Second-Order Effects

CONSEQUENCES

The key thing in economics, whenever someone makes an assertion to you, is to always ask, "And then what?" Actually, it's not such a bad idea to ask it about everything. But you should always ask, "And then what?"

• Warren Buffett

In Bevelin’s TransCorp dialogue, John tells the CEO: "We see the immediate benefits of investment in machines. We don't see competitive actions and that all the benefits go to the customer."

"In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects," wrote the French journalist economist Claude Frederic Bastiat in his 1850 essay, That Which is Seen, and That Which is Not Seen. He continues:

Of these effects, the first only is immediate; it manifests itself simultaneously with its cause - it is seen. The others unfold in succession - they are not seen... Between a good and a bad economist this constitutes the whole difference - the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee.

Consider secondary and long-term effects of an action. Charles Munger points out that in a commodity business or in a business earning substandard returns, all of the advantages from great improvements are going to flow through to the customers. The people who sell the machinery - and, by and large, even the internal bureaucrats urging you to buy the equipment - show you projections with the amount you'll save at current prices with the new technology. However, they don't do the second step of the analysis - which is to determine how much is going to stay home and how much is just going to flow through to the customer.

I've never seen a single projection incorporating that second step in my life. And I see them all the time. Rather, they always read: "This capital outlay will save you so much money that it will pay for itself in three years." So you keep buying things that will pay for themselves in three years. And after 20 years of doing it, somehow you've earned a return of only about 4% per annum. That's the textile business. And it isn't that the machines weren't better. It's just that the savings didn't go to you. The cost reductions came through all right. But the benefit of the cost reductions didn't go to the guy who bought the equipment.

Warren Buffett describes how competition can erase the expected benefits:

Many of our competitors ... 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.

Whenever we install a policy, take an action or evaluate statements, we must trace the consequences. When doing so, we must remember four key things:

1. Consider the whole system, including direct and indirect effects.
2. Trace how one consequence could lead to another. We cannot foresee every consequence, but we can look for plausible unwanted effects.
3. Consider feedback, time, scale, repetition, critical thresholds and limits.
4. Compare alternatives by their expected net costs and benefits over time, measured against what we want to achieve.

We can't get something for nothing.

Take the issue on alternative energy sources. Some relevant headlines when thinking about alternatives: Energy used versus usable energy produced (considering the entire production process)? Infrastructure requirements? Scalable? Transport and storage? Costs (considering subsidies)? Who pays? Environmental benefits and costs? Sustainability? Consequences over time? Degree of difficulty in properly evaluating all the factors involved? Consequences of being wrong?

Judge an action by its net consequences over time considering the whole system. Follow up changes in individual variables by determining how the rest of the system will respond over time. Reducing risk in one area may increase it in another. Changes in one variable may change the entire system. One change may cause another change causing another, etc. This includes considering short and long-term consequences since there may be a long time between an action and its full effects.

Marcus Tullius Cicero said: "Extreme justice is extreme injustice." Some systems should be made deliberately a little unfair if they carry better consequences for us all. Charles Munger tells us about the Navy model - a rule with net benefits:

If you're a captain in the Navy and you've been up for 24 hours straight and have to go to sleep and you turn the ship over to a competent first mate in tough conditions and he takes the ship aground - clearly through no fault of yours - they don't court martial you, but your naval career is over. Napoleon said he liked luckier generals - he wasn't into supporting losers. Well, the Navy likes luckier captains. You can say, "That's too tough. That's not law school. That's not due process." Well, the Navy model is better in its context than would be the law school model. The Navy model really forces people to pay attention when conditions are tough - because they know that there's no excuse. Very simply, if your ship goes aground, your career is over. "It doesn't matter whether it was your fault or not. Nobody's interested in your fault. It's just a rule that we happen to have - for the good of all, all effects considered." I like some rules like that - I think that the civilization works better with some of these no-fault rules. But that stuff tends to be anathema around law schools. "It's not due process. You're not really searching for justice." Well, I am searching for justice when I argue for the Navy rule - for the justice of fewer ships going aground. Considering the net benefit, I don't care if one captain has some unfairness in his life. After all, it's not like he's being court marshalled. He just has to look for a new line of work. And he keeps vested pension rights and so on. So it's not like it's the end of the world.