Your comments are well taken. I have been in many situations where executives, particularily senior ones, have embeddd mental models of how their business works – not taking into account the inevitable evolution in their industries. In these situations, financial analysis may be viewed more as a confirmation of their intuition than as an input.

I wonder, Scott, how much of this is due to short term horizon of some executives and how much is due to executive egos. In past decades executive compensation systems tended to reward short term performance and ignore long term competitiveness. Such systems could inhibit executives from spending capital to increase long term gains – especially if replacement capital also entailed the write-off of prematurely retired assets. But I think most executive compensation systems have been tweaked to reduce such short term bias.

An equally difficult problem has been the emotional ties executives have to existing operations and capital. One man I worked for – one of the most admired CEO's in the U.S. – was unable in the 80's to let go of a failed pet project draining hundreds of millions from his otherwise outstanding company. IMO, it was a matter of saving face. The Space Shuttle Challenger disaster gave him an out. He was able to blame the demise of his project on the inability to launch satellites, a critical success factor. Zapmail's demise wasn't an example of a disaster forcing a capital expenditure for new technology, but rather a disaster enabling a redeployment of resources.

Sorry, I forgot about my comment here. You can find Hanson's general argument about the problems with health care in Cato Unbound:

http://www.cato-unbound.org/2007/09/10/robin-hanson/cut-medicine-in-half/

I'm having trouble finding the data he uses to support the particular claim that new treatments are often ineffective. I believe he's using the RAND study and other aggregate studies that find no significant correlation between better health and health spending after a certain point, and extrapolating that new treatments and equipment are likely to be expensive.

I thought about the whole natural disaster thing a little more. (Forgive me if someone already said this; this blog generates a lot of comments these days!) Like I said before, disasters don't discriminate between old and new capital. They're equal-opportunity destroyers, barring some major exceptions–obviously newer buildings tend to have better safety standards than older buildings, but the vast majority of capital replacement we're talking about isn't on this scale. The reporter could still be right if, in fact, businesses are biased to not replace capital often enough. There could still be enough old vs. new capital that a natural disaster prod could fix a market failure. This would also depend on the rate of disaster. One every year would have a much worse effect on capital substitution than one every ten years.

But imagine you're a shopkeeper. You know that disasters don't discriminate. You also know (approximately) the rate of natural disaster in your area. You think you can refurbish your shop, change out your capital, and thereby better serve your customers. Do you? It depends on the risk of a disaster hitting the new capital versus the profit you would make from serving your customers. If you live on the Florida coast, it might be very risky to go ahead and make the capital substitution.

In this case, natural disasters aren't the cure for a market failure of capital substitution–they're the cause. The shopkeeper is absorbing the risk by losing some profit, while customers are absorbing the risk by shopping in a less efficient store. Seems to me that they're all spending the right amount, now that the cause is uncertainty rather than bias. It's as efficient a solution you can get in such a case. I think it's reasonable to believe this is more likely than a bias against capital substitution.

A weather event destroys capital. The exisitng physical capital is destroyed by the weather, the financial capital of insurance is destroyed by having to replace the physical capital. The insurance capital is invested before being payed as a claim. Once it is payed it no longer finances another market determined worthy investment. There is less capital.

In the broken window analogy. The glass maker benefits when an window of a shop is broken but the shop owner has less money after replacing the window. The suit maker has fewer sales because the shop owner buys a window instead of a new suit. Opportunity cost!

That being said, there is a very good article in HBR by Clayton Christensen about "innovation Killers – How Financial Tools Destroy Your Capacity to Do New Things"

One of the misapplictions of finance is to use fixed and sunk costs unwisely. He uses the steel industry as an example. Some integrated steel makers refused to innovate because of their embedded capital. This does not relate directly to the weather example unless we assume that some industries are slow to innovate because of the misapplication of financial principles and get a nudge from mother nature. But of course their insurance rates will increase and must pay either way.

I agree that revenue projections are almost always wrong, but not always on the high side. Projecting the behavior of customers (revenue) is generally more difficult than predicting the behavior of the internal organization (costs). We should expect sales and marketing estimates to be less reliable, and they are, as you point out.

Positive NPV investments are missed, but probably due to conscious decisions as often as due to incorrect estimates. Most organizations just do not have the resources to pursue every proposal. Prioritizing capital spending opportunities is a critical job for the large company.

Someone here made a mighty statement the other day that I have been paraphrasing mercilessly ever since:
Communism's appeal lies in the fact that it simplifies a tremendously complicated system down to the point that any idiot can understand how it is supposed to work.

Now, things certainly do get replaced and upgraded. Computerized bits get added, coils get replaced as they go bad, things like that. The big pieces do not, in this case the electric compressor motor. I suppose one could choose an arbitrary number of parts that need to be replaced before it is "new", but I would say for example that putting in new seats, an alternator and a battery does not necessarily make a car "new", either.

The distinction would be to me that in a serious natural disaster the majority of equipment would be a total loss. That hugely expensive and unique electric motor is now an expensive mountain of scrap metal. Compared to that, the constant effort of replacing broken parts and doing continuous improvement programs to tweak the system seem much less like "replacement" and more like "maintenance."

Revenue projections are a major part in many of the decision, and revenue is based on marketing projections and estimates.

Sales and marketing are notoriously fuzzy, unless a business is mature and very stable (less frequent these days).

Accordingly some bad investments are made and some investments with a positive NPV are missed.

I didn't make any comment, I just mentioned I had heard the idea before.

Still there's a 'so-what' factor. Who cares? Natural disasters are a fact of life. The smart productive people are going to avoid disaster-prone areas and have a greater ability to recover if disaster strikes.

I know, don't feed the troll, but when we get such a hanging pitch, how can anyone with an ounce of common sense resist mocking him out of the park.

Higher income, higher education, greater openness… sounds much like the preventative checks Malthus wrote about. So wouldn't that indicate it isn't a natural disaster forcing progress but a society that better copes with natural disasters?

I think that's true, Hobson, even for very profitable companies. For several years I analyzed and prioritized large capital requests for a large and rapidly-growing transportation compay. Some projects would have saved our firm money if implemented. But the net present value of many such projects fell far below that of other capital requests. Capital for all the projects could have been found, but at a progressively higher cost as more debt was assumed. Further, the management talent to implement all feasible projects at once was just not available.

I'm sure there's some fear of negligence. Defensive medicine – especially the ordering of medical tests – is a reality delivered to us by outrageous jury awards.

My wife, a former OR manager who has directly dealt with surgeon's requests for equipment, tells me that equipment upgrades are more often just a case of competitive pressure. A surgeon gets access to new, easier-to-use equipment at a new hospital. The surgeon then tells the older hospital that they want the new equipment for all their surgeries. The older hospital must either upgrade or risk losing the revenue generated by the surgeon.

Neither does the broken window fallacy fully deal with the errors in the reporter’s assumptions. Essential to it being a fallacy is the assumption that all windows are more valuable unbroken than broken. Anyone with an imagination could dream up a scenario where such is not the case (consider R factors for example).

What does address the reporter’s question, as "Steve" noted above (but didn't elaborate), "Natural disasters aren't selective in what or who is damaged." Because for the most part people replace stuff that has outlived its useful life, most of the stuff in the path of a hurricane has plenty of useful and efficient life left in them. Moreover, the new stuff will, on average, be much more valuable than the old stuff. Surely the value of the destroyed useful stuff will vastly outweigh the value of the inefficient stuff that a hurricane would cause to be replaced.

A better answer to the reporter would have pointed out that he had identified an extremely thin silver lining to an otherwise large and destructive cloud.

http://www.boston.com/bostonglobe/ideas/articles/2008/07/06/how_disasters_help/?page=full

It's worse than Don makes it sound in his original post: it contains an egregious misunderstanding (and therefore misapplication) of Schumpeter's idea of creative destruction.

And it mentions Naomi Klein as if she had any grasp at all of the subjects she deigns to write about.

Drivel from start to finish; shame on the Boston Globe for giving its imprimatur to such a pile of errors and incomprehension