The newest Nobel laureate in economics, the University of Chicago’s Richard Thaler, has many insights useful to business leaders. The most obvious is the “endowment effect,” which says that we humans tend to value things we already have over things we don’t have.
Thaler’s research focuses on ways that decision-makers are not totally rational. In one classic example, the same bet is offered in two different contexts.
In the first case, you are offered the chance to bet on the toss of a coin: You can win $10 if you call the coin toss correctly, or lose $10 if you call the toss incorrectly. Most people will decline the bet.
In the second case, a bet is described differently: You are told that you are about to lose $10, but there’s a 50-50 chance you could come out with no loss—but with the prospect of a $20 loss if the coin toss works against you. That’s really the same bet as in the first example, but framed as loss avoidance rather than seeking a gain. People are much more likely to take the second bet; they will take larger risks to try to avoid a loss.
The obvious business example is going on right now, as it does most Octobers in corporations around the world. Division managers are trying to shove earnings from this year into next year. Normally, earnings made sooner are better than earnings made later. But corporations tend to penalize underperformance relative to plan far more than they reward overperformance. So managers who are confident of making this year’s plan are moving earnings into next year, so that they won’t miss next year’s plan.
Or suppose early in the year that a manager is confident she will make plan, but thinks that with a new approach to sales, there’s a 50-50 chance of tripling her division’s earnings. But that would be at the risk of not making plan. Will she take the gamble? Most companies should encourage a bet that offers a 50-50 chance of tripling earnings. In practice, corporate leadership typically is critical of failure to make plan regardless of the upside potential sought.
Business leaders should think about the behavior they want with respect to risk, and whether they are appropriately rewarding it.
Another Thaler contribution is “mental accounting,” having separate buckets for different expenditures. We may have a “vacation” budget in our heads, and a “household maintenance” budget, and we tend not to mix them. If we get an unusually good deal on our airfare to Hawaii, we won’t use the savings to have the carpets cleaned; we’ll spend more at the bar on our vacation, keeping the money in the appropriate bucket.
That is suboptimal, but maybe an appropriate rule of thumb for a busy family. For a corporation, though, resources should be deployed wherever they provide the most bang for the buck. Department budgets are a crutch for decision-making and should not limit the company’s appropriate resource allocation.
Fairness is another Thaler topic. I’ve written about the benefits of price gouging, but Thaler shows in his research the downside: strong public opinion against it. Consumers seem happier looking at empty shelves than well-stocked shelves with price tags above normal. They do, however, seem to accept companies passing cost increases along to customers.
Let’s say you run a building supply company located in a hurricane warning area, and everyone is coming in to buy plywood. It would be bad practice to raise prices with a sign that says: “We have raised our prices so that plywood is only bought by those who really need it.”
Good practice would be to raise prices with a sign that says “Our wholesale cost of plywood has increased, and we have to pass the cost along to you. But we have not raised our profit margin.”
Many companies are already using the “nudge” concept developed by Thaler. In the past, new employees at many companies could enroll in a 401(k) plan by filling out a form. The more common practice now is that employees are automatically enrolled unless they fill out a form to opt out. Employees still have complete choice, but with the default condition being participation, the rate of employees who save is much higher.
Nudging can also be used in sales, as in bundling a service plan with a product as the norm, but giving customers the option to decline the service. Best practice is to test such ideas, because sometimes the nudge will push customers away.
Here’s what I take away from Thaler’s research. The world is a complicated place. Getting every decision perfectly right is hard work, so human beings have devised a set of second-best decision processes that are much easier to implement. This enables us to devote the limited resource of attention to the most important issues facing us (which are more often related to family than finances). In the business world we should recognize that our normal way of thinking isn’t always optimal, especially if we can devote attention getting decisions right.
Richard Thaler’s Nobel Prize: Lessons For Business Leaders – Forbes