First-Order Thinking

Aug 29

5 min read

Don’t business decisions often look wonderfully simple before we make them?

Reduce prices - We'll sell more.
Hire more people - We'll increase capacity.
Automate the work - Our costs will reduce.
Buy the building and stop wasting money on rent.

Each statement may well be perfectly correct. But there may be a problem that happens afterwards.

One of the most useful habits I've developed over years of making decisions, including plenty of bad ones, is to ask a second question. Not only: What happens? But: What happens next? What does it then lead to? That small distinction between first-order thinking from second-order thinking can completely change the answer, and the action.

The Story

I think the first time I can recall coming across this idea was reading Naomi Klein's wonderful No Logo around the turn of the millennium, when she wrote about something called Marlboro Friday.

On 2 April 1993, Philip Morris announced that it would dramatically discount Marlboro cigarettes in America. Cheaper brands had been taking market share. The first-order logic was obvious enough: reduce the price and win those customers back. You can almost hear the CEO shouting the command in the boardroom.

But something extraordinary happened, and it made history. Philip Morris's share price fell by around 23% in a single day. Investors weren't simply calculating the lost margin on a packet of cigarettes. They were asking what the decision meant.

Marlboro had spent decades and enormous amounts of money becoming one of the world's great premium brands. It had never discounted anything. If even Marlboro now had to compete primarily on price, perhaps that brand value wasn't worth what everyone thought it was. A 40-cent discount had suddenly raised a multi-billion-dollar question about the value of branding itself.

Ironically, the strategy worked rather better than the panic suggested. Marlboro soon recovered its market share.

But the episode stayed with me because it demonstrated that changing a price doesn't simply change a price. It changes perception, behaviour, positioning, competitors' responses and expectations about what happens next.

And there is a wonderful counter-example.

In 2011, American department store J.C. Penney appointed Ron Johnson as CEO.

On paper, Johnson was an extraordinary hire. He had helped create Apple's enormously successful retail stores and previously worked at Target. He arrived with an apparently sensible observation about department-store retail. J.C. Penney was addicted to discounts.

Prices were marked up, coupons were issued, sales followed sales, and customers navigated through a permanent sea of promotions. Johnson thought this was absurd, so instead he introduced simpler, everyday pricing. Stop playing games with customers. Offer them a fair price in the first place.

First-order thinking said this should work. Customers like lower prices. Customers like simplicity. And customers don't like being manipulated. Except… Something rather important had been missed.

J.C. Penney customers liked discounts.

The coupon wasn't merely a mechanism for reducing the price. It had become part of the JC Penny experience. Customers had been trained to search for bargains and enjoyed the feeling that they had beaten the stated price. Remove the discount and you didn't merely change what something cost. You changed how buying it felt.

This was worse than Marlborough Friday’s rather minute waltz with death, as JC Penny saw no fast correction.

Sales collapsed. J.C. Penney reported a 25% fall in revenue in the first year of Johnson's transformation, and he was gone after seventeen months.

The first consequence of removing discounts was simpler pricing. The next consequence was changing customer behaviour. And that's where the trouble was hiding when the decision was made.

What Happens Next?

Second-order thinking is not so much about predicting every possible consequence. Let’s not procrastinate. If we demanded certainty before acting, nobody would ever do anything.But it is about following the chain one step further than feels natural.

Take discounting. A 20% discount may increase sales. But what happens next?

If you’re someone who buys certain products only when they’re on offer, raise your hand?

Perhaps customers will learn to wait for the next discount. Full-price sales fall. Margin declines. The business needs greater volume to produce the same profit. More promotions become necessary. The medicine starts feeding the illness.

Hiring creates another example. The business is overwhelmed, so we employ another five people. Capacity then increases. And what happens next?

Management becomes more complicated. Communication requires more structure. Payroll rises permanently, but demand may not. The founder who hired people to reduce their workload discovers they now spend considerably more time managing them, at a greater cost all round.

AI makes the question particularly relevant today. Automating customer service can reduce costs dramatically, potentially at least. But what happens next?

Perhaps response times improve and customers are delighted. Or perhaps customers encounter the same synthetic answer three times, become furious and eventually require an expensive human being to repair both the problem and the relationship.

Remote call centers anyone?

And we see it with customer service tickets, when a solution is presented, then forgotten about a moment later.

The first-order calculation measured the cost of answering the enquiry.

The second-order calculation includes the value of the customer.

Property developers have to learn about this as they get sensible and start wanting to hold stock. Save £50,000 by specifying cheaper materials today and the appraisal improves. What happens next?

It used to feel like a good decision when disposal was the order of the day.

But once you’re the owner, maintenance increases, the building ages badly, tenants perceive it as lower quality and rental value suffers for twenty years and beyond. The cheapest decision and the most profitable decision are not necessarily the same thing.

This is where founders get caught.

We tend to evaluate decisions at the point of impact because that's where cause and effect are easiest to see.

Second-order effects arrive later, bringing demon days, somewhere else in the business, sometimes looking like they’re something entirely unrelated.

A pricing decision becomes a brand problem.
A recruitment decision becomes a culture problem.
A cost saving becomes a retention problem.
An automation becomes a customer-service problem.

We've often forgotten the decision that started it.

The Season

Within our GamePlan cycle, this is precisely the sort of thinking winter exists for.

Winter gives us the luxury of doing something other seasons cannot, and that’s thinking ahead.

The evidence gathered and sorted during autumn tells us what happened. Winter asks what we should do about it. But good planning cannot stop at choosing an action.

It needs to map consequences.

If we increase prices, what happens next?
If we recruit ten people, what new management systems will they require?
If we enter this market, what capacity will success demand?
If AI removes half this task, what happens to the other half?

We won't, and inevitably we don’t, get every answer right. That's why spring exists - to test, measure, correct and refine before summer places greater weight upon the decisions we've made.

But winter is where we give ourselves permission to think beyond the immediate result. To pre-crastinate perhaps?

Strategy is partly the art of choosing what to do.But an equally important part is imagining what that choice sets in motion. Because almost every bad business decision began life looking like a perfectly sensible answer to the first question. The expensive bit was what happened next.