Sunday, January 30, 2011

Relativity in Our Mind

Stumbled upon a celebrated behavioural economics study conducted by Amos Tversky and Daniel Kahneman (father of BE and one of my intellectual gurus these days) today. It goes in the following manner. Suppose you have two errands to run today. The first one is to buy a new pen, and the second one to buy a suit for work. At a stationery store, you find a nice ‘Cross’ pen for Rs 1,200. You are set to buy it, when you remember that the same pen is on sale for Rs 1,000 at another store 15 min away. What do you do? Do you decide to take the 15-min trip to save Rs 200? Most people faced with the dilemma say that would take the trip to save the Rs 200.

Now you are on your second task: you are shopping for your suit. You find a luxurious grey pinstripe suit for Rs12,000 and decide to buy it, but then another customer whispers in your ear that the exact same suit is on sale for only Rs 11,800 at another store, just 15 minutes away. Do you make the second 15-minute trip? In this case most people say that they would not.

But what is going on here? Is 15 minutes of your time worth Rs 200, or isn’t it? In reality, of course Rs 200 is Rs 200- no matter how you count it. The only question you should ask in this case is whether the trip across the town, and the 15 minutes it would take, is worth extra Rs 200 you would save. Whether the amount from which this Rs 200 will be saved is Rs 1,200 or Rs 12,000 should be irrelevant.

Yet most of us would choose to value Rs 200 discount on the pen more than the same amount of discount on a more expensive item. Behavioral economists have a name for this irrationality- its called ‘Relativity’. What it means is that our decisions are influenced by the context in which they are taken. In our example Rs 200 discount on the pen looked attractive because the amount is significant relative to the price of the pen. Whereas the same amount of discount is insignificant relative to the price of the suit (16.7% and 1.67% discount for the pen and suit respectively).

This is also why it is so easy to add Rs 2,000 to a Rs 500,000 wedding catering bill, when the same person will clip coupons to save Rs 40 on a Rs 250 medium Papa John pizza. And also for the same reason your happiness is not a function of how much you earn rather it is a function of how much your wife’s sister’s husband make (apparently there is a theory that has spotted this particular relationship metric!!).  It was for good reason, after all, that the Ten Commandments admonished, “Neither shall you desire your neighbour’s house nor field, or male or female slave, or donkey or anything that belongs to your neighbour”. This might just be the toughest commandment to follow, considering that by our very nature we are wired to compare.    

Thursday, January 27, 2011

Incentivising Work Outs Using BE

I guess most of us feel the need to exercise as we grapple with our steadily growing waistline. Sometime we even have a go at it by going for a run or enrolling ourselves in the neighbourhood gymnasium. If you belong to the former category, most people (like me) the ‘josh’ lasts couple of days or weeks at best, before excuses start gaining their hold. An aching shin bone, sprained calf, no time, long hours- so on and so forth. Some of us feel that the gym is the better option. Why? - Because we pay a fee at the gym and chances are because of this economic penalty we get ‘locked in’. Or more simply put we feel that we need to get the value out of the economic penalty that we have paid up front.  Now consider the situation when we pay a daily fee as we use the services of the gymnasium; I would assume many of us would not trust ourselves that we would continue going to the gymnasium. We would think that bunking a day would be costless simply because we will not pay for it. Now this goes against the sound economic principle of ‘time value of money’, according to which payment made at an earlier point should be costlier than payments at a later point. This cognitive bias can be explained by behavioural economic theory of loss aversion. Loss aversion signifies our higher sensitivity to losses than equivalent gains. In this case we feel that we will discipline ourselves by arousing our sensitivity to losses- the value against the gymnasium fee.

Two Harvard economics students, Yifan Zhang and Geoff Oberhofer, lean heavily on behavioural economics to motivate gym-goers to workout. The concept, Gym-Pact, employs what Zhang calls “motivational fees” – members pay more money when they do not exercise.
The students are trying to tackle a particular economic challenge: because gym fees are paid up front, there is little future economic penalty for not working out. In effect, you’ve already paid the maximum economic penalty. Gym-Pact addresses this issue by linking your economic penalty/reward to your weekly workout schedule. For example, members currently pay up to $25 per week when they fail to exercise at least three times and $75 for dropping out of the program. Conversely, members who hit the gym at least four times per week pay nothing.

What Zhang and Oberhofer did was change the factor of motivation for the gym-goers. Whereas in the standard gym payoff scenario the motivation is loss aversion, in Gym-Pact the motivation is straightforward- reward for work out.
Hopefully Gym-Pact will get more people to the gym than before.  However, one wonders what will happen to Gym-Pact’s revenue if its members never default!!

Wednesday, January 26, 2011

BE and Marketers' Tool Kit

The art of selling, as a body of knowledge, is quite like folk art form. Much of it is not formally documented and passed down through societal intuition. This knowledge or intuition often works very well for the marketers. Behavioural economics in the last few decades has thrown some light in practices oft used but less understood.  Behavioural research on decision making in psychology, marketing, economics and related fields is substantially advancing our understanding of how and why many established marketing principles work. To the extent that these advances deepen our understanding of consumer behaviour, that’s a win for everyone.
In this article we will talk about some interesting and obvious tools that every marketer should have up his sleeves. These are used but randomly by companies. A systematic focus and strategy would help marketers win their customer over time over and over again.

1.       Make a Product’s Cost Less Painful
In almost every purchasing decision, consumers have the option to do nothing: they can always save their money for another day. That’s why the marketer’s task is not just to beat competitors but also to persuade shoppers to part with their money in the first place. According to economic principle, the pain of payment should be identical for every buck we spend. However, the reality is quite different.

Marketers know that delayed payment option can increase customers’ willingness to buy. One logical explanation is: the time value of money makes future payments less costly than immediate ones. But there is a second, less rational basis for this phenomenon. Payments, like all losses, are viscerally unpleasant. But emotions experienced in the present—now—are especially important. (For the same reason many of us avoid meeting our bosses when things are not moving at work and try pushing the encounter for later)  Even small delays in payment can soften the immediate sting of parting with your money and thereby remove an important barrier to purchase.

Another way to minimize the pain of payment is to understand the ways “mental accounting” affects decision making. Consumers use different mental accounts for money they obtain from different sources rather than treating every rupee they own equally, as economists believe they do, or should. Commonly observed mental accounts include windfall gains, pocket money, income, and savings. Windfall gains and pocket money are usually the easiest for consumers to spend because they are least valued. Income is less easy to relinquish, and savings the most difficult of all. Marketers can be effective by understanding the sources of money with their customers. For example banks can develop algorithm to identify regular income and windfall gains and pitch financial products to customers.

2.       Power of Default Option

Evidence abound that presenting one option as a default increases the chance it will be chosen. Defaults—what you get if you don’t actively make a choice—work partly by instilling a perception of ownership before any purchase takes place. Sometimes when we’re “given” something by default, it becomes a part of us—and we are more loath to part with it. A McKinsey study reveals the following- an Italian telecom company increased the acceptance rate of an offer made to customers when they called to cancel their service. Originally, a script informed them that they would receive 100 free calls if they kept their plan. The script was reworded to say, “We have already credited your account with 100 calls—how could you use those?” Many customers did not want to give up free talk time they felt they already owned. The spin of default option turned the decision on its head!!

Defaults work best when decision makers are too indifferent, confused, or conflicted to consider their options. That principle is particularly relevant in a world that’s increasingly awash with choices—a default eliminates the need to make a decision. The default, however, must also be a good choice for most people. Attempting to mislead customers will ultimately backfire by breeding distrust.

3.       Paradox of Choice

More choice does not always lead to higher utility as many economists believe. In absence of a default option, marketers must be wary of generating “choice overload,” which makes consumers less likely to purchase. In a classic field experiment, some grocery store shoppers were offered the chance to taste a selection of 24 jams, while others were offered only 6. The greater variety drew more shoppers to sample the jams, but few made a purchase. By contrast, although fewer consumers stopped to taste the 6 jams on offer, sales from this group were more than five times higher.

There are two problems when marketers present great number of choices to customers. First, these choices make consumers work harder to find their preferred option, a potential barrier to purchase. Second, large assortments lead to a heightened awareness that every option requires you to forgo desirable features available in some other product. And this will reduce the experienced utility of the chosen option. Reducing the number of options makes people likelier not only to reach a decision easily but also to feel more satisfied with their choice.

4.       Positioning Your Preferred Option Carefully

How marketers position a product, can influence the buyers immensely. Consider the experience of the jewellery store owner whose consignment of turquoise jewellery wasn’t selling. Displaying it more prominently didn’t achieve anything, nor did increased efforts by her sales staff. Exasperated, she gave her sales manager instructions to mark the lot down “x½” and departed on a buying trip. On her return, she found that the manager misread the note and had mistakenly doubled the price of the items—and sold the lot. In this case; shoppers almost certainly didn’t base their purchases on an absolute maximum price. Instead, they made inferences from the price about the jewellery’s quality, which generated a context  specific willingness to pay.

The power of this kind of relative positioning explains why marketers sometimes benefit from offering a few clearly inferior options. Even if they don’t sell, they may increase sales of slightly better products the store really wants to move. Similarly, many restaurants find that the second-most-expensive bottle of wine is very popular—and so is the second cheapest. Customers who buy the former feel they are getting something special but not going over the top. Those who buy the latter feel they are getting a bargain but not being cheap. Sony found the same thing with headphones: consumers buy them at a given price if there is a more expensive option—but not if they are the most expensive option on offer.

Another way to position choices relates not to the products a company offers but to the way it displays them. Our research suggests, for instance, that ice cream shoppers in grocery stores look at the brand first, flavor second, and price last. Organizing supermarket aisles according to way consumers prefer to buy specific products makes customers both happier and less likely to base their purchase decisions on price—allowing retailers to sell higherpriced, higher-margin products. (This explains why aisles are rarely organized by price.) For thermostats, by contrast, people generally start with price, then function, and finally brand. The merchandise layout should therefore be quite different.

Marketers have long been aware that irrationality helps shape consumer behavior. Behavioral economics can make that irrationality more predictable. Understanding exactly how small changes to the details of an offer can influence the way people react to it is crucial to unlocking significant value—often at very low cost.

Monday, January 24, 2011

Social vs Financial Motivation

Read an interesting experiment conducted by one LBS prof on behavioural economics. He randomly picked up 80 post graduate students and divided into three different groups of roughly the same size. These three groups were assigned very similar and very boring tasks individually. The first group was informed that they will receive no payment for their work. The second group members were to get only 50 cents for their work and the third 5$.

After the day of work, it was observed that people worked very hard when they were paid nothing and worked almost not at all when they were paid 50 cents. When they were paid 5$ they worked hard again.
What was happening here? Turns out that people live in two separate markets. The first one is the social market in which we do favours to people. The second is the financial markets in which we work for labour. When people were offered nothing, they thought they were doing a favour and they worked hard. When they were paid 50 cents, they did not think that they were cooperating in the experiment and getting 50 cents on top of that. Instead these 50 cents replaced their social motivation with the financial motivation. What happened as an outcome was- they were paid very little and they worked very little. The third group worked more because they were paid more.

I think this experiment packs in a whole lot of lessons in public policy, governance and development sector

Saturday, January 22, 2011

Pre-Mortem to avoid Post-Mortem in Strategic Decision Making

We see it all the time. A project plan finalized after much back-slapping ending in smoke. A plan adopted by the top management and supported by key decision makers are not full proof. One reason is that people are reluctant to speak up about their reservations during the planning phase. People generally find it risky to raise impolite or politically incorrect objections to a plan proposed by their bosses and embrace the safety of silence. By making it safe for dissenters who are knowledgeable about the undertaking and worried about its weaknesses to speak up, we can improve a project's chances of success.

Research conducted  by Deborah J. Mitchell, Jay Russo, and Nancy Pennington, from Wharton, Cornell and  the University of Colorado respectively, found that prospective hindsight - imagining that an event has already occurred - increases the ability to correctly identify reasons for future outcomes by as much as 30%. This method of prospective hindsight has an interesting name – pre-mortem, which helps project teams identify risks at the outset.

A pre-mortem is the hypothetical opposite of a post-mortem. A post-mortem in a medical setting allows health professionals, police and the family to learn what caused a subject's death. Everyone benefits except, of course, the patient. A pre-mortem in a business setting comes at the beginning of a project rather than the end, so that the project can be improved rather than autopsied. Unlike a typical critiquing session, in which project team members are asked what might go wrong, the pre-mortem operates on the assumption that the patient has died, and so asks what did go wrong. The team members' task is to generate plausible reasons for the project's failure.

A typical pre-mortem begins after the team has been briefed on the plan. The leader starts the exercise by informing everyone that the project has failed spectacularly. Over the next few minutes those in the room independently write down every reason they can think of for the failure - especially the kinds of things they ordinarily wouldn't mention as potential problems, for fear of being impolite. For example, in a session held at one start up Education Company, an executive suggested that a project to attract the issues of armed forces had failed because interest waned when a particular executive was transferred. Another pinned the failure to a changes in the policy in Army.

Next the leader asks each team member, starting with the project manager, to read one reason from his or her list; everyone states a different reason until all have been recorded. After the session is over, the project manager reviews the list, looking for ways to strengthen the plan.

In a session regarding a project to make state-of-the-art computer algorithms available to military air-campaign planners, a team member who had been silent during the previous lengthy kickoff meeting volunteered that one of the algorithms wouldn't easily fit on certain laptop computers being used in the field. Accordingly, the software would take hours to run when users needed quick results. Unless the team could find a workaround, he argued, the project was impractical. It turned out that the algorithm developers had already created a powerful shortcut, which they had been reluctant to mention. Their shortcut was substituted, and the project went on to be highly successful.

One of the objections to this method is that it may lead to situation where objections cloud the original plan and the project is abandoned. Here the argument is that if the objections are indeed too strong may be the project is worth abandonment. However, experience show that in 78% of the time original plan is modified for the better and not abandoned.

What pre-mortem does and does it pretty cleverly - it incentivizes dissent. It also places creative objections on the table to a plan or project. This allowance of dissent and objections ‘robustifies’ the decision making process. It also reduces the kind of ‘bash on regardless’ attitude often assumed by people who are overinvested in a project. Moreover, in describing weaknesses that no one else has mentioned, team members feel valued for their intelligence and experience, and others learn from them. The exercise also sensitizes the team to pick up early signs of trouble once the project gets under way. In the end, a pre-mortem may be the best way to avoid any need for a painful post-mortem.

Acknowledgement - This article is inspired by the works of behavioral economist, Gary Klein who is the inventor of the term pre-mortem.

Friday, January 21, 2011

Behavioral Distortions in Strategy

Behavioral economics focuses on the irrationalities of so called ‘Homo Economicus’. Though a relatively new branch of economics that has evolved over close to four decades, behavioural economics has gained currency in our understanding of what goes on behind economic decision making process. Executives shaping the strategy of corporations recognise the importance of introducing the concepts of behavioural economics into the strategic decision making process. There have been significant volume of academic and empirical research that show that there are cognitive biases- systematic tendencies to deviate from rational calculations,  influencing our decision making process at an individual level and consequently at a broad corporate level. Some of these biases creep into the ‘system’ even when we are aware of its presence. There are tools prescribed by researchers and academicians that can help eliminate these biases to a great extent and render decision processes robust if not error free. The impact of behavioural economics on the strategic positioning of a company and the strategic choices that it makes is not fully understood though currently as a research area it enjoys a lot of attention. Cognitive biases apply to issues like resource allocation, market entry or exit decisions, mergers and acquisitions, a key technological choice, a new product launch.  The strategic positioning of a company is the outcome of such decisions. Therefore, at one level behavioural economics impacts the strategy and competitive positioning of a company in a very direct manner. Understanding and measuring that impact would allow executives to take improved strategic decisions.

Strategic decisions involve some fact gathering and analysis. It relies on the insights and judgment of a number of executives (a number sometimes as small as one). And it is reached after a process—sometimes very formal, sometimes completely informal—turning the data and judgment into a decision. Though companies vary in processes - there are some key elements in robust decision making processes generally observed. These elements are:-
1.      1. Assessment: forecasting demand and competitor reaction, assessing own capabilities, and tailoring the evaluation approach to the specific decision etc.
2.     2. Process: Gathering all critical information for the decision makers, giving floor to dissenting voices, comments from people from unrelated fields etc.
3.       3. Focus on targets: Resource allocation, aligning targets and incentives, fixing short term and long term goals etc.

However, such well-crafted strategy is often found wanting in terms of delivery of satisfactory outcome. Such failures result in loss of initiative and resources. It would be a worthwhile exercise to explore the biases in executive decisions and its impact on overall strategy of the firm. And also quantify the financial benefits of processes that ‘debias’ strategic decisions and help corporations to strategically position themselves more accurately and effectively.

Strategy is often the game changer; right strategy taking a corporation to a position of eminence and the wrong one causing downfall. It can be safely said that strategy is a result of a complex decision making process fraught with irrationality and biases. Understanding and correcting these biases will have enormous impact on the competitive positioning and success of a corporation. 

Thursday, January 20, 2011

Irrationality and Our Optimism

All of us will be quite unanimous about the statement that optimism is a great human faculty.  It is an inner force that drives us to venture into the unknown, pulls us from the depths of despair and sometimes gives us the raw energy to pull on when things are tough. Expressions of optimisms that conjure up the indomitable human spirit abound in our literature. Often in our lives we use quotes brimming with optimism to egg others on. We have seen that the perspective of optimism turns the table around. I have a personal favourite here- Thomas Edison at the age of 67 met with a disaster-the factory that he built over the years was completely gutted in a terrible fire on a chilly New Jersey night. Next morning, Mr Edison looked at the ruins of his factory and said this of his loss: “There's value in disaster. All our mistakes are burnt up.  Thank God, we can start anew.” This is an enviable perspective that gives birth to fresh enterprise.

But optimism sits squarely on the right side of realism on our mental continuum. For all the virtues of optimism, there is an unmistakable play of cognitive bias from which it is almost impossible for us to escape. Optimism often leads us towards beliefs and opinions which are not rational. For example almost all of us believe ourselves in the top 20 per cent of the population when it comes to driving, pleasing a partner, or managing business. Even drivers laid up after an accident caused by them, genuinely refuse to accept that they have poor driving skill. Almost all of us are irrationally optimistic about our health and lifespan- all of us like to think that we will live long. In business optimism not only generates unrealistic forecasts, but also leads managers to underestimate future challenges more subtly – for instance, by ignoring the risk of a clash with an incumbent competition while entering into a particular segment. Those who are in sales would know that over-optimism tends to produce over-commitment. Over-optimism may create organizational biases as well- for example when the management takes an optimistic business call, dissenting or doubting voice is equated with disloyalty.

Collective optimism can also lead to large-scale disasters. Over-optimism of a very large number of people about their repayment capacity on mortgages led to the housing bubble and recession in the United States. Irrationality and optimism are at the very heart of any economic bubble. Now a very relevant question is – what is the remedy of irrational optimism? Can we escape from it? A raft of research in psychology and behavioural economics indicate that as individuals we are very ill equipped to handle irrational optimism. Corporations are slightly better off. By putting the right set of processes and safeguards, they may be able reduce or discourage over-optimism. One of my intellectual heroes of our time, Nassim Taleb in this latest book “How to live in a world that we do not understand” underscores this very point of future uncertainty and irrational optimism thereby. He suggests ways to adjust to some humility about how much we understand the world we live in. Thinking small, taking two insurance policies and reminding ourselves morning and evening that we don’t know much about the future and having some discipline and quality control over the decisions we need to make may help cure the irrationality around optimism.

However, let’s not forget that optimism can be a very good thing, contributing towards success and happiness in life. However, in many important areas of our lives we tend to be irrationally optimistic. In times of uncertainty and rapid changes, we should be wary of irrational optimism, be it for ourselves or our organization.