Saturday, April 24, 2010

Freakonomics: Chapter 6

Charlie Munger says the most important rule in management is "Get the incentives right". Munger argues that the power of incentives is constantly underestimated. In Freakonomics, Steven Levitt shows us how pervasive incentives are in society, and what we can learn from that. Value investors who can grasp the power of incentives put themselves in a position to understand which companies are utilizing the full potential of their managements.

Levitt continues to use the economic tool of regression analysis to illustrate some correlations which are not widely known. Levitt notes that in the aggreggate, white and black parents give their children very different names. Therefore, he sets on the task of determining whether the names of children tend to affect their socioeconomic status later in life.

Some startling research has shown that job applicants with "black" names are less likely to get call-backs from potential employers (This research was done by sending out large resume samples to employers, some with black names and some with white names.) Furthermore, Levitt finds that an adult with a "black" name does end up with a lower socioeconomic status.

But using regression analysis, Levitt explains that after holding other factors constant (e.g. race, income, education etc.), a person's name actually matters not in his future success or lack thereof. Parents, however, spend great time and resources coming up with a name that will set their child up for success. In doing so, Levitt has found that popular names filter down the status levels, with popular names among high-income earners becoming popular names among the general population some years later.

People (illustrated here in the last two chapters using parents as an example) routinely put resources into factors that they cannot control. In doing so, they will often ignore factors that are important. Managers should seek to educate themselves so that they may apply their time towards efforts that yield positive results.

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