Saturday, April 3, 2010

Freakonomics: Introduction

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.

While the tools of economics are often applied to understand data about jobs, real estate, banking and investment, economics is a science of measurement that can be applied to a range of other subjects. This book uses these economic tools to break down a wide variety of interesting topics, and is based on the following fundamental ideas:

1) Incentives are the cornerstone of modern life
2) The conventional wisdom is often wrong
3) Dramatic effects often have distant, even subtle, causes
4) Experts use their informational advantage to serve their own agenda
5) Knowing what to measure and how to measure it makes a complicated world much less so

To demonstrate these ideas in action, Levitt takes the reader through a few quick examples in the introduction. First, he discusses the crime wave in the United States of the early 1990s. Crime was on the rise, and all the experts were saying that it would continue to do so, for various reasons. Instead, crime - of all types - started to drop in dramatic fashion, and once again the "experts" had their explanatory, after-the-fact opinions (perhaps much like the media attempts to explain daily stock price movements). But Levitt argues that they all missed the boat. Instead, he argues that the legalization of abortion in 1973 (which occurred during Roe vs Wade) is the biggest reason that crime started to drop in the mid-1990s and continued to do so. Many of the people who were most likely to commit crimes (those born of poor, unmarried, teenage mothers) were not born!

Secondly, those who believe a real estate agent is on their side are sorely mistaken. On the surface, it seems as though an agent's incentives are aligned with those of a prospective seller. After all, the realtor's final commission is tied to selling price. Levitt demonstrates, however, that after expenses and sharing commissions and kicking up fees to the company, a real-estate agent doesn't make a whole lot for incremental increases in price. For example, on a $300K house, the seller would get $9400 for a 3% increase in price, but the agent's additional share is just $150. As a result, an agent just wants to get a deal done as quickly and effortlessly as possible, rather than put in a whole bunch of extra time and work to get the seller the best possible price.

Are real-estate agents simply a special breed of sleazy slime balls? Not really, as Levitt argues this type of thing is common to all professionals, including doctors, lawyers, auto mechanics, plumbers etc. The difference, though, is that real-estate data is abundantly available, and so it is easy to demonstrate this phenomenon with this particular group. Levitt separated real-estate data into two groups: in the first, the agents were selling their own homes, while in the second, they were selling other people's homes. Levitt found that agents left their own homes on the market for 10 days longer, and sold them for an extra 3% (all other factors equal).

Finally, Levitt tackles the issue of money and politics. While most people believe elections can be bought, Levitt argues that the data just doesn't support this. The winning party does spend more money than the losing party, but many confuse the cause-and-effect of this relationship (like the czar who heard that the most diseased region of his country had the most doctors...and subsequently ordered all doctors killed). Most campaign donors want to support a winner, which is why the winner spends the most money. To show this, Levitt looked at campaigns where the same two candidates went head to head and different amounts of money were spent. Levitt found that halving ones campaign spend resulted in only a 1 point drop in final performance.

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