On March 27, 2024, the world bid farewell to Daniel Kahneman, a trained psychologist, the Nobel Prize winner in Economics in 2002, and one of the pioneers of Behavioral Economics. Kahneman revolutionized our understanding of human judgment and decision-making under uncertainty. His legacy, particularly in collaboration with Amos Tversky, challenged the conventional idea that we are inherently rational, highlighting how our decisions are shaped by cognitive errors that are systematic and predictable.

This shift in common understanding has extended its influence to disciplines such as management, marketing, and public policy. Kahneman and Tversky studied how we make decisions and the shortcuts our minds use without our awareness. These shortcuts are efficient because they allow us to operate with incomplete information, but the efficiency gained comes at a cost.

To better understand this phenomenon, it is essential to familiarize oneself with two key concepts within the context of Behavioral Economics:

  1. Heuristics: unconscious rules or mental shortcuts that simplify decision-making. Generally, they operate by substituting a difficult question with an easier one (e.g., "How likely are we to meet the budget?" becomes "Did we meet it last week?"). Interestingly, while they facilitate quick decisions, they can lead to overconfidence or ignoring relevant information.
  2. Cognitive bias: systematic errors we make when making decisions (e.g., approving a proposal based on who proposes it rather than the quality of the proposal itself). Interestingly, these errors are not random but predictable, which gives us the opportunity to anticipate them.
Although heuristics simplify decision-making, they can sometimes lead to cognitive biases.

🤯 Why is Behavioral Economics relevant in management?

Managing an organization involves coordinating actions with other people: workers, customers, directors, shareholders, and regulators. The phrase "to manage is to manage people" is often used, and to coordinate efficiently with others, it's useful to understand how those people think and make decisions.

Many leaders have a good intuition about how to coordinate their team, develop autonomy in their direct reports, and articulate compelling strategies. However, it is certainly possible to complement intuition by using the practical, evidence-based knowledge offered by Behavioral Economics.

📖 What concepts can be useful for organizations?

Multiple heuristics and over 180 cognitive biases have been characterized, which we will continue to explore in future editions of the newsletter. However, today we will share some concepts that we believe are useful for leaders making decisions:

>> For example, if you ask a communications manager about the likelihood of the company facing a media scandal, this probability will be estimated much higher if a similar company recently experienced a scandal.

  • Representativeness Heuristic: We tend to judge the probability of an event based on how much it resembles a situation we have previously experienced, despite it not being statistically correct.

>> For example, in financial markets, it is common to think that a successful company makes good investments. However, being good in its core business does not necessarily mean it is good in others. Another example is a CEO who might assess the potential success of a project based on its similarity to previous projects, without considering the unique variables that differentiate it.

  • Confirmation Bias: People tend to seek information that confirms our pre-existing beliefs, regardless of whether these beliefs are well-founded or not.

>> For example, if a television channel manager is evaluating investing in a radio station, they are likely to seek people and data that reaffirm this decision, not necessarily information that illustrates the true market space.

🤝 Take-away: The Rebel Conclusion?

Traditional economics operated with the assumption of the existence of "Homo economicus," a rational being capable of making logical decisions that maximize their own benefit. Kahneman and Tversky demonstrated that this idea is a theoretical abstraction far from reality and that our decisions can systematically deviate from the predictions of traditional economics. The human brain tends to operate efficiently using heuristics. This mechanism can be useful, but it can also lead to sub-optimal decisions.

Although leaders often rely on their intuition for team management and strategy, Behavioral Economics offers evidence-based tools that can complement and enrich intuition, especially when facing decisions with high stakes (hiring/firing someone, launching a new marketing campaign, executing a partnership, promoting someone).

We believe that a deeper understanding of the biases that influence people and the limitations of rationality allows for the design of more robust management processes. We have seen that integrating principles of Behavioral Economics into management contributes to creating a more aware and less naive culture regarding decision-making.

Because when making decisions, our non-rational ways of operating are always present.

Sebastián Balmaceda - Fernando Brierley - Lucía Rossel

💬 Questions for Reflection

  1. In what areas is my intuition playing too prominent a role, and should I challenge it using data?
  2. What processes can I implement to evaluate the effectiveness of decision-making in my organization?
  3. Who could help me provide a counterpoint and challenge my potential confirmation biases?


📕 Recommendation

  1. Book: "The Undoing Project" written by Michael Lewis (author of Moneyball). It explores how Kahneman and Tversky's personal history is related to their scientific advances. The book describes examples of their work in an easy-to-understand way. A shorter version of this story is featured in an article by Cass Sunstein and Richard Thaler (Behavioral Economics experts) for The New Yorker.
  2. Podcast: A conversation between economist Steven Levitt and Daniel Kahneman in 2021 that provides an opportunity to become familiar with Kahneman's revolutionary and unique ideas.
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