Economic Thinking

Economics is the study of choice in using scarce resources that have alternative uses. As economist Thomas Sowell observed, “there are no solutions [to economic problems], only trade-offs.” Good economic thinking seeks to understand these trade-offs so we can create the greatest value for ourselves and others.

In economics, scarcity means using a resource in one way prevents you from using it in another. For example, the choice to use gold to make jewelry means that same gold cannot be used to make electronic components, coins or dental crowns. The highest-valued alternative not chosen is the opportunity cost of that gold.

All economic decisions involve costs and benefits, but not all involve money. Choosing a financial investment involves money. Choosing what to listen to during your commute does not. Both have an opportunity cost. Because we want to employ resources – including people and their time – in the most valued way, opportunity cost must always be considered.

Marginal analysis is an important element in good economic thinking that can greatly improve business decisions. Marginal analysis considers the benefits and costs associated with a specific change. Mistakes to be avoided include inappropriately considering unrecoverable costs (sunk costs) or using totals and averages which hide or subsidize unprofitable assets or activities.

In keeping with our Vision, we strive to create mutual benefit by delivering products and services customers prefer to their alternatives, as well as profitability for Koch. The magnitude and risks of a decision should determine how much to invest in analysis, including the range of outcomes to consider.

Good economic thinking and, thereby, good decision making requires accurate measures of scarcity and relative value.  Thus, for a society to be prosperous and progress, it must generate measures of what people value and the availability of resources to satisfy those values. Such measures can only arise from voluntary exchanges in the form of relative prices.

The same is true for an organization, which is why we base our decisions on measures derived from economically sound prices set by these conditions.

All decisions, large and small, benefit from challenge and good economic and critical thinking. Thousands of employees making better decisions every day provide a major competitive advantage and can be the difference between success and failure.
 

Other things being equal, people prefer the satisfaction of a given value now, rather than later. This time preference varies from person to person and for the same person at different periods. The higher your time preference, the more willing you are to sacrifice a benefit in the future to get what you want now. The lower your time preference, the more you are willing to forgo a benefit now to bring about a better future.

The degree of your time preference is the amount of additional satisfaction required in the future for you to give up a unit of satisfaction now. The ratio of these differing valuations represents the price of time to you. When property rights are clearly defined and respected, time preference decreases, individuals are more willing to save and businesses are more willing to invest long term.

Our long-term focus has been essential to Koch’s success, which is why our owners reinvest 90% of earnings and seek employees who are contribution motivated and have a talent that will help us create long-term value. These, invariably, are employees who have lower time preferences.

This long-term focus has caused us to develop many capabilities, such as becoming better able to select from diverse investment opportunities with different risks, returns and time horizons. To help us do this, we estimate the ratio of the risk-adjusted net present value (NPV) of different opportunities to the capital consumed. When done properly this helps us compare the benefit of a short-term profit opportunity to one that is longer term. It also provides a sense of urgency to quickly address problems and opportunities that can affect our future.

This emphasis keeps us from unduly penalizing earnings volatility – as public companies often feel forced to do – and to stay with an underperforming business when – and only when – we have hard evidence it has sufficient risk-adjusted potential. When it truly does, it can lead to a virtuous cycle of mutual benefit which furthers our long-term success.

Risk and reward are inseparable and a basic fact of business — as well as life. But not all risks are equal. We approach risks involving human safety differently from those associated with the margins in a multi-year contract. Our goal is to make risk decisions in a manner consistent with our principles. This encompasses eliminating catastrophic risks – like those that could lead to a potential loss of life or a major environmental issue – and optimizing other risks.

Before pursuing opportunities, we seek to understand their risks and potential rewards and then determine whether to absorb, mitigate or avoid those risks. As employees, we are expected to apply Koch’s risk philosophy, not our own.

Applying the company’s risk philosophy can be especially difficult when you are making financial decisions. Koch’s substantial resources enable it to undertake far greater and larger financial risks than you would yourself. Suppose you have two opportunities that require the same investment. One has a 90% chance of making $100,000 and 10% chance of making nothing. The other has a 50% chance of making $1 million and a 50% chance of making nothing. On a risk-adjusted basis, the expected value of the first opportunity is $90,000 and the second is $500,000; therefore, you should pursue the second opportunity. Although you only get a positive result for Koch 50% of the time, it is the right decision. It is natural to settle for the safer alternative but doing so leads to an unsatisfactory return on capital and makes Koch less profitable over time.

One challenge in motivating good decision making is the principal/agent problem. This tends to be created whenever a principal (owner) hires an agent (employee, consultant or broker). The principal wants the agent to act in the best interest of the principal, while the agent usually wants what is best for the agent.

Consider what can happen when the principal and the agent have different risk profiles or incentives. Sometimes agents play it safe because there is no personal upside to taking appropriate risks. Incentives discourage prudent risk-taking when they fail to reward optimal outcomes and excessively penalize losses. Conversely, agents may take unauthorized or imprudent risks when there is not much personal downside. In such situations, agents “go for broke.” Entire companies have been destroyed as a result of this problem. Even so, we don’t want to create a rule-based, overly cautious culture. We seek to align the interests of all employees and agents so they will make decisions that maximize the long-term success of the company.

Good risk-adjusted decision making also involves avoiding various decision traps. These predictable, systematic failings in judgment affect us all. One of the most serious and frequent is confirmation bias, which occurs when we preferentially look for evidence that supports what we want to believe and ignore or discount evidence to the contrary. This particular trap led to our disastrous acquisition of Purina Mills in 1998.

To help us avoid decision traps and appropriately address risks in our decisions and actions, our approach includes:

• Building a strong culture and capabilities to avoid catastrophic risks and minimize disruptions from incidents (stewardship).
  
• Engaging others with diverse experience to challenge our assumptions.
  
• Developing realistic scenarios for a sufficiently wide range of potential outcomes, recognizing that we cannot perfectly predict the future.
  
• Establishing measures to monitor progress and creating options so adjustments can be made as needed.
  
• Experimenting on an appropriate scale rather than diving in without proper analysis (plunging).
  
• Not letting prior losses or a leader’s initial rejection prevent consideration of a good opportunity.
  
• Recognizing the uncertainty in our investment assumptions, which are greatest for those farthest out, such as the large risks in long-term price and terminal value assumptions.
  
• Accounting for the improvements our competitors will probably make when projecting our own improvements.

Risk and reward cannot be our only criteria for evaluating opportunities. We apply our principle-based framework to ensure that we have the capabilities to make an opportunity successful long term. This includes considering its opportunity cost – not just whether it will be profitable, but whether it will provide a higher return on capital and other resources than alternative opportunities.