An Introduction to Behavioral Economics and Negotiations

In his latest book, The Undoing Project, author Michael Lewis introduces us to the fathers of behavioral economics, Amos Tversky and Daniel Kahneman. Its first chapter describes how Houston Rockets General Manager Daryl Morey used behavioral economics to rebuild the team beginning in 2007. The key, Daryl Morey noticed, was that his recruiters and coaching staff invariably fell prey to specific errors in their decision making when selecting players. For example, recruiters who found a candidate they liked tended to overvalue information reinforcing their decision and ignore information suggesting that the player should not, in fact, be drafted. Eliminate these errors in judgment, replacing “judgment calls” with hard data, and they could pay less for better players. This was the same approach the Oakland A’s used to achieve success during their famous 2002 baseball season and the subject of Michael Lewis’ prior book, Moneyball.
What is behavioral economics, and how does it relate to the work we do as business lawyers? In short, behavioral economics is the science of how people make decisions. By understanding the techniques people use to make their decisions, including those that cause us to occasionally make bad decisions, we can accomplish two things. First, we can help other people make better decisions (or perhaps, instead, make the decisions we want them to make). Second, we can better understand our own decision making processes and, with a more concrete understanding, improve them.  Understanding decision making can improve our performance in a large number of arenas, but certainly assists in performing such tasks as negotiating deals, structuring contracts, or building compliance systems.
Behavioral economics builds on the traditional economics concept of normative decision theory, which describes the rules by which a fully rational individual makes choices. Normative decision theory makes two basic assumptions. First, that the person making choices has complete information. In other words, the person knows all the information relevant to making the choice. Second, normative decision theory assumes that the person is rational—that is, capable of making choices that are logical and consistent based on that person’s desires. For example, if a person prefers coffee to tea, and also prefers hot chocolate to coffee, then a rational person will ask for a hot chocolate when offered a choice between that and tea (this is called the principal of transitivity). When you know the logical rules by which rational persons make decisions, the argument goes, you can build mathematical and logic models of their behavior, use those models to predict results, and also develop responsive strategies. These rules of logical choice, called utility theory, were described by mathematician John von Neumann and economist Oskar Morganstern in their 1944 work, Theory of Games and Economic Behavior, and form the basis for modern game theory.
The problem with utility theory is its limited application in real-world situations. People don’t have complete information when they make decisions, and as Tversky and Kahneman proved, people do not follow the rules of rational decision making when making choices. Instead, decision making employs a variety of cognitive short cuts, called heuristics. Behavioral scientists, through empirical studies, have identified dozens of these heuristics. They bear names such as “planning fallacy,” “anchoring,” “confirmation bias,” and “loss aversion,” but they essentially describe the rules by which human minds tend to make decisions in place of the strict logical constructs that utility theory describes. In short, behavioral economics provides a useful tool for predicting and understanding decisions where standard economics tends to fail. For example, anchoring refers to a tendency to determine subjective values based on recent exposures to something similar, although unrelated. When asked to guess the percentage of African countries in the UN, people consistently pick a higher number when exposed to the number 65 than when exposed to the number 10 just prior to guessing.  The planning fallacy refers to the consistent tendency to underestimate the length of time a task will take, even when a person has extensive experience performing that task. Kahneman and Tversky’s work is significant—Kahneman was awarded the Nobel Prize in Economics for his work in the area.
Understanding these rules can play a significant role in negotiations. For example, an attorney who understands how anchoring works can employ the concept to set expectations both for his client and the opposite party that are reasonable and conducive to obtaining a negotiated solution. In addition, the attorney can be more aware of situations where anchoring might be affecting her own decision making, resulting in a potentially poor negotiation outcome. This article explores some of the more significant heuristics and how they affect negotiations.
Planning Fallacy
In Thinking, Fast and Slow, Daniel Kahneman describes the process of planning a book for a psychology course. When he polled the group of authors about how long they thought the project would take, they estimated about two years. Kahneman then asked the most experienced member of the group how long similar projects had taken in the past. After a little thought, the expert replied, “I cannot think of any group that finished in less than seven years,” and he said that about 40 percent of the projects had failed to reach completion altogether! Still, even though none of the authors were prepared to make a seven-year investment in a project with only a 60-percent chance of success, they went ahead designing the book. They finished it eight years later, and it was never used.
Closely related to the optimism heuristic, the “planning fallacy” refers to the tendency for people to consistently underestimate both the time and costs for completing projects. Although the most obvious examples come from large public works projects, any lawyer can think of the times that a lawsuit, negotiation, or business deal took longer than expected and cost more than estimated. Empirical studies show that the planning fallacy reflects an underlying psychological tendency to ignore historical evidence when estimating the time and expense for a project. In one study, students were asked to es