The Nobel Memorial Prize, management, and human cognitive limitations

July 1, 2018

The Nobel Memorial Prize in Economic Sciences was once again awarded to an economist whose research involves human cognitive limitations. He gets the prize in economics for having "built a bridge between the economic and psychological analyses of individual decision-making". In their motivation, the Royal Academy of Sciences writes, “Thaler has given economists new insights into human psychology and new frameworks for understanding and predicting economic outcomes. His contributions include the theory of mental accounting, a new approach to boundedly rational behavior; the planner-doer model, with a new framework for self-control problems; and his work on social preferences, which has given us a new perspective on fairness. Last but not least, he has shown how policies based on insights from behavioral economics can help individuals make better decisions.” These decisions affect both private financial decisions and markets. We are obviously not as rational as the theories we learn in school proclaimed. We value, as an example, own personal things and areas of knowledge more than others, and are looking at ways to legitimize our decisions: whether the information for a decision is irrelevant or if the patterns are wrong. We are influenced by our brains too often and act impulsively, myopic (nearsighted) and manipulative. Our preferences are inconsistent, and we are more impatient in the short run than the long run. We prefer a decision that means we will keep 90 percent before a decision where we lose 10 percent, even though the two options are identical. We also prefer $100 today compared to $110 next week, but at the same time we prefer $110 52 weeks from now compared $100 in 52 weeks. I put some hope that the Nobel Memorial Prize can help to develop the way we manage and lead our companies and organizations based on the recognized science of our human behavior. At least the winner, Richard M. Thaler, means that it is possible to nudge (gently push) or affect our behavior to become more efficient and “rational” in our decision making by developing ways of thinking about the processes that support our plans and actions.Let's take a closer look at the most prominent financial management instrument: the traditional budget process. A process which in its design reinforces our tendency to shortsightedness and create manipulative, dysfunctional behavior. For example, a manager who has a cost budget always likes to consume all resources allocated to the account as the probability increases to get the same resources or more next year. Anyone who has a marketing budget will similarly always want to negotiate down the sales budget (target) so that it is easier to reach. If sales and possible incentives(targets) are achieved, he/she is likely to try to move sale revenues to next year to get a good start of the year. Reaching the budget (forecast and decided allocation) shows that he/she is good at forecasting and a good manager, which increases the likelihood of success in future negotiations for allocation of resources.The December effect that occurs in many organizations is just one example that in the long run leads to poorer performance of employees and reduced returns for owners and financiers. The budget game can thus look as an act of rationality, but has proven not to be anchored in reality. A manager who bases the budget (forecast or consumption of resources) on facts and realistic assumptions, faces a risk of reduced funding, thus reduces his/her responsibility and power.Management is all about influencing behavior and to making it function, thus, the traditional management model based on assumptions of rationality must be challenged. If the traditional models are challenged and developed, my hope is that our plans and decisions can lead to actions that are more in line with today's complex reality. Today we see that organizations which are developing their processes for planning and decision making, in tune with both the business rhythm and human behavior, achieve better results. So far, these organizations are in the minority, but perhaps a Nobel Memorial Prize is exactly what is needed to nudge the majority in the right direction.

 

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