Rudiger Pohl offered the following explanations of hindsight bias:

Most prominent among the proposes explanations are cognitive accounts which assume that hindsight bias results from an inability to ignore the solution. Among the early approaches are the following three: (1) Fischhoff (1975) assumed an immediate and irreversible assimilation of the solution into one’s knowledge base. As a consequence, the reconstructed estimate will be biased towards the solution. (2) Tversky and Kahneman (1974) proposed a cognitive heuristic for the anchoring effected, named anchoring and insufficient adjustment. The same mechanism may apply here, if the solution is assumed to serve as an “anchor” in the reconstruction process. The reconstruction starts from this anchor and is then adjusted in the direction of one’s knowledge base. However, this adjustment process may stop too early, for example at the point where the first plausible value is reached, thus ending to a biased reconstruction. (3) Hell (1988) argued that the relative trace strengths of the regional estimate and of the solution might predict the amount of hindsight bias. The stronger the trace strength of the solution relative to that of the original estimate, the larger hindsight bias should be.

Pohl also offers an evolutionary explanation of hindsight bias:

Finally, some authors argued that hindsight bias is not necessarily a bothersome consequence of a “faulty” information process system, but that is may rather represent an unavoidable by-product of an evolutionary evolved function, namely adaptive learning. According to this view, hindsight bias is seen as the consequence of our most valuable ability to update previously held knowledge. This may be seen as a necessary process in order to prevent memory overload and thus to maintain normal cognitive functioning. Besides, updating allows us to keep our knowledge more coherent and to draw better inferences.

Ziva Junda, in social cognition, offers the following explanation of why hindsight bias occurs:

Preceding events take on new meaning and importance as they are made to cohere with the known outcome. Now that we know that our friends have filed for divorce, any ambiguous behavior we have seen is reinterpreted as indicative of tension, any disagreement gains significance, and any signs of affection seem irrelevant. It now seems obvious that their marriage was doomed from the start…Moreover, having adjusted our interpretations in light of current knowledge, it is difficult to imagine how things could have happened differently.

When making likelihood judgments, we often rely on the availability heuristic: The more difficult it is for us to imagine an outcome, the more unlikely it seems. Therefore, the difficulty we experience imagining how things might have turned out differently makes us all the more convinced that the outcomes that did occur were bound to have occurred.

Hindsight bias has large implications for criminal trials. In Jury Selection Hale Starr and Mark McCormick offer the following:

The effects of hindsight bias – which result in being held to a higher standard – are most critical for both criminal and civil defendants. The defense is more susceptible to the hindsight bias since their actions are generally the ones being evaluated fro reasonableness in foresight-foreseeability. When jurors perceive that the results of particular actions were “reasonably” more likely after the outcome is known, defendants are judged as having been capable of knowing more than they knew at the time the action was taken and therefore as capable of preventing the “bad” outcome.

In post-verdict surveys jurors unknowingly demonstrate some of the effects of hindsight bias:

“I can’t understand why the managers didn’t try to get more information or use the information they had available. They should have known there would be safety problems at the plant”.

“The defendants should have known people would remove the safety shield around the tire. There should have been warnings so people wouldn’t do that”

“Even though he was a kid, he should have known that once he showed the others who had been drinking that he had a gun, things would get out of hand. He should have known guns invited violence.

Jurors influenced by the hindsight bias look at the evidence presented and determine that the defendants knew or should have known their actions were unsafe, unwise, or created a dangerous situation. Hindsight bias often results in the judgment that the event was “an accident or tragedy waiting to happen.”

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Protection Against Hindsight Bias

In Principles of Forecasting, Jon Scott Armstrong, offers the following advice on how to protect yourself:

The surest protection against (hindsight bias) is disciplining ourselves to make explicit predictions, showing what we did in fact know (sounds like a decision journal). That record can also provide us with some protection against those individuals who are wont to second guess us, producing exaggerated claims of what we should have known (and perhaps should have told them). If these observers look to this record, it may show them that we are generally less proficient as forecaster than they would like while protecting us against charges of having blown a particular assignment. Having an explicit record can also protect us against overconfidence in our own forecasting ability: If we feel that we “knew all along” what was going to happen, then it is natural enough to think that we will have similar success in the future. Unfortunately, an exaggerated perception of a surprise-free past maybe portend a surprised-full future.

Documenting the reasons we made a forecast makes it possible for us to know not only how well the forecast did, but also where it went astray. For example, subsequent experiences may show that we used wrong (or misunderstood) inputs. In that case, we can, in principle, rerun the forecasting process with better inputs and assess the accuracy of our (retrospectively) revised forecasts. Perhaps we did have the right theory and procedures, but were applying them to a mistaken picture of then-current conditions…Of course inputs are also subject to hindsight bias, hence we need to record them explicitly as well. The essence of making sense out of outcome knowledge is reinterpreting the processes and conditions that produced the reported event.

Hindsight Bias is part of the Farnam Street latticework of mental models.