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Successful trading and investing requires finding an edge. At our site, we look for broad themes that most are getting wrong. Since there are many very intelligent, very savvy people who work in the investment world, it may be difficult to find corners of knowledge that are under-represented.

We have suggested that one such opportunity is the very poor understanding of government and the policy-making process. Few seem to remember their role, be it analyst, fund manager, or investor. Instead they react as a voter, using their personal opinions about the merits of the policy.

Take our recent discussion of housing problems as an example. For many observers it is important for them to express their personal feelings about the merits of the legislation -- whether it will be effective, whether it is fair to those not affected, how much it will cost, and the possible message to future borrowers and businesses. These are all excellent questions, if one is a Member of Congress deciding how to vote on the bill. They have little or nothing to do with the impact of the legislation on the housing market, the economy, or the stock market.

The Business Comparison

We know from many years of teaching and interaction with investors that most people have a strong personal bias. In a broad sense, they believe that government is error prone and dysfunctional while business is efficient and effective. In fact, the decision-making processes of large organizations in the public and private sector are quite similar. The classes in MBA and MPA programs are more similar than different.

We are going to take a harder look at this bias, starting with a better understanding of organizational decision making. Readers who spend a few minutes with us on this summary will be getting the most relevant portions of classes ordinarily requiring many months of study.

Revisiting the Business Examples

Some time ago we provided three examples of business decisions. These were all actual case studies of widely-known businesses in actual situations. To fully appreciate our point, please take a few minutes to review the prior article. Make your own guess about the situations involved. The actual companies are identified at the end of this article.

Decision-Making Types

Organizational decision making can be usefully classified as one of three quite different types. While there is extensive literature in organization theory on this problem, our analysis is chiefly inspired by one work, Essence of Decision: Explaining the Cuban Missile Crisis, by Graham Allison (now added to our recommended reading list). TheWikipedia article notes the seminal nature of this work, which they identify as the "founding study of the John F. Kennedy School of Government.

Allison identifies three models--the rational, the incremental, and the bureaucratic.

In the "rational" model, the organization analyzes problems and creates general solutions. Decisions resulting from the rational model are often similar to those of a single human actor. This does not mean that the decisions are the most effective, just that they exhibit a certain consistency of method and planning.

Some organizational decisions are more like piecemeal reactions than general solutions. Decisions may be reached to try a number of simultaneous approaches not all of which are consistent. This method, which can be called the incremental approach, results in policies that address part of a problem. Ideas that work get expanded. Those that do not often die out.

A third broad type of decision making is bureaucratic in nature. Any large organization - private or public - has different departments or parts. Each department has its own interest in control over a project, expanded responsibility for members, and veto of anything that does not fit. It is highly rule-based.

Returning to the Three Business Decisions

The first example, Company A, was The Coca-Cola Company (NYSE:KO). After taste-testing comparisons, they abandoned the original recipe for their leading beverage and launched New Coke. The failure of this initiative led to some fast footwork, including the resumption of Classic Coke.

The second example, Company B, is Google, Inc. (NASDAQ:GOOG). Google innovates by encouraging employees to develop ideas, allowing everyone time for that brainstorming function. The myriad of Google search applications is a result of this approach. Some, like Google Maps, get expanded. Others, like Google Answers, may end after testing. It is a modern success story illustrating the incremental method.

The third example, Company C, is a major auto company that we will not name here. The company considered a plan almost identical to the current initiative by Chrysler. The Chrysler plan, well-known to anyone seeing their current advertising, has successfully drawn new customers to the showrooms by offering fuel price protection to the average buyer. Chrysler realizes that there is a need for a transition to more fuel-efficient vehicles. The price protection approach helps them to succeed in making that transition. Chrysler was able, through a new leadership team, to overcome entrenched departmental bureaucracy.

Application to Public Policy

The takeaway for investors is realizing when government agencies are following a successful process. Too often the market pundits will criticize a policy as being too small and not comprehensive. Recent examples include the various Fed initiatives to address liquidity in credit markets and the assortment of actions directed at the housing market.

We will review each of these decision processes in more detail. For now, investors can gain by taking a more open-minded approach to government actions that do not seem, at first glance, to go far enough.

A preview: Most pundits make the initial student mistake of thinking of government strictly through the rational model.

Source: Reviewing Three Characteristic Business Decisions and Applying to Public Policy