Wednesday, May 28, 2008

Prospect Theory trumps "Economic Man"

This post talks about multiple research examples that strongly indicate people choose guaranteed small benefit over a non-guaranteed but potentially large benefit. Interestingly, this only applies to decisions not based purely on the math and probabilities.


"This experiment, repeated again and again by many researchers, across ages, genders, cultures and even species, rocked economics, yielded the same result. Directly contradicting the traditional idea of "economic man”, Prospect Theory recognizes that people have subjective values for gains and losses. We have evolved a cognitive bias: a pair of heuristics. One, a sure gain is better than a chance at a greater gain, or "A bird in the hand is worth two in the bush." And two, a sure loss is worse than a chance at a greater loss, or "Run away and live to fight another day." Of course, these are not rigid rules. Only a fool would take a sure $100 over a 50 percent chance at $1,000,000. But all things being equal, we tend to be risk-adverse when it comes to gains and risk-seeking when it comes to losses.


I can see how this applies in some of the partnerships that I strike. For example, if I’m working on a revenue share deal I could offer a guaranteed payment or we could do a straight split (e.g., 50/50) of revenue that came in. Even though it may be the majority of the cases would result in a greater payment to the partner, I could see how they’d prefer that my company take on the margin risk. Let me make this more concrete. Let’s say I have a widget to sell that we can predict should fetch at least $100 and where the partner would be happy with $50 out of every unit sold. In reality, it may be that I can sell that widget for $120 some times and $75 other times. As long as I believed I could net north of $50 of margin per sale, I’d go with the flat fee to the partner and they’d probably be happier that way.


I know of a real world example in the travel industry. Most vacation property managers pay a set percentage of the rental fee they collect (separate from direct costs). There’s a property manager who runs one of the best property management firms out there who takes a different approach. They have worked out an arrangement where they pay a fixed per night fee to their property owners. It turns out that they are good at yield management so they are able to get a much better financial return by paying the fixed amount. Both parties are happy.

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