19 October 2015

Shooting Yourself in the Foot with Focus and Loss Aversion

My wife and I are (re)visiting The Netherlands for a few days and we rented an apartment via booking.com. When we arrived, the owners asked us to pay the city tax in cash since they didn’t want to pay a processing fee to the credit card company. You can imagine how that felt like, particularly after 24+ hours without sleep and a trans-Atlantic flight.

Just to be clear, the city tax is about 15 Euros. I’m not sure how much they would have had to pay for the payment, but even a fee as high as 5% would have resulted in a cost of less than one Euro.

Unfortunately, this is not the only situation I encountered in which (small business) people shoot themselves in the foot because they focus on avoiding (small) losses on narrow mental accounts.

Some restaurant owners want each and every table (seating) to be profitable and, occasionally, become sales-aggressive or impolite.

A print-shop owner stopped handing out candy because someone took a hand-full from the candy jar.

A business owner wants to make a profit on each and every transaction, thus refusing to make some small deliveries.

A small-shop keeper refuses to install a bankcard-payment POS because the bank charges him 3% of every transaction.

Each of these examples makes intuitive sense: nobody likes to lose money.

The focus on making a profit on each and every transaction might sound like good management, but it simply isn’t.

Each such decision is like shooting yourself in the foot and later wonder why you can’t run.

Sure, a restaurateur might squeeze another few dollars or euros from a client, but there’s a good chance that person will never set foot again in the restaurant. A shop keeper will avoid paying the bank the transaction fees, but some existing clients might start avoiding the shop, while potential clients will not even consider it since they can’t pay with their bankcards.

You might think that such problems occur only for small businesses, but this isn’t exactly the case.

Let’s do a thought experiment:

Imagine that a friendly alien comes from the sky and proposes the following gamble: a fair coin will be flipped and if the space-ship side comes up, you will win 150$, while if the other side comes up you will lose 100$. Each side has a 50:50 chance to come up.

Would you take this bet?

I’m not sure what you would do, but I have shown this situation to hundreds of participants in my training programs in applied behavioral economics, many of them in pretty large businesses.

Only about 10% of them say that they would take this bet. For all the others, taking a bet in which you can either win 150$ with 50% probability or lose 100$ with 50% probability is unacceptable.

This holds even after I compute the expected value of the gamble (which is +25$)

One participant asked me if the bet is played only once and I answered yes. He said that if it is only once he doesn’t take it, but if it would have been played several times, he would take it.

Here’s the key: if you play this bet several times, on average your chance of overall gaining money increases, even if you will sometimes lose. If you play ad infinitum it is certain that you will end up gaining money.

Imagine a conference room with 20 people having to decide if each of them would take the above mentioned bet. If all of them are from the same company, it is like the group (company) would play the bet 20 times.

Up to now, no one realized this. Every person makes a decision on their own and, usually, the decision is to not take the bet. Overall the group (company) loses because everyone thinks individually…

I am not criticizing anyone, but it might be a good idea to take a look on the rewards and penalties systems. If, during an evaluation period of one year, an (each) employee has to make one such decision she will most likely not take the risk because there’s a good chance (50%) that she will lose money for the business and her evaluation will be bad, her bonus will disappear and so might her job.

Small businesses shoot themselves in the foot because they focus on avoiding loses on each and every transaction.

Large(r) business shoot themselves in the foot because they focus on evaluating each employee / department / manager etc.   

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