Second Order Effects

If you’re a fan of Charlie Munger, which why wouldn’t you be? You’re probably familiar with his “lattice work of mental models” and thoughts on second-order effects.

Examples of unintended second-order effects abound, but I recently came across a neat story that’s practically a text-book illustrations. It’s from the book, Predictably Irrational, by Dan Airely. Dan’s example involves the hot-button issue of CEO pay.

According to the story, in 1976 the average CEO was paid 36 times as much as the average worker. Moving into 1993, that average climbed to 131 times as much. Outrageous, right? So federal regulators got involved and forced public companies to provide details on top executive compensation. Regulators hoped transparency would stop the trend of outrageous CEO salaries and perks.

You can probably guess what happened. By 2010, when Dan wrote his book, CEO’s were earning an average of 369 times the average worker; about three times as much as before executive compensation went public. The publicity caused CEOs to compare compensation with everyone else in their peer group and salaries skyrocketed. Second-order effects indeed.