Fine distinctions, big rewards

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In business as in sport, the prizes allotted to winners and runners-up are often out of all proportion to the differences between them.

Every day, the photographs from Sydney show the joy on the faces of the winners and the anguish of the losers. Yet it is a sporting cliché that the margin between victory and defeat is small. In a typical event, someone whose speed is 99% of the gold medallist’s will go home empty-handed. Someone who runs 95% as fast as the winner will be an average club athlete and will not be in Australia at all.

For most purposes, differences of this magnitude do not matter. The runners in the Greek Olympics spent the time between games delivering letters. If Achilles could run with the speed of a hundred arrows, while Herodotus could only rate ninety-five, their respective employers would barely notice. Possibly Achilles delivered a few more letters, and earned a little more. But he would earn at most five per cent more.

A race is an artificial environment in which small differences in talent are greatly magnified. Only when we put Achilles and Herodotus side by side and give them exactly the same task can we see the difference between them. And then – because it is the winning, not the taking part that really matters – the rewards of Achilles are far greater than those of Herodotus.

This contrast between the race and the delivering letters has its analogue in business. In some activities, output is more or less proportional to input. In others, a slight superiority of input is translated into an enormous difference in the perceived value of the output. These activities are typically the ones that yield big profits for successful companies and high earnings for able individuals.

For instance, pharmaceuticals is, and almost always have been, an exceptionally profitable industry. Not for all companies, however. The history of the business is littered with failed entrants. The profits of pharmaceutical companies have rested largely on a small number of blockbuster drugs. Most ill people want the gold medallist, not the bronze or the also ran.

The car market is different. There is no agreement on which is the best car. Some people want performance, some comfort, others go mainly on appearance. And even if we all thought a Rolls Royce or Ferrari was best, most of us cannot afford one. Lada and Skoda sold cars; they just had to accept lower prices. The Ladas of the pharmaceutical business never even get to market.

In both types of activity it is the runners up who set the baseline. And we need Herodotus because Achilles can’t deliver all the mail himself. And we need Herodotus at the Olympics because there needs to be someone for Achilles to beat. To ensure a constant supply of new drugs, there must be hundreds of failures as well as the few successes. But the difference between the successful and the baseline is much larger in pharmaceuticals than in the mail delivery business. And that means the overall level of earnings is higher too. So it is not just that the best pharmaceutical companies earn high returns. The overall level of industry profits is high.

These differences in the economic characteristics of processes also have an important influence on the distribution of earnings. In the courtroom there is a winner and a loser. So a small difference in the talents of your attorney can become a crucial difference in the result. That is why the best lawyers are well paid. I can complete a golf round with only 25% more shots than Tiger Woods, but the gap between our earnings on the professional circuit is a lot wider than that. And J.K. Rowling’s royalties are orders of magnitude ahead of other children’s novelists whose books are not as popular as Harry Potter.

But while I want my company’s audit done well, I am not sure about paying a large premium for it.. The green keeper who mows Tiger Woods’ course 25% faster gets paid 25% more. And the bookshop that sells twice as many copies of Ms Rowling’s latest work does twice, but only twice.

So how can we distinguish the Olympic athlete from the fleet of foot mailman? Sometimes there is literally a race. Look for situations where the product’s functions are precisely specified and there is general agreement on the criteria of effectiveness. This is true of drugs but not of cars. It is true of spreadsheets, so most people use the same one, even if that was once Lotus and now Excel. But it seems different people have different requirements of a search engine.

And sometimes a small difference in quality translates into a large difference in the perceived value of the product. This happens mostly when the product cost is small relative to the implications of the outcome. It is worth paying more for a drug that will keep you alive, or for a lawyer who will keep you out of jail. Similarly, it is worth paying more to a financial adviser who will make you rich. And it is enough that you believe they might secure you continued health, or freedom, or wealth. It doesn’t have to be true.

And above all avoid situations where quantity can be substituted for quality. That’s why the guy who mows the greens for Tiger Woods doesn’t earn as much as Tiger even though he is just as essential to the Masters’ championship.

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