RSS feedsA relatively new school of thought, behavioural economics, uses experiments and surveys to work out how and why people, including entrepreneurs, make the economic decisions they do. These findings are changing our understanding of how the economy works.
For decades, economists assumed that individuals could, at least approximately, be treated as independent, rational and selfish.
Traditional economics holds that people take decisions by weighing up cost and benefit and doing whatever is in their own best interests. When it comes to starting or running a business, that means taking whatever option makes the company the most profit.
However, the behavioural economists’ findings suggest that people are simply not like this, be they ordinary consumers or CEOs.
Here is an example. Suppose I give you £10. You have the option to give a proportion of it to an anonymous stranger. If you do, I will treble whatever you have given, then ask the stranger to return to you as much of the resulting sum as they wish. How much would you give? Suppose, instead, that we play the same game, but this time your role is that of the stranger. If someone gave you all of the £10, which I then trebled to £30, how much would you return?
If people are selfish, the rational answer is clear you don’t give the stranger anything and, if in the role of the stranger, you just pocket the money and leave. In fact, when this experiment is done for real, people do give money to the stranger. Moreover, in the stranger’s role, people usually return sufficient to split the profit. It seems our economic instincts are not selfish. Instead, we cooperate and seek mutually beneficial solutions.
Behavioural economists have carried out hundreds of experiments like this, and one consistent finding is that entrepreneurs are no more self-interested or greedy than anyone else.
A large number of studies specifically examined the behaviour of business executives, with the findings challenging one of the longest-held economic beliefs: it seems many companies might not aim to maximise profit.
An analogy. I live in Dublin and a group of us like to watch our local rugby team, Leinster, on a Friday night. We have two options for getting to the ground: walk or drive. The drive usually takes half as long as the walk. But we are more likely to miss a kick-off if we drive. Why? Because on some Fridays the traffic is so bad that the drive, which takes 20 minutes on average, can take over an hour. The walk is always 40 minutes. Always. The option that is the shortest on average is also the one most likely to make us miss a kick-off. Walking is the better option.
Exactly the same logic can apply to business decisions. In an uncertain business environment, the option that will, on average, make most profit, can also be one that most risks making a substantial loss. Is there evidence that business decisions are like this? If so, how do entrepreneurs respond?
Studies of executives’ motivations consistently report that making profit is not their top priority, especially if there is any risk to the company’s long-term survival. Many also say that increasing market share, which provides for greater certainty, is more important than increasing profit. When researchers give entrepreneurs business scenarios and make them choose options, they often avoid highly profitable options that risk losses.
The work of behavioural economists suggests answers to longstanding puzzles in business economics. For instance; why are executives who bring in the highest profits not also the best paid? Perhaps because they are also likely to take excessive risks.
Similarly, when the so-called ‘shareholder value’ movement increased pressure on executives to return profits, many complained. Why would top businesspeople dislike pressure to increase profit? Maybe because they knew they were risking too much to make it. It seems that the bottom line may not, after all, be the bo ttom line.
Pete Lunn’s new book ‘Basic Instincts: Human Nature and the New Economics’ is published by Marshall Cavendish priced £19.99
