Episode #251: Free-Rider Friday, July 2019

What a GREAT Free-Rider Friday! Ed and Ron cruised through the most interesting news and topics that caught their attention this past week.

Here are Ed’s Topics…

• “What That Giant Asteroid of Gold Would Really Do to the Economy,” FEE, July 10, 2019, by David Youngberg.

• “Disruptive trends that will transform the auto industry,” McKinsey & Company. And according to Zuora, founded by Tien Tzuo (Episode #230), every major auto company has launched a subscription program. Porsche reports that 80% of its subscribers are completely new to the brand. Volvo plans to have one-half The of its automobiles on subscriptions by 2025. The worldwide market for automobile subscriptions is expected to be $1.5 trillion worldwide by 2030!

• “The Overuse of Mathematics in Economics,” FEE, June 17, 2019, by Luka Nicolic.

• “Efficiency or Deficiency?,” Grace Marshall, July 12, 2019.

• From TSOE listener Daniel D’Alto, The Origins of the Cubicle. 

• “The Costs of a Cup of Coffee,” Political Calculations, July 19, 2019.

And Here are Ron’s Topics…

• “Uber is testing an all-in-one subscription for rides, food delivery, bikes, and scooters,” The Verge, July 23, 2019, by Andrew J. Hawkins.

• “Unintended, uh, whatever, man,” The Economist, July 13, 2019.

• “New ways of selling books clash with France’s old pricing rules,” The Economist, July 6, 2019.

• “Ball-game theory, The Economist, July 13, 2019.

• The AICPA’s PCPS 2018 Survey of 1,910 CPA firms reports a declining use of hourly pricing and an “increasing use of value pricing and “value billing” [whatever that is?] and fixed pricing.” Depending on size, the percentage of firms report anywhere from 15-50% of revenue is now derived from value pricing or “value billing.” Hourly billing is between 59-80%, so we still have a long way to go. Fixed pricing is from 20-30%. Take these surveys with a grain of salt, since they are non-random and contain errors in reporting, interpretation of meaning, etc. But they do give us a vector of what is happening, and it is clear that hourly billing is waning.

Episode #250: INFLUXUS RECIPROCI FALSUM

INFLUXUS RECIPROCI FALSUM - “The Correlation False”

The idea for this show started when we ran across the book Spurious Correlations by Tyler Vigen at the San Jose Tech Museum. Ed and Ron both picked it up and immediately loved it. And a show was born! So what’s up with the show title??? Literally translated, it means “the correlation false” and if you’ve been listening to the show for any period of time you probably picked up on the fact that Ed understands a thing or two about Latin.

Now that you’ve read this far, Episode 250 of The Soul of Enterprise was — predictably — about the confusion between correlation and causation. Folks - some of these examples are hilarious! 

Let’s get a few key things out of the way before diving into the examples.

• Correlation: two things vary together. Ron likes the example that wet streets cause rain.

• Graph Paper Diaries has an excellent description of correlation/causation confusion along with six examples:

  • Thing A caused Thing B (causality)

  • Thing B caused Thing A (reversed causality)

  • Thing A causes Thing B which then makes Thing A worse (bidirectional causality)

  • Thing A causes Thing X causes Thing Y which ends up causing Thing B (indirect causality)

  • Some other Thing C is causing both A and B (common cause)

  • It’s due to chance (spurious or coincidental)

• Data dredging: Provided enough data, it is possible to find things that correlate even when they shouldn’t. The world of big data and big correlations. Statistical significance increases as sample size increases. Every one of the correlations in Tyler Vigen’s book was discovered by a computer. 

In terms of methodology, Vigen used Pearson’s correlation coefficient which is common for expressing linear relationships between variables. You can double-check any statistic in the book, and find many more charts: http://tylervigen.com/sources.

Spurious Correlations documents a statistically significant correlation between many humorous variables, including:

• Earnings per share of Domino’s Pizza Group and Economic loss due to cybercrime (98%).

• Undergraduate enrollment at U.S. universities and Injuries related to falling TVs (99.6%).

• Customer satisfaction with Taco Bell and International oil production (79.9%).

• Stay-at-home-dads and Walt Disney Company revenue (93.8%).

• Beef consumption and deaths caused by lightning (87%).
  

Real stories of correlations ≠ causations

Mark Twain: “The difference between reality and fiction is that fiction has to make sense.”

• The Economist had an article “Enough is never enough,” that discussed whether or not advertising is good or bad? A survey of 1 million Europeans who self-reported life satisfaction with variation in total advertising spending as a share of GDP and found a significant inverse relationship: a doubling of ad spending = 3% drop in life-satisfaction. So, North Korea should be most satisfied on the planet!??! 

• Adding one more woman in senior management or to a company’s board, raises its return on assets by 8-13 basis points (hundreds of a percentage point), according to one study. An IMF study shows a higher share of women on bank boards is associated with greater financial resilience, and greater financial stability.

• The correlation between unemployment and inflation was postulated in 1958 by William Phillips, a London School of Economics professor. Milton Friedman falsified this theory but it still rules at the Federal Reserve Bank.

• Discussing brushfires in Australia, The Arsonist by Chloe Hooper reports [from a book review in The Economist, “Into the inferno,” June 15, 2019.

  • “People are more inclined to destruction in places where “high youth unemployment, child abuse and neglect, intergenerational welfare dependency and poor public transportation meet the margins of the bush.”

Based on this book, Risk Savvy: How to Make Good Decisions, (Gerd Gigerenzer, 2014), the author believes we live in a risk-illiterate society. There is some truth to that. When meteorologists report a 30% chance of rain tomorrow, what does that mean?

• Some think, it will rain 30% of the time tomorrow

• Others, it will rain in 30% of the region

• Others still, three out of ten meteorologists think it will rain and 7 don’t.

What it actually means: That it will rain on 30 percent of the days for which this announcement is made.

Many of us smile at fortune-tellers, but when they’re armed with computer algorithms rather than tarot cards, we take their predictions seriously and pay for them. One amazing fact Gigerenzer points out in his book is the 5-year survival rates of prescreening for cancer. This is achieved by screening at an earlier age (age 60, say, rather than 67 due to symptoms). Say the patient dies at 70 no matter what. In the first case, the 5-year survival = 100%; in the second case it is 0%.

Statisticians call this the lead time bias. The high survival rates don’t tell us if lives are saved. PSA screening detects both progressive and non-progressive cancers. It can’t distinguish between them. More men die with prostate cancer than from it. As such, Gigerenzer concludes that prostate cancer screening has no proven mortality reduction, only proven harm. It’s the same with mammography.

Gigerenzer First Law: The more the media report on a health risk, the smaller the danger for you.

In the book, The Cult of Statistical Significance: How the Standard Error Costs Us Jobs, Justice, and Lives (Stephen T. Ziliak and Deirdre N. McCloskey), Deirdre points out that statistical significance is not the same thing as a scientific finding. In fact, it can be misleading at best. Also,

“The mainstream in science, as any scientist will tell you, is often wrong. Otherwise, come to think of it, science would be complete.”

Science has stopped asking “How much is the effect? And What difference does the effect make? Fit isn’t the same as importance. W. Edwards Deming used to say: “Statistical significance provides no rational plan of action.”

The VeraSage Symposium

Use this link for more information: VeraSage DownUnder 2019

As you may or may not know, VeraSage meets biennially for a VeraSage Symposium [“to drink together,” and for the first time ever the Symposium this year is being held in Australia in November.

In conjunction with Australian Senior Fellow John Chisholm we have put together what we think is a terrific program covering two events—a one day “Transforming Your Firm” workshop in Melbourne on Tuesday, November 12, followed by the two-day VeraSage Symposium commencing Wednesday evening November 13 and running to the 15th, being held in Geelong about 70 miles from Melbourne on the wonderful Bellarine Peninsula.

Ron has visited Melbourne, Geelong, and the Bellarine Peninsula several times now and trust me they are wonderful places to visit and experience some of the best of what Australia has to offer.

In addition to the formal programs the Aussie contingent have put together some wonderful social events, with a special emphasis to showcase the local food and (of course) the wine. If you are at all interested in attending, register online or contact John Chisholm at john@chisconsult.com for further information, or any travel recommendations—especially if this is your first time visiting Australia.

You will see from the website that early bird pricing is available until end of August and attendance will be strictly limited. We look forward to seeing you Downunder in November!

Even MORE Examples and Resources for Correlation and Causation

• 10 Correlations that are not Causations

• Null hypothesis

• Type 1 vs Type 2 errors

• Karl Popper

Episode #249: The Adaptive Capacity Model

Do You Know the Real Capacity of Your Firm? 

Ed and Ron went through the Adaptive Capacity model this past week on the radio show. The show notes are below. This was a complex topic covered over the course of an hour. It is definitely worth a listen or two!

Maximum vs. Optimal Capacity

All firms have a theoretical maximum capacity and a theoretical optimal capacity. From a strategy perspective, it is essential to see how that capacity is being allocated to each customer segment. Your maximum capacity is the total number of customers you firm can adequately service, while the optimal capacity is the point at which customers can be served adequately while maintaining your competitive advantage and pricing integrity.

Usually, for most professional firms, optimal capacity is between 60 and 80 percent of maximum capacity. 

Insuring a proper amount of capacity is allocated to various customer segments, while offering a differentiating value proposition within each segment, is an essential element of implementing value pricing strategies. It also prevents bad customers—those who are not willing to pay for the value you deliver—from crowding out good customers.

The Adaptive Capacity Model

Think of your firm as a Boeing 777 airplane, similar the one below.

When United Airlines places a Boeing 777 in service, it adds a certain capacity to its fleet. However, it goes one step further, by dividing up that marginal capacity into five segments:

A. First class
B. Business class
C. Full fare coach
D. Coach
F. Leisure, Priceline.com, and Bereavement fares 

The airlines—and hotels, cruise lines, golf courses, car rental agencies, and other industries with fixed capacity—are adept at managing and predicting their adaptive capacity to maximize profitability. 

Lessons from Yield Management

The airlines understand it is the last–minute customer who values the seat the most and hence they reserve a portion of each plane’s capacity for their best customers. They do this even at the risk the plane will take off with some of those high price seats empty—and that revenue can never be recaptured since they cannot inventory seats. 

Why do they take that risk? Because the rewards of reserving capacity for price insensitive customers comprise the majority of their profits.

Airlines allocate only so many seats to coach, leisure, Priceline.com (or bereavement) seats, which they offer well in advance of the flight. However, no airline adds capacity in order to accommodate these customers. 

This point is noteworthy, as too many firms will, in fact, add capacity—or reallocate capacity from higher-valued customers—in order to serve low-valued customers. This is the equivalent of the airlines putting the upper deck in the back of the plane rather than the front.

Furthermore, many companies will turn away high–value, last minute work from its best customers because it is operating near maximum capacity, usually at the low–end of the value curve for price sensitive customers. This is common during peak seasons; the lost profit opportunities are incalculable.

Many worry about running below optimal capacity and cut their prices in order to attract work, especially in downturns or slow cycles. This strategy is fine, but you must understand the tradeoff you’re making. Usually, that capacity could be better utilized selling more valued-added services to your first–class and business-class customers, who are less price sensitive than new customers.

This way, the firm does not cut its price and degrade its pricing integrity in order to attract price sensitive customers, sending a signal into the marketplace it is willing to engage in this strategy and affecting the perception of its value proposition. 

The conventional wisdom is you have to be at maximum capacity—where demand exceeds supply—to raise prices. But since when do you have to wait to be fully booked to demand a premium price? Do not confuse working harder (supply-side capacity) with working smarter (demand side pricing).

Prices are determined by value created for the customer, not the internal capacity constraints of your firm. How much fixed capacity are you allocating to each customer class? What will be the criteria you use to ascertain where in your airplane each customer sits? By viewing your firm as an airplane with a fixed amount of seats, you will begin to adapt your capacity to those customers who appreciate—and are willing to pay for—your value proposition.

Additional Reading 

• An Important Question (about your business and profit)

Episode #207 Reprise: Interview with George Gilder

Did you catch the reprise of Episode #207 while Ed and Ron were on vacation last week? In lieu of show notes, we have opted to post the transcript of our interview with George Gilder about his book, Life After Google: The Fall of Big Data and the Rise of the Blockchain Economy. 

The transcript can be found here.

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