The burgeoning field of behavioral economics has many insights for the aspiring CEO. In a series of posts, I will bring up a few of the key concepts of behavioral economics and discuss how they apply to a would-be business tycoon.
Does Fairness Matter?
Reference-dependent preferences, an idea first pioneered by Kahneman and Tversky in 1979, are a cornerstone of behavioral economics. The main idea is people’s utility is affected by gains and losses coded from a neutral reference point, rather than by final asset positions. This means that people don’t feel like they’ve won or lost based on how much money they’ve netted alone, but based on how much money they’ve netted relative to a specific reference point.
A simple example of a reference point is the expected value of a wager — if the expected value of a bet is $100, but a person ends up winning only $20, they will feel like they have lost money, even though, overall, they have gained. There are many other possibilities for a reference point. Expectations are another key example of a reference point. If someone expects a raise of $1000 every year, because he has been getting it year after year, a raise of only $800 will not feel like a gain, but instead as a loss of $200.
So what effect does all of this have on our CEO? One of the main implications involves wages. Every CEO needs to understand how to motivate his employees to work, while still earning a profit. A crucial part of how to do this is by choosing the right wage. Reference points can embody notions of fairness. People expect to have their hard work reciprocated through fitting wages. When the wage changes from the wage that is considered “fair”, even if the CEO believes that it is the correct new wage, employees may react with anger and shirking. This is especially true if the management is perceived to be increasing its own share at the expense of its workers.
For the savvy CEO, both in the real world and in a business simulation such as the CEO Game, it makes one must be aware of the way wage decisions are perceived. Employee morale is key, and the CEO must not dampen it, through decisions about wages, raises, and bonuses that violate employee expectations or their sense of fairness. In these tough economic times, especially, when cut backs are necessary, some firms are finding it better to cut all workers’ hours equally and keep all of them than to fire old workers in order to hire new, cheaper ones. There are many other creative responses to the current recession that incorporate the findings of behavioral economists.
The CEO Game.
September 15th, 2009 at 5:15 pm
[...] See the original post: Behavioral Economics – Fairness In The Workplace [...]
September 22nd, 2009 at 1:07 pm
[...] back to our good friend prospect theory, which was mentioned in the first article I wrote about behavioral economics. In addition to valuable insights on reference points, prospect theory states that people are [...]