Did Our Own Irrational Behavior Lead Us to this Economic Crisis?

Do you think you always behave rationally? Have American people, as individuals or as corporate representatives, behaved rationally during the recent decades? Does rational behavior have anything to do with the current economic crisis? How do we define rational behavior?

These are questions that might help us getting a better understanding of what went wrong in the first place and, perhaps, how we can avoid or mitigate the next worldwide economic collapse.

Wikipedia defines rationality as follows:

Individuals or organizations are often called rational if they tend to act somehow optimally in pursuit of their goals.

In economics, "goal" is usually translated into optimizing one's expected payoff according to a utility scale, or in a simpler sense, into maximizing one's expected profit. Therefore, loosely speaking, people are economically rational if they try to maximize their expected profit.

There are, however, many ways in which we can see people behave systematically against their own goal. In an earlier post, we talked about wishful-betting and wishful-thinking, which could be considered as examples of how people behave irrationally in a systematic way.

Peter Ubel in his book "Free Market Madness: Why Human Nature is at Odds with Economics" argues that a completely free-market, which is a concept based on rational behavior, is dysfunctional. That is, people's potential to behave irrationally always necessitates a level of market regulation.

These regulations should prevent people from making irrational decisions on a large scale.

The author believes that the roots of the current economic disaster can be found in the irrational behavior of individuals.

Ubel, too, believes in wishful-thinking as a source of irrational behavior. However, he gives it a new name: unrealistic optimism.

As an example, unrealistic optimism in believing that the housing prices always go up, was one of the reasons that we fell into this economic downturn in the first place.

I received these feedbacks through my communication with my valued friend Amir Kermani (his points but in my words).

• Wishful thinking might lead to wrong expectations. We should keep in mind that this is only one of the sources that might lead to irrational behavior.
• Before the government can prevent any wrong expectations, it should have the ability to obtain more accurate ones itself. There is no gaurantee that the government can set its expectations more accurately than the firms or individuals. Therefore, government regulations cannot be the ultimate solution for this probem.
• We should also look for the sources of wrong expectations. That is, why and how people fall into this trap in the first place. We should look for the root causes not just the symptoms.

Ubel talks about his book in an interview with Harvard Business Online. You can listen to this interview by clicking here.

Have Supply Chains Overreacted to the Economic Downturn?

Increased complexity of supply chains, due to globalization trend, is not news to people who work in this field. What is unprecedented, however, is the combination of this complexity with a severe global recession. One of the consequences of this combination is the spread of extra conservative behavior in different stages of supply chains.

In March, Best Buy Co. said it could have sold more electronics equipment in the three months ended Feb. 28, but its suppliers' deep cuts made it tough to keep shelves stocked. Suppliers "all decided to build a lot less," says Best Buy merchandizing chief Michael Vitelli.

reports the Wall Street Journal in its May 18, 2009 article titled "Clarity Is Missing Link in Supply Chain."

The article relates the conservative behavior of supply chains to reduced visibility which in turn is a result of more complexity. For most firms, there are many stages upstream and/or downstream of their complex supply chains. If something goes wrong in any of these stages, which is quite likely in a global recession, the consequences could be severe for the firms.

It is like driving in a road full of unexpected turns and obstacles. If you want to drive in such a road in a foggy night where you can see only a few yards ahead of you, you have no choice but to drive very slowly and with extra caution.

When firms are under financial pressures of a recession, they lose their appetite for any kind of risk. In addition, firms' limited ability to see what is happening in their extensive supply chain intensifies this risk-averse behavior. When most of supply chain stages turn into extra cautious, risk-averse decision makers, the supply chain profit could drop considerably.

To ease this problem, we can look for solutions which either decrease the level of uncertainties or their impacts, or increase the risk tolerance of the supply chain decision makers.

The above mentioned article suggests that we could reduce the level of uncertainties by creating more visibility through information and forecast sharing. That is, different stages of supply chains should share the related information to help each other make more informed decisions. Although, information sharing can always increase the supply chain profit, it has an even more important role when the uncertainties have dramatically increased due to a global economic crisis.

Another solution which might decrease the impact of uncertainties on each stage of supply chains is risk-sharing agreements (contracts). Revenue-sharing, buyback, and quantity-flexibility contracts are among mechanisms which let the stages of supply chains to share the inherent risk and therefore feel less vulnerable to unexpected changes. Hence, the supply chain as a whole could act more aggressively and gain more expected profit.

I am wondering if there are other ways to address this problem. Is there any way that we can increase the risk tolerance of decision makers in supply chains? What do you think?

I should thank my friend Jon Freeman who brought the above Wall Street Journal article to my attention.

Should We Blame Business Schools for our Economic Crisis?

Critics have so far put the blame for this economic downturn mainly on the government's inappropriate regulations, the American consumers' overspending, greedy behaviors in the financial sector, or even economists' incompetent models.

Recently, however, a professor at McGill University has found a new accused: business schools.

Henry Mintzberg in his recent article "America's monumental failure of management" which appeared on The Globe and Mail, argues that the approach of business schools in educating future business leaders has major flaws and has had an important role in the current crisis.

Mintzberg believes the current MBA education system trains managers/leaders to be decisive based on the limited information provided to them in each case study. As a result, MBA graduates could easily undermine the depth of knowledge that a decision maker needs when a high level decision is to be made. He states:

Management is a practice, learned in context. No manager, let alone leader, has ever been created in a classroom. Programs that claim to do so promote hubris instead. And that has been carried from the business schools into corporate America on a massive scale.

I do not agree with all of the author's thoughts. I believe he undermines the usefulness of the skills that the students learn in most MBA programs. Nevertheless, I found the article provocative and very interesting.

Mintzberg talks about his article in an interview with Harvard Business Online. You can listen to this interview by clicking here.

UMASS Boston students and faculty can access the article through e-journal service of the library. First, search for "The Globe and Mail" electronic journal. Then in the LexisNixis database search for the title of the article.

How Wishful Thinking Porpagates

The way that a decision maker handles the risks involved in a decision, risk-behavior, could have great impact on the future success or failure of that decsion. Therefore, it is useful to know where this risk-behavior comes from.

Is a decision maker's risk-behavior mostly influenced by the personality of that individual, or is it mostly influenced by the decision making environment?

Saybert and Bloomfield in their article, Contagion of Wishful Thinking in Markets, which appeared in May-2009 issue of the Management Science, show that the interaction of decision makers with each other can impact their risk-behavior. More specifically, they try to show how wishful betting might lead to wishful thinking when decision makers interact with each other.

In one of their experiments, the authors examine the decision making behavior of two groups of individuals who have to make a risky decision (a bet). The first group have access to the objective probabilities. That is, the first group are individuals who know the probability of each possible outcome of their decisions (bets). The experiment results show, although people in this group have unbiased belief about the probabilities of the outcomes, they have a tendency toward making the decisions as if the probability of their favorable outcome is higher than what this probability actually is. This is what they call wishful betting.

This observation can explain the risk-seeking behavior of a decision maker in some cases. The authors then examine the second group who do not have access to the objective probabilities of outcomes, but can observe the decisions of the first group. The results of the experiment show that the second group actually come to believe that the probability of their favorable outcome is higher than what that probability actually is. Hence, they bet accordingly. This is what they call wishful thinking.

I found this research interesting, since it shows how risk-behavior of a decision maker, if observable to others, can impact the risk-behavior of other decision makers.

So, one might naturally ask:

"if we can change the observability of individuals' risk-behavior in an organization, can we influence the risk-behavior of each decision maker?"

A positive answer suggests that, if we want more risk-seeking behaviors in the organization, in an R&D department for example, we should announce publicly any bold move carried out by each researcher. On the other hand, if we want more risk-aversion behaviors, we should cover up any risky decision made by individuals.

What do you think?

UMASS Boston students and faculty can click here to see a PDF version of the paper by Saybert and Bloomfield.

Risk Behavior and the Fall of Successful Companies

Jim Collins in his latest book, How the Mighty Fall and Why Some Companies Never Give In, investigates the roots and reasons that many successful companies have declined to a level of irrelevance or even death. The author also tries to show how companies can avoid this fall.

He argues that the first stages of decline can start while all the evidences suggest that a company is still climbing the ladder of success, "The Silent Creep of Doom" he names it. Collins characterizes five stages in this decline:

1- Hubris Born of Success: When the success of a company turns its managers to arrogantly believe that they are entitled to win the game no matter what.
2- Undisciplined Pursuit of More: Managers' excessive self confidence makes them to pursue goals way beyond their reach or expertise.
3- Denial of Risk and Peril: The Managers' strong belief that they are destined for success, leads them to amplify the positive data and ignore all signs of possible danger ahead.
4- Grasping for Salvation: When the evidence for the decline of the company become more obvious than anyone can deny it, instead of trying to solve the roots of the problem, the managers try to convince (fool) everyone, including themselves, that there is a dramatic solution that can overhaul the company overnight.
5- Capitulation to Irrelevance or Death: If the company cannot avoid stage 4 by reaching for a solution that addresses the roots of the problem, there is no destination but irrelevance or death.

Although the author does not make his argument in the context of risk management, we can find interesting risk management lessons in the way he describes the fall of a successful company. Here are two:

a) The author's notion of "the silent creep of doom" reminds us of the fact that in many cases the source of disaster might be already in the making, hidden in the plain sight, while everyone thinks that nothing is wrong with this successful company. Therefore, it is imperative for companies to put in place detection mechanisms that can warn us before it is too late (early risk detection).

b) Successful companies are poised to suffer from a false sense of security. A sequence of successful results might create this illusion that they are going to do fine no matter what! In other words, success can result in excessive risk-taking behaviors. The false sense of security might even reach a level of risk denial. That is, decision makers might ignore evidences of potential risk. Many of this evidences could be in the form of "near misses". Analyzing near misses is a powerful tool for early detection of risk. However, the decision makers' excessive risk taking and/or risk denial attitude prevent them from learning from near misses.

You can listen to an interview with the author on the "Business Week Cover Story" podcast page.

An excerpt of the Collin's new book appeared in BusinessWeek, May 25, 2009. UMASS Boston students and faculty, click here to find the excerpt.