Tag: Mental Model

Metaphors

Aristotle Metaphor

For most people a metaphor is a matter of extraordinary rather than ordinary language. “For this reason,” write Mark Johnson and George Lakoff in their book Metaphors We Live By, “most people think they can get along perfectly well without a metaphor.”

We have found, on the contrary, that metaphor is pervasive in everyday life, not just in language but in thought and action. Our ordinary conceptual system, in terms of which we both think and act, is fundamentally metaphorical in nature.

Metaphor

What governs our thought governs our functioning. “Our concepts (even something as simple as the word we use) structure what we perceive, how we get around in the world, and how we relate to other people.”

Since communication is based on the same conceptual system that we use in thinking and acting, language is an important source of evidence for what the system is like.

Most of our ordinary conceptual system is metaphorical in nature.

To give some idea of what it could mean for a concept to be metaphorical and for such a concept to structure an everyday activity, let us start with the concept ARGUMENT and the conceptual metaphor ARGUMENT IS WAR. This metaphor is reflected in our everyday language by a wide variety of expressions:

ARGUMENT IS WAR

Your claims are indefensible.
He attacked every weak point in my argument.
His criticisms were right on target.
I demolished his argument.
I’ve never won an argument with him.
You disagree? Okay, shoot!
If you use that strategy, he’ll wipe you out.
He shot down all of my arguments.

It is important to see that we don’t just talk about arguments in terms of war. We can actually win or lose arguments. We see the person we are arguing with as an opponent. We attack his positions and we defend our own. We gain and lose ground. We plan and use strategies. If we find a position indefensible, we can abandon it and take a new line of attack. Many of the things we do in arguing are partially structured by the concept of war. Though there is no physical battle, there is a verbal battle, and the structure of an argument—attack, defense, counter-attack, etc.—reflects this. It is in this sense that the ARGUMENT IS WAR metaphor is one that we live by in this culture; its structures the actions we perform in arguing.

Try to imagine a culture where arguments are not viewed in terms of war, where no one wins or loses, where there is no sense of attacking or defending, gaining or losing ground. Imagine a culture where an argument is viewed as a dance, the participants are seen as performers, and the goal is to perform in a balanced and aesthetically pleasing way. In such a culture, people would view arguments differently, experience them differently, carry them out differently, and talk about them differently. But we would probably not view them as arguing at all: they would simply be doing something different. It would seem strange even to call what they were doing “arguing.” In perhaps the most neutral way of describing this difference between their culture and ours would be to say that we have a discourse form structured in terms of battle and they have one structured in terms of dance.

This is an example of what it means for a metaphorical concept, namely, ARGUMENT IS WAR, to structure (at least in part) what we do and how we understand what we are doing when we argue. The essence of metaphor is understanding and experiencing one kind of thing in terms of another. It is not that arguments are a subspecies of war. Arguments and wars are different kinds of things–verbal discourse and armed conflict–and the actions performed are different kinds of actions. But ARGUMENT is partially structured, understood, performed, and talked about in terms of WAR. The concept is metaphorically structured, the activity is metaphorically structured, and, consequently, the language is metaphorically structured.

In the Investing: The Last Liberal Art, Robert Hagstrom writes:

At the simplest level, a metaphor is a way to convey meaning using out-of-ordinary, nonliteral language. When we say that “work was a living hell,” we don’t really mean to say that we spent the day beating back fire and shoveling ashes, but rather we want to communicate, in no uncertain terms, that it was a hard day at the office. Used this way, a metaphor is a concise, memorable, and often colorful way to express emotions. In a deeper sense, metaphors represent not only language but also thought and action.

Metaphors are much more than a poetic imagination or rhetorical flourish. They can help us translate ideas into mental models and those models form the basis of worldly wisdom.

what is a metaphor?

Many people contend that metaphors are necessary to stimulate new ideas. Hagstrom continues:

In the same way that a metaphor helps communicate one concept by comparing it to another concept that is widely understood, using a simple model to describe one idea can help us grasp the complexities of a similar idea. In both cases we are using one concept (the source) to better understand another (the target). Used this way, metaphors not only express existing ideas, they stimulate new ones.

Insensitivity To Base Rates: An Introduction

Our insensitivity to base rates emanates from the representativeness heuristic and is a common psychological bias.

From Smart Choices: A Practical Guide to Making Better Decisions:

Donald Jones is either a librarian or a salesman. His personality can best be described as retiring. What are the odds that he is a librarian?

When we use this little problem in seminars, the typical response goes something like this: “Oh, it’s pretty clear that he’s a librarian. It’s much more likely that a librarian will be retiring; salesmen usually have outgoing personalities. The odds that he’s a librarian must be at least 90 percent.” Sounds good, but it’s totally wrong.

The trouble with this logic is that it neglects to consider that there are far more salesmen than male librarians. In fact, in the United States, salesmen outnumber male librarians 100 to 1. Before you even considered the fact that Donald Jones is “retiring,” therefore, you should have assigned only a 1 percent chance that Jones is a librarian. That is the base rate.

Now, consider the characteristic “retiring.” Suppose half of all male librarians are retiring, whereas only 5 percent of salesmen are. That works out to 10 retiring salesmen for every retiring librarian — making the odds that Jones is a librarian closer to 10 percent than to 90 percent. Ignoring the base rate can lead you wildly astray.

* * *

Charlie Munger, instructs us how to think about base rates with an example of an employee who got caught for stealing, claiming she’s never done it before and will never do it again:

You find an isolated example of a little old lady in the See’s Candy Company, one of our subsidiaries, getting into the till. And what does she say? “I never did it before, I’ll never do it again. This is going to ruin my life. Please help me.” And you know her children and her friends, and she’d been around 30 years and standing behind the candy counter with swollen ankles. When you’re an old lady it isn’t that glorious a life. And you’re rich and powerful and there she is: “I never did it before, I’ll never do it again.” Well how likely is it that she never did it before? If you’re going to catch 10 embezzlements a year, what are the chances that any one of them — applying what Tversky and Kahneman called base rate information — will be somebody who only did it this once? And the people who have done it before and are going to do it again, what are they all going to say? Well in the history of the See’s Candy Company they always say, “I never did it before, and I’m never going to do it again.” And we cashier them. It would be evil not to, because terrible behavior spreads (Greshams law).

* * *

Max Bazerman, in Judgment in Managerial Decision Making, writes:

(Our tendency to ignore base rates) is even stronger when the specific information is vivid and compelling, as Kahneman and Tversky illustrated in one study from 1972. Participants were given a brief description of a person who enjoyed puzzles and was both mathematically inclined and introverted. Some participants were told that this description was selected from a set of seventy engineers and thirty lawyers. Others were told that the description came from a list of thirty engineers and seventy lawyers. Next, participants were asked to estimate the probability that the person described was an engineer. Even though people admitted that the brief description did not offer a foolproof means of distinguishing lawyers from engineers, most tended to believe the description was of an engineer. Their assessments were relatively impervious to differences in base rates of engineers (70 percent versus 30 percent of the sample group.)

Participants do use base-rate data correctly when no other information is provided. In the absence of a personal description, people use the base rates sensibly and believe that a person picked at random from a group made up mostly of lawyers is most likely to be a lawyer. Thus, people understand the relevance of base-rate information, but tend to disregard such data when individuating data are also available.

Ignoring base rates has many unfortunate implications. … Similarly, unnecessary emotional distress is caused in the divorce process because of the failure of couples to create prenuptial agreements that facilitate the peaceful resolution of a marriage. The suggestion of a prenuptial agreement is often viewed as a sign of bad faith. However, in far too many cases, the failure to create prenuptial agreements occurs when individuals approach marriage with the false belief that the high base rate for divorce does not apply to them.

* * *

Of course, this applies to investing as well. This conversation with Sanjay Bakshi speaks to this:

One of the great lessons from studying history is to do with “base rates”. “Base rate” is a technical term of describing odds in terms of prior probabilities. The base rate of having a drunken-driving accident is higher than those of having accidents in a sober state.

So, what’s the base rate of investing in IPOs? When you buy a stock in an IPO, and if you flip it, you make money if it’s a hot IPO. If it’s not a hot IPO, you lose money. But what’s the base rate – the averaged out experience – the prior probability of the activity of subscribing for IPOs – in the long run?

If you do that calculation, you’ll find that the base rate of IPO investing (in fact, it’s not even investing … it’s speculating) sucks! [T]hat’s the case, not just in India, but in every market, in different time periods.

[…]

When you evaluate whether smoking is good for you or not, if you look at the average experience of 1,000 smokers and compare them with a 1,000 non-smokers, you’ll see what happens.

People don’t do that. They get influenced by individual stories like a smoker who lived till he was 95. Such a smoker will force many people to ignore base rates, and to focus on his story, to fool themselves into believing that smoking can’t be all that bad for them.

What is the base rate of investing in leveraged companies in bull markets?

[…]

This is what you learn by studying history. You know that the base rate of investing in an airline business sucks. There’s this famous joke about how to become a millionaire. You start with a billion, and then you buy an airline. That applies very well in this business. It applies in so many other businesses.

Take the paper industry as an example. Averaged out returns on capital for paper industry are bad for pretty good reasons. You are selling a commodity. It’s an extremely capital intensive business. There’s a lot of over-capacity. And if you understand microeconomics, you really are a price taker. There’s no pricing power for you. Extreme competition in such an environment is going to cause your returns on capital to be below what you would want to have.

It’s not hard to figure this out (although I took a while to figure it out myself). Look at the track record of paper companies around the world, and the airline companies around the world, or the IPOs around the world, or the textile companies around the world. Sure, there’ll be exceptions. But we need to focus on the average experience and not the exceptional ones. The metaphor I like to use here is that of a pond. You are the fisherman. If you want to catch a lot of fish, then you must go to a pond where there’s a lot of fish. You don’t want to go to fish in a pond where there’s very little fish. You may be a great fisherman, but unless you go to a pond where there’s a lot of fish, you are not going to find a lot of fish.

[…]

So one of the great lessons from studying history is to see what has really worked well and what has turned out to be a disaster – and to learn from both.

***

Bias from Insensitivity To Base Rates is part of the Farnam Street Latticework of Mental Models.

Mental Model: Game Theory

Game Theory

From Game Theory, by Morton Davis:

The theory of games is a theory of decision making. It considers how one should make decisions and to a lesser extent, how one does make them. You make a number of decisions every day. Some involve deep thought, while others are almost automatic. Your decisions are linked to your goals—if you know the consequences of each of your options, the solution is easy. Decide where you want to be and choose the path that takes you there. When you enter an elevator with a particular floor in mind (your goal), you push the button (one of your choices) that corresponds to your floor. Building a bridge involves more complex decisions but, to a competent engineer, is no different in principle. The engineer calculates the greatest load the bridge is expected to bear and designs a bridge to withstand it. When chance plays a role, however, decisions are harder to make. … Game theory was designed as a decision-making tool to be used in more complex situations, situations in which chance and your choice are not the only factors operating. … (Game theory problems) differ from the problems described earlier—building a bridge and installing telephones—in one essential respect: While decision makers are trying to manipulate their environment, their environment is trying to manipulate them. A store owner who lowers her price to gain a larger share of the market must know that her competitors will react in kind. … Because everyone’s strategy affects the outcome, a player must worry about what everyone else does and knows that everyone else is worrying about him or her.

What is a game? From Game Theory and Strategy:

Game theory is the logical analysis of situations of conflict and cooperation. More specifically, a game is defined to be any situation in which:

  1. There are at least two players. A player may be an individual, but it may also be a more general entity like a company, a nation, or even a biological species.
  2. Each player has a number of possible strategies, courses of action which he or she may choose to follow.
  3. The strategies chosen by each player determine the outcome of the game.
  4. Associated to each possible outcome of the game is a collection of numerical payoffs, one to each player. These payoffs represent the value of the outcome to the different players.

…Game theory is the study of how players should rationally play games. Each player would like the game to end in an outcome which gives him as large a payoff as possible.

From Greg Mankiw’s Economics textbook:

Game theory is the study of how people behave in strategic situations. By ‘strategic’ we mane a situation in which each person, when deciding what actions to take, must consider how others might respond to that action. Because the number of firms in an oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce. In making its production decision, each firm in an oligopoly should consider how its decision might affect the production decisions of all other firms.

Game theory is not necessary for understanding competitive or monopoly markets. In a competitive market, each firm is so small compared to the market that strategic interactions with other firms are not important. In a monopolized market, strategic interactions are absent because the market has only one firm. But, as we will see, game theory is quite useful for understanding the behavior of oligopolies.

A particularly important ‘game’ is called the prisoners’ dilemma.

Markets with only a few sellers

Because an oligopolistic market has only a small group of sellers, a key feature of oligopoly is the tension between cooperation and self-interest. The oligopolists are best off when they cooperate and act like a monopolist – producing a small quantity of output and charging a price above marginal cost. Yet because each oligopolist cares only about its own profit, there are powerful incentives at work that hinder a group of firms from maintaining the cooperative outcome.

Avinash Dixit and Barry Nalebuff, in their book “Thinking Strategically” offer:

Everyone’s best choice depends on what others are going to do, whether it’s going to war or maneuvering in a traffic jam.

These situations, in which people’s choices depend on the behavior or the choices of other people, are the ones that usually don’t permit any simple summation. Rather we have to look at the system of interaction.

Michael J. Mauboussin relates game theory to firm interaction

How a firm interacts with other firms plays an important role in shaping sustainable value creation. Here we not only consider how many companies interact with their competitors, but how companies can co-evolve.

Game Theory is one of the best tools to understand interaction. Game Theory forces managers to put themselves in the shoes of other players rather than viewing games solely from their own perspective.

The classic two-player example of game theory is the prisoners’ dilemma.

Game Theory is part of the Farnam Street latticework of Mental Models. See all posts on game theory.

The Red Queen Effect: Avoid Running Faster and Faster Only to Stay in the Same Place

The Red Queen Effect

Charles Lutwidge Dodgson (1832-1898), better known by his pseudonym Lewis Carroll, was not only an author but a keen observer of human nature. His most famous works are Alice’s Adventures in Wonderland and its sequel Through the Looking Glasswhich have become timeless classics.

“Bees have to move very fast to stay still.”

— David Foster Wallace

In Through the Looking Glass, Alice, a young girl, gets schooled by the Red Queen in an important life lesson that many of us fail to heed. Alice finds herself running faster and faster but saying in the same place.

Alice never could quite make out, in thinking it over afterwards, how it was that they began: all she remembers is, that they were running hand in hand, and the Queen went so fast that it was all she could do to keep up with her: and still the Queen kept crying ‘Faster! Faster!’ but Alice felt she could not go faster, though she had not breath left to say so.

The most curious part of the thing was, that the trees and the other things round them never changed their places at all: however fast they went, they never seemed to pass anything. ‘I wonder if all the things move along with us?’ thought poor puzzled Alice. And the Queen seemed to guess her thoughts, for she cried, ‘Faster! Don’t try to talk!’

Eventually, the Queen stops running and props Alice up against a tree, telling her to rest.

Alice looked round her in great surprise. ‘Why, I do believe we’ve been under this tree the whole time! Everything’s just as it was!’

‘Of course it is,’ said the Queen, ‘what would you have it?’

‘Well, in our country,’ said Alice, still panting a little, ‘you’d generally get to somewhere else — if you ran very fast for a long time, as we’ve been doing.’

‘A slow sort of country!’ said the Queen. ‘Now, here, you see, it takes all the running you can do, to keep in the same place.

If you want to get somewhere else, you must run at least twice as fast as that!’

“It is not the strongest of the species that survives,
nor the most intelligent,
but the one most responsive to change.”

— Charles Darwin

Smarter, Not Harder

The Red Queen Effect means we can’t be complacent or we’ll fall behind. To survive another day we have to run very fast and hard, we need to co-evolve with the systems we interact with.

If all animals evolved at the same rate, there would be no change in the relative interactions between species. However, not all animals evolve at the same rate. As Darwin observed, some are more “responsive to change” than others. Species that are more responsive to change can gain a relative advantage over the ones they compete with and increase the odds of survival. In the short run, these small gains don’t make much of a difference, but as generations pass the advantage can compound. A compounding advantage… that sounds nice.

Everyone from Entrepreneurs and Fortune 500 CEOs to best-selling authors and middle managers is embedded is in their own Red Queen. Rather than run harder, wouldn’t it be nice to run smarter?

Here are just three of the ways we try to avoid the Red Queen.

  1. We invest significantly in new product development and content. Our courses, evolve quickly incorporating student-tested concepts that work and reducing the importance of the ones that don’t. Another example, our learning community, adds real-world value to people who make decisions by discussing time-tested principles. This is not a popular path as it’s incredibly expensive in time and money. Standing still, however, is more expensive. We’re not in the business of Edutainment but rather providing better outcomes. If we fail to keep getting better, we won’t exist.
  2. We try to spend our limited mental resources working on things that won’t change next week. We call these mental models and the ones we want to focus on are the ones that stand the test of time.
  3. We recognize how the world works and not how we want it to work. When the world isn’t working the way we’d like it to, it’s easy to say the world is wrong and sit back to see what happens. You know what happens right? You fall behind and it’s even harder to catch up. It’s like you’re on a plane. When you’re flying into the wind you have to work very hard. When you’re flying with the wind at your back, you need to expend less energy and you get there earlier. Recognizing reality and adapting your behavior creates a tailwind.

More Examples of the Red Queen Effect

In Deep Simplicity, John Gribbon describes the red queen principle with frogs.

There are lots of ways in which the frogs, who want to eat flies, and the flies, who want to avoid being eaten, interact. Frogs might evolve longer tongues, for fly-catching purposes; flies might evolve faster flight, to escape. Flies might evolve an unpleasant taste, or even excrete poisons that damage the frogs, and so on. We’ll pick one possibility. If a frog has a particularly sticky tongue, it will find it easier to catch flies. But if flies have particularly slippery bodies, they will find it easier to escape, even if the tongue touches them. Imagine a stable situation in which a certain number of frogs live on a pond and eat a certain proportion of the flies around them each year.

Because of a mutation a frog developes an extra sticky tongue. It will do well, compared with other frogs, and genes for extra sticky tongues will spread through the frog population. At first, a larger proportion of flies gets eaten. But the ones who don’t get eaten will be the more slippery ones, so genes for extra slipperiness will spread through the fly population. After a while, there will be the same number of frogs on the pond as before, and the same proportion of flies will be eaten each year. It looks as if nothing has changed – but the frogs have got stickier tongues, and the flies have got more slippery bodies.

Drugs and disease also represent an “arms-race.”

Siddhartha Mukherjee, in his Pulitzer-prize winning book The Emperor of All Maladies describes this in the context of drugs and cancer.

In August 2000, Jerry Mayfield, a forty-one-year-old Louisiana policeman diagnosed with CML, began treatment with Gleevec. Mayfield’s cancer responded briskly at first. The fraction of leukemic cells in his bone marrow dropped over six months. His blood count normalized and his symptoms improved; he felt rejuvenated—“like a new man [on] a wonderful drug.” But the response was short-lived. In the winter of 2003, Mayfield’s CML stopped responding. Moshe Talpaz, the oncologist treating Mayfield in Houston, increased the dose of Gleevec, then increased it again, hoping to outpace the leukemia. But by October of that year, there was no response. Leukemia cells had fully recolonized his bone marrow and blood and invaded his spleen. Mayfield’s cancer had become resistant to targeted therapy…

… Even targeted therapy, then, was a cat-and-mouse game. One could direct endless arrows at the Achilles’ heel of cancer, but the disease might simply shift its foot, switching one vulnerability for another. We were locked in a perpetual battle with a volatile combatant. When CML cells kicked Gleevec away, only a different molecular variant would drive them down, and when they outgrew that drug, then we would need the next-generation drug. If the vigilance was dropped, even for a moment, then the weight of the battle would shift. In Lewis Carroll’s Through the Looking-Glass, the Red Queen tells Alice that the world keeps shifting so quickly under her feet that she has to keep running just to keep her position. This is our predicament with cancer: we are forced to keep running merely to keep still.

This doesn’t only happen in nature, there are many business examples as well. 

In describing the capital investment needed to maintain a relative placement in the textile industry, Warren Buffett writes:

Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

In other words, more and more money is needed just to maintain your relative position in the industry and stay in the game. This situation plays out over and over again and brings with it many ripple effects. For example, the company distracted by maintaining a relative position in a poor industry places resources in a position almost assured to get a poor return on capital.

Inflation also causes a Red Queen Effect, here’s Buffett Again:

Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer.

High rates of inflation create a tax on capital that makes much corporate investment unwise—at least if measured by the criterion of a positive real investment return to owners. This “hurdle rate” the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners—has increased dramatically in recent years. The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.

The Red Queen is part of the Farnam Street latticework of mental models.

Sources:
– The excellent Sanjay Bakshi
Wikipedia
Through the Looking Glass

The Feynman Technique: The Best Way to Learn Anything

There are four simple steps to the Feynman Technique, which I’ll explain below:

  1. Choose a Concept
  2. Teach it to a Toddler
  3. Identify Gaps and Go Back to The Source Material
  4. Review and Simplify (optional)

***

If you’re not learning you’re standing still. So what’s the best way to learn new subjects and identify gaps in our existing knowledge?

Two Types of Knowledge

There are two types of knowledge and most of us focus on the wrong one. The first type of knowledge focuses on knowing the name of something. The second focuses on knowing something. These are not the same thing. The famous Nobel winning physicist Richard Feynman understood the difference between knowing something and knowing the name of something and it’s one of the most important reasons for his success. In fact, he created a formula for learning that ensured he understood something better than everyone else.

It’s called the Feynman Technique and it will help you learn anything faster and with greater understanding. Best of all, it’s incredibly easy to implement.

“The person who says he knows what he thinks but cannot express it usually does not know what he thinks.”

— Mortimer Adler

There are four steps to the Feynman Technique.

Step 1: Teach it to a child

Take out a blank sheet of paper and write the subject you want to learn at the top. Write out what you know about the subject as if you were teaching it to a child. Not your smart adult friend but rather an 8-year-old who has just enough vocabulary and attention span to understand basic concepts and relationships.

A lot of people tend to use complicated vocabulary and jargon to mask when they don’t understand something. The problem is we only fool ourselves because we don’t know that we don’t understand. In addition, using jargon conceals our misunderstanding from those around us.

When you write out an idea from start to finish in simple language that a child can understand (tip: use only the most common words), you force yourself to understand the concept at a deeper level and simplify relationships and connections between ideas. If you struggle, you have a clear understanding of where you have some gaps. That tension is good –it heralds an opportunity to learn.

Step 2: Review

In step one, you will inevitably encounter gaps in your knowledge where you’re forgetting something important, are not able to explain it, or simply have trouble connecting an important concept.
This is invaluable feedback because you’ve discovered the edge of your knowledge. Competence is knowing the limit of your abilities, and you’ve just identified one!
This is where the learning starts. Now you know where you got stuck, go back to the source material and re-learn it until you can explain it in basic terms.
Identifying the boundaries of your understanding also limits the mistakes you’re liable to make and increases your chance of success when applying knowledge.

Step 3: Organize and Simplify

Now you have a set of hand-crafted notes. Review them to make sure you didn’t mistakenly borrow any of the jargon from the source material. Organize them into a simple story that flows.
Read them out loud. If the explanation isn’t simple or sounds confusing that’s a good indication that your understanding in that area still needs some work.

Step 4 (optional): Transmit

If you really want to be sure of your understanding, run it past someone (ideally who knows little of the subject –or find that 8-year-old!). The ultimate test of your knowledge is your capacity to convey it to another.

***

Not only is this a wonderful recipe for learning but it’s also a window into a different way of thinking that allows you to tear ideas apart and reconstruct them from the ground up. (Elon Musk calls this thinking from first principles.) This leads to a much deeper understanding of the ideas and concepts. Importantly, approaching problems in this way allows you to understand when others don’t know what they are talking about.

Feynman’s approach intuitively believes that intelligence is a process of growth, which dovetails nicely with the work of Carol Dweck, who beautifully describes the difference between a fixed and growth mindset.

Mental Model: Prisoners’ Dilemma

The prisoners’ dilemma is the best known strategy game in social science. The game shows why two entities might not cooperate even when it appears in their best (rational) interest to do so. What is rational for the individual in certain circumstances is not rational for the group — that is, pursuing a strategy that is rational for you leads to a worse outcome.

With applications to economics, politics, and business the game illustrates the conflict, which can sometimes arise, between individual and group rationality.

From Greg Mankiw’s Economics textbook:

The prisoners’ dilemma is a story about two criminals who have been captured by the police. Let’s call them Mr Black and Mr Pink. The police have enough evidence to convict Mr Black and Mr Pink of a relatively minor crime, illegal possession of a handgun, so that each would spend a year in jail. The police also suspect that the two criminals have committed a jewelery robbery together, but they lack hard evidence to convict them of this major crime. The police question Mr Black and Mr Pink in separate rooms, and they offer each of them the following deal:

Right now we can lock you up for 1 year. If you confess to the jewelery robbery and implicate your partner, however, we’ll give you immunity and you can go free. Your partner will get 20 years in jail. But if you both confess to the crime, we won’t need your testimony and we can avoid the cost of a trial, so you will each get an intermediate sentence of 8 years.

If Mr Black and Mr Pink, heartless criminals that they are, care only about their own sentences, what would you expect them to do? Would they confess or remain silent? Each prisoner has two strategies: confess or remain silent. The sentence each prisoner gets depends on the strategy chosen by his or her partner in crime.

Consider first Mr Black’s decision. He reasons as follows:

I don’t know what Mr Pink is going to do. If he remains silent, my best strategy is to confess, since then I’ll go free rather than spending a year in jail. If he confesses, my best strategy is still to confess, since then I’ll spend 8 years in jail rather than 20. So, regardless of what Mr Pink does, I am better off confessing.

In the language of game theory, a strategy is called a dominant strategy if it is the best strategy for a player to follow regardless of the strategies pursued by other players. In this case, confessing is a dominant strategy for Mr Black. He spends less time in jail if he confesses, regardless of whether Mr Pink confesses or remains silent.

Now consider Mr Pink’s decision. He faces exactly the same choices as Mr Black, and he reasons in much the same way. Regardless of what Mr Black does, Mr Pink can reduce his time in jail by confessing. In other words, confessing is a dominant strategy for Mr Pink.

In the end, both Mr Black and Mr Pink confess, and both spend 8 years in jail. Yet, from their standpoint, this is a terrible outcome. If they had both remained silent, both of them would have been better off, spending only 1 year in jail on the gun charge. By each pursuing his own interests, the two prisoners together reach an outcome that is worse for each of them.

To see how difficult it is to maintain cooperation, imagine that, before the police captured Mr Black and Mr Pink, the two criminals had made a pack not to confess. Clearly, this agreement would make them both better off if they both live up to it, because they would each spend only 1 year in jail. But would the two criminals in fact remain silent, simply because they had agreed to? Once they are being questioned separately, the logic of self-interest takes over and leads them to confess. Cooperation between the two prisoners is difficult to maintain because cooperation is individually irrational.

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Michael J. Mauboussin writes:

The classic two-player example of game theory is the prisoners’ dilemma. We can recast the prisoners’ dilemma in a business context by considering a simple case of capacity addition. Say two competitors, A and B, are considering adding capacity. If competitor A adds capacity and B doesn’t, A gets an outsized payoff. Likewise, if B adds capacity and A doesn’t than B gets the large payoff. If neither expands, A and B aren’t as well-off as if one alone had added capacity. But if both add capacity, they’re worse off of than if they had done nothing.

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Avinash Dixit offers:

Consider two firms, say Coca-Cola and Pepsi, selling similar products. Each must decide on a pricing strategy. They best exploit their joint market power when both charge a high price; each makes a profit of ten million dollars per month. If one sets a competitive low price, it wins a lot of customers away from the rival. Suppose its profit rises to twelve million dollars, and that of the rival falls to seven million. If both set low prices, the profit of each is nine million dollars. Here, the low-price strategy is akin to the prisoner’s confession, and the high-price akin to keeping silent. Call the former cheating, and the latter cooperation. Then cheating is each firm’s dominant strategy, but the result when both “cheat” is worse for each than that of both cooperating.

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Warren Buffett provides some illumination as to how the Prisoners’ Dilemma plays out in business in the 1985 Berkshire Hathaway Annual report.

The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage. But that in no way means that our labor force deserves any blame for our closing. In fact, in comparison with employees of American industry generally, our workers were poorly paid, as has been the case throughout the textile business. In contract negotiations, union leaders and members were sensitive to our disadvantageous cost position and did not push for unrealistic wage increases or unproductive work practices. To the contrary, they tried just as hard as we did to keep us competitive. Even during our liquidation period they performed superbly. (Ironically, we would have been better off financially if our union had behaved unreasonably some years ago; we then would have recognized the impossible future that we faced, promptly closed down, and avoided significant future losses.)

Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industry-wide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers. I always thought myself in the position described by Woody Allen in one of his movies: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray we have the wisdom to choose correctly.”

For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.

Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington’s basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational.

Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 — on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.

This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise. The situation is suggestive of Samuel Johnson’s horse: “A horse that can count to ten is a remarkable horse – not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.

My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Some years ago I wrote: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.

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Mauboussin adds:

Our discussion so far has focused on competition. But thoughtful strategic analysis also recognizes the role of co-evolution, or cooperation, in business. Not all business relationships are conflictual. Sometimes companies outside the purview of a firm’s competitive set can heavily influence its value creation prospects.

Consider the example of DVD makers (software) and DVD player makers (hardware). These companies do not compete with one another. But the more DVD titles that are available, the more attractive it will be for a consumer to buy a DVD player and vice versa. Another example is the Wintel standard—added features on Microsoft’s operating system required more powerful Intel microprocessors, and more powerful microprocessors could support updated operating systems. Complementors make the added value pie bigger. Competitors fight over a fixed pie.

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Mankiw offers another real world example:

Consider an oligopoly with two members, called Iran and Saudi Arabia. Both countries sell crude oil. After prolonged negotiation, the countries agree to keep oil production low in order to keep the world price of oil high. After they agree on production levels, each country must decide whether to cooperate and live up to this agreement or to ignore it and produce at a higher level. The following image shows how the profits of the two countries depend on the strategies they choose.

Suppose you are the leader of Saudi Arabia. You might reason as follows:
I could keep production low as we agreed, or I could raise my production and sell more oil on world markets. If Iran lives up to the agreement and keeps its production low, then my country ears profit of $60 billion with high production and $50 billion with low production. In this case, Saudi Arabia is better off with high production. If Iran fails to live up to the agreement and produces at a high level, then my country earns $40 billion with high production and $30 billion with low production. Once again, Saudia Arabia is better off with high production. So, regardless of what Iran chooses to do, my country is better off reneging on our agreement and producing at a high level.

Producing at a high level is a dominant strategy for Saudi Arabia. Of course, Iran reasons in exactly the same way, and so both countries produce at a high level. The result is the inferior outcome (from both Iran and Saudi Arabia’s standpoint) with low profits in each country.

This example illustrates why oligopolies have trouble maintaining monopoly profits. The monopoly outcome is jointly rational for the oligopoly, but each oligopolist has an incentive to cheat. Just as self-interest drives the prisoners in the prisoners’ dilemma to confess, self-interest makes it difficult for the oligopoly to maintain the cooperative outcome with low production, high prices and monopoly prices.

Other examples of prisoners’ dilemma’s include: arms races, advertising, and common resources (see the Tradegy of the Commons)

The Prisoners’ Dilemma is part of the Farnam Street latticework of Mental Models.