This article builds on quantified ordinal modelling theory which I have talked about in the past. Here, I apply quantified ordinal modelling to human action.
This allows us to predict an actual decision by an actor. It is not necessarily an optimal decision, but it is a prediction of the actual decision the actor will make. This article will take the form of a discussion between me and Nathanael Stover because it is an actual discussion which took place on the academic forums of Mises University 2014. This post will use summaries in some cases.
- If A occurs on some probability and we do not know what probability, the rational expectation is a probability of 50%. This minimizes error.
- If we know A occurs more often than B, but we do not know what probability B occurs on, the rational expectation is that A occurs on a 75% probability. This is because we assume B on 50% we know A occurs more probably than B, but we don’t know how much more ofter, so again we assume 50%.
I think this logic applies to Case Probability. I think this is very much the intuitive approach entrepreneurs take, even without thinking about it.
I think the intuitive approach involves gut feelings, subconscious calculations, and conscious calculations with a low degree of confidence.
Intuitive statements may include, “I think this is going to happen,” or “I feel like this is going to happen.”
As [another poster] point[s] out, the entrepeneur’s action shows an expectation or belief that doing X is better than doing ‘X, although that expectation may not match with reality.
John, It sometimes is possible to quantify class probabilities, but you are describing case probabilities.
We cannot assume that there are only two options. What if there are three or an unknown number of options? Often entrepreneurs have an infinite number of factors contributing to the success or failure of a given endeavor and they may be faced with a huge number of results that could be achieved depending on the market. As you and other posters here mention, entrepreneurs use “gut feeling”, but I would rather describe it as judgment involving an educated and experienced understanding of the market and industry and literally thousands of variables and factors that contribute to this unique case in front of the entrepreneur today.
Math has some uses, but I do not think it has any use here. The judgments entrepreneurs make may be based in part on quantitative risk assessments, data summaries, financial ratios, and accounting analysis.
Thank you for your response. This conversation is quickly becoming complex, but here are some partial answers. Please pardon my Twitter-style verse:
- I am describing case pro, not class. I am arguing we can still quantify, despite the usual thought otherwise.
- We needn’t assume 2 options. This was for simplicity. It works for an arbitrary length scale of information. They key is that it is an ordinal, not cardinal, process. This method of quant even works without cardinal information.
- Me and other posters use “gut feeling” or “intuitive approach” because this is the language of Klein in his talk and the Austrians writ large.
- I agree, the intuitive approach involves education, experience, etc. Yes it can involve many complex factors.
- Utilizing data to make a judgement about the future can be very much, though I grant you not entirely, quantitative. Yet all of this was precisely what I was NOT referring to. Finance ratios, etc may be called a “formal estimation.” I was referring to a gut-feeling, intuitive, “informal estimation.” This estimation does not involve prior data, but logical process and even physical feeling. Yet my key point here is that this logical process, even without cardinal information, can create posterior data through my ordinal approach.
- To illustrate: Let’s say I don’t know the price of A, nor do I know the price of B, but I do know that A costs less than B. You can see that this could not be useful in formal estimation. We can logically deduce, however, that A “probably costs about half of B.” This is an informal estimate, but it is mathematically and logically valid. It even holds if we don’t KNOW A costs less than B. Maybe we just feel like, expect, best-guess, etc. that A costs less than B. Still holds.
John, I feel like we are not talking about the same thing. I cannot visualize an entrepreneur making a decision based on what you describe, so could you give me a concrete example? Thanks.
I am talking about a case probability of profiting on a specific entrepreneurial project.
Actually, using a number like 75% could be confusing because it encourages the use of mathematical calculations on a decision that is not mathematical at all. Will I use 75% to make a projection of the future value of this project? How would a quantification of entrepreneurial decisions be used? Would there be any connection between the numbers and reality? For example, I am an investor. Entrepreneur Jim has three projects A>B>C. Thus if I understand your methodology, A(88%)>B(75%)>C(50%). Entrepreneur Sue has projects S>T, so S(75%)>T(50%). What good are these percentages to me as an investor looking at the 5 projects? Is A(88%) better than S(75%)? What if Sue is a better entrepreneur than Jim? I cannot think of any value to having numbers like these. I cannot see any connection to reality.
Perhaps if you showed me a concrete example, that would help? I don’t know.
I am glad to see you have at least partly understood my method. Yes, A(88%)>B(75%)>C(50%) with respect to Jim and S(75%)>T(50%) with respect to Sue.
However it does not necessarily follow that S > C. It could be the case that such a statement is true, but it would not prima facie be expected. The two value scales are not necessarily compatible because Joe and Sue are expected to value projects in different ways.
If Joe and Sue value projects in precisely the same way, it might be true that S > C, but this is a seperate question. Joe would have to consider S and T and place them into his scale of A, B, and C, then Sue would do similarly, and it might turn out that they produce the same whole-event scales at the end of the day, but this would not at all be obvious at first.
It is unlikely that Joe will value S and T to 75% and 50% as Sue did because that would mean P(T) = P(C) and P(B) = P(S). In the real world, having exactly equal probabilities for complex events is extremely rare. It is more likely that Joe will value P(T) > P(C) or P(T) < P(C) and so on. Although it is theoretically possible that he would say P(T) ~ = P(C).
A concrete example would be Joe’s 2 investment possibilities are Microsoft or Walmart stock. Sarah’s 2 investment possibilities are Office Depot or Exxon Gas stock.
Joe intuitively feels like (based on experience, education….but NOT based on formal evaluation through P/E ratios, etc.) Microsoft has a better reputation and therefore he thinks it’s more undervalued. In short, he thinks investing in Microsoft will probably produce more ROI. Let P(X) be the expected ROI from investing in X. Joe’s gut says P(M) > P(W).
Sarah thinks that Exxon Gas is better than Office Depot. Again, this is her opinion, not the result of some equation. Her gut says P(E) > P(O).
Does it follow that P(M) > P(O)? It might, but it would involve adding information to the question which we do not yet have. This is because intuitive values are respective of the evaluator. Sarah cannot have Joe’s opinion for him and vice versa. It might be the case that they would have precisely the same opinion when they consider the other companies, but that would not be obvious based on our current information. I would expect that people usually have different intuitions, opinions, subjective valuations and so on.
Basically, to answer “Is P(M) > P(O)?” One of three things must happen:
- Joe must consider M, W, P, and O. (Intuitive for Joe, not Sarah.)
- Sarah must consider M, W, P, and O. (Intuitive for Sarah, not Joe.)
- We must consider some objective standard which evaluates M, W, P, and O. (Non-intuitive approach).
Lastly, the intuitive approach does not refer to the optimal action. It refers to the expected action. When Joe considers various possibilities, he will chose the one he thinks is most beneficial. This does not mean it is the one which actually is most beneficial.
It could be the case that Joe or Sarah is a better entrepeneur. In my opinion this would mean that either Joe or Sarah more frequently acts in a way that is consistent with their objectively optimal action, and I do think such an action exists.
Warren Buffet could say: “Project P is 99% and Project D is a 85%.”
Or Warren Buffet could simply state: “P has a very strong competitive advantage compared to D, but D is also a strong company with a very innovative and flexible leadership team.”
The first statement has quantified Buffet’s subjective opinion on P and D, but does that have any advantage over the second statement? Is this the type of use you were thinking about when you described this theory?
Precisely! I think in some contexts the number would be better and in other contexts the number would be less helpful than the specific, subjective opinion. The opinion might be better because it contains additional information. For example, how the business might go about improving and why
The number is also helpful because it helps us answer the question, “What would Buffet actually do?” The answer is he would pick Project P of the two. This is not clear merely from the subjective language.
Overall, I think economics benefits from the ability to translate back and forth.