We don’t make rational decisions most of the time. Many of the decisions we make have little consequence. It would be nice to become better at choosing the thing of the most value for a change. But much of it depends on what we value, and part of it is contextual and emotional.
Richard Thaler spent much of his life demystifying the core premise of economic theory — that people choose by optimizing. We don’t.
What happens when the stakes are higher? Say when we are making business decisions. Are we more diligent?
I came across a good interview of Richard Thaler by Malcolm Gladwell (see video below) with several useful data points on decision-making. It reminded me of an example I saw in Thaler’s book.
Testing and evaluating assumptions
In Misbehaving: The Making of Behavioral Economics, Thaler provides an example of business decisions at GM. The financing deal the automaker was offering was worse than other deals they had on the table. Yet cars were going like crazy.
Thinking about it, Thaler figured out that what was likely happening was that people were thinking a $ 600 rebate on a car was little, but an interest rate that was one third of the current rate was a good deal. So they went for it. A friend of his was consulting with GM at the time and said he should write it up. Thaler did and was subsequently invited to GM. He says:
In my first meeting, a vice president of marketing gave me my schedule for the day. I had a series of half hour meetings with different people in the marketing department. Many of them also seemed to be vice presidents.
In that first meeting I asked who was in charge of evaluating the low-interest-rate promotion, which reduced the price of the cars sold by hundreds of millions of dollars. My host was not certain, but assured me it had to be one of the people I would be meeting. By the end of the day I would know.
During the day several people described how the interest rate of 2.9% had been determined. Apparently Roger Smith, the (then) CEO, had called a meeting to determine how they were going to deal with the surplus inventory of that year and someone had suggested a promotion based on lower interest rates. Everyone agreed this was a great idea. But what rate should they use? One manager suggested 4.9%. Another said 3.9%. After each suggestion, someone would be sent to make calculations. Finally, someone suggested 2.9%, and Roger decided he liked the sound of that number. The whole process took less than an hour.
But when I asked people who would evaluate the promotion and decide what to do next year, I got blank stares followed by, “Not me.” The day ended in the office of my host. I reported that, as far as I could tell, no one would be thinking about these questions, and this struck me as a mistake. He suggested that I write him a proposal for what might be done.
After what I learned during that visit, I was pretty sure I did not want this consulting job, but I did send him a short proposal making two suggestions for what I thought they should do. First, figure out why the promotion had worked so well. Second, make a plan for the future, especially since they should expect that Ford and Chrysler were likely to copy GM’s successful promotion.
After a month I received a curt reply. My recommendation had been discussed bu top management and was rejected. The company had instead resolved to better plan its production and avoid excess summer inventory. This would eliminate the need to evaluate the promotion and plan for the future, since there would be no more end-of-model-year sales. I was astounded. A huge company had spent hundred of millions of dollars on a promotion and did not bother to figure out how and why it worked.
As I learned over the years […] the reluctance to experiment, test, evaluate, and learn that I experienced at General Motors is all too common.
Thaler noted that the excess inventory issue the next two summers and after them seemed to persist. He says:
Overconfidence is a powerful force.
Are there psychological and social advantages to this kind of behavior? Thaler rejects the notion and says that it is a play to want to win too badly. (Another example of the overconfidence bias Thaler brings up is the job interview.)
Thaler tells the GM story at minute 39.56 of the interview with Malcolm Galdwell below. The full conversation is worth listening to. If you want to have a good laugh skip to the hour-mark where Gladwell gets personal again.