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Management Practices

How Do We Make Decisions?

Leon Alexander | October 16, 2015 | 12:07 PM

During the course of the day, each salon owner and service provider makes a number of decisions that vary from what to eat for lunch to fundamental decisions that affect the salon business. But what criteria do we use when making a business decision? And why do we use different criteria for personal decisions?

Do you remember the story of Odysseus and the Sirens? Odysseus is heading back home after the Trojan War and is standing on the deck of his ship, he's talking to his first mate, and he's saying, "Tomorrow, we will sail past those rocks, and on those rocks sit some beautiful women called Sirens. These women sing an enchanting song, a song so alluring all sailors who hear it crash into the rocks and die." You would expect they would choose an alternate route around the Sirens, instead Odysseus says, "I want to hear that song so what I'm going to do is pour wax in all your ears so you can't hear the song, and then I'm going to have you tie me to the mast so I can listen and we can all sail by unaffected." This is a captain putting the life of every single person on the ship at risk so he can hear a song.

Tying yourself to a mast is perhaps the oldest written example of what psychologists call a commitment device. A commitment device is a decision you make with a cool head to bind yourself so you don't do something regrettable when you have a ‘hot head.’ Scholars have long invoked this metaphor of two selves when it comes to questions of temptation. First, there is the present self. This is like Odysseus when he's hearing the song, he thinks about the here and now and the immediate gratification. Then there's this other self, the future self. This is Odysseus as an old man who wants nothing more than to retire in a sunny villa with his wife Penelope outside of Ithaca.

Why do we need commitment devices? Because resisting temptation is hard. To abstain from the enjoyment, which is in our power, or to seek distant rather than immediate results, are among the most painful exertions of the human will. If you set goals for yourself and you're like a lot of other people, you probably realize it's not that your goals are physically impossible that's keeping you from achieving them, it's you lack the self-discipline to stick to them. It's physically possible to lose weight. It's physically possible to exercise more, but resisting temptation is hard.

The other reason it's difficult to resist temptation is because it's an unequal battle between the present self and the future self. The present self is present. It's in control. It's in power right now. It has these strong, heroic arms that can lift doughnuts into your mouth and the future self is not even around. It's off in the future. It's weak. It doesn't even have a lawyer present. There's nobody to stick up for the future self, therefore the present self can trounce all over its dreams. There is this battle between the two selves that's being fought, and we need commitment devices to level the playing field between the two.

There are other commitment devices such as locking a credit card away with a key, not bringing junk food into the house so you won't eat it or unplugging your Internet connection so you can’t use your computer.

There are two concerns with commitment devices. The first is, when you've got one of these devices in place it's a constant reminder, you have no self-control. You're telling yourself, "without you, commitment device, I am nothing, I have no self-discipline." When you don't have a commitment device in place and are offered a doughnut, you have no defense mechanism," – so you eat it.

The other problem with commitment devices is you can weasel your way out of them. You say, I'm going to a cocktail party and I'll be drinking. So in effect, you are like Odysseus and the first mate in one person. You're putting yourself, you're binding yourself, and you're weaseling your way out of it, and then you're beating yourself up afterwards.

Your decisions today are going to determine your future well-being.

We all make decisions every day; we want to know what the right thing is to do from the financial to the gastronomic, to the professional, to the romantic. If somebody could tell us how to do exactly the right thing at all times, it would be a tremendous gift. It turns out the world was given this gift in 1738 by a Dutch polymath named Daniel Bernoulli.

This is Bernoulli's gift. The expected value of any of our actions that is, the goodness that we can count on getting, is the product of two simple things: the odds this action will allow us to gain something, and the value of gain to us.”

In a sense, what Bernoulli was saying, if we can estimate and multiply these two things, we will know precisely how we should behave.

It's not very simple in everyday life. People are horrible at estimating both odds and values.

There are two kinds of errors people make when trying to decide the right thing to do, Errors in estimating the odds they're going to succeed, and errors in estimating the value of their own success. Calculating odds would seem to be something rather easy. There are six sides to a die, two sides to a coin, and 52 cards in a deck. We all know what the likelihood is of pulling the ace of spades or of flipping a heads. It turns out this is not an easy idea to apply in everyday life. It's why we spend more. I should say, lose more gambling than on all other forms of entertainment combined. But this isn't how people do odds.

The way people figure odds requires that we consider the question, “are more dogs or pigs on leashes observed in any particular day in Times Square?” Of course, you all know the answer is dogs. The way you know the answer is dogs is because you quickly reviewed in memory the times you've seen dogs and pigs on leashes. It was easy to remember seeing dogs, not so easy to remember pigs. You assumed if dogs on leashes came more quickly to your mind, then dogs on leashes are more probable. That's not a bad rule of thumb, except when it is.

Are there more four-letter English words with R in the third place or R in the first place?  You check memory briefly, make a quick scan, and it's easy to say to yourself, Ring, Rang, Rung, and more difficult to say to yourself, Pare, Park, they come more slowly. In fact, there are many more words in the English language with R in the third than the first place. The reason words with R in the third place come slowly to your mind isn't because they're improbable, unlikely or infrequent. It's because the mind recalls words by their first letter. You shout out the sound, and the word comes. It's like the dictionary; it's hard to look words up by the third letter. This example illustrates how the idea that the quickness with which things comes to mind can give you a sense of probability, not fact.

The lottery is an excellent test case of people's ability to compute probabilities. Economists refer to the lottery as a stupidity tax because the odds of getting any payoff by investing your money in a lottery ticket are approximately equivalent to flushing the money directly down the toilet.

Why in the world would anybody ever play the lottery? There are many answers, one reason is, we see a lot of winners on TV and we read about it in the paper. When was the last time you saw extensive interviews with everybody who lost? If we required television stations run a 30-second interview with each loser every time they interview a winner, the 100 million losers in the last lottery would require nine and a half years of your undivided attention to watch them say, “I lost.” If you watch nine and a half years of television with no sleep, no breaks and you saw loss after loss, then at the end there's 30 seconds of, "and I won," the likelihood you would play the lottery is small.

Let me give you an example of a little raffle. There are 10 tickets in this raffle. Nine of them have been sold to nine individuals. It costs you a dollar to buy the ticket and, if you win, you get 20 dollars. Is this a good bet? The expected value of this raffle is two dollars; this is a raffle in which you should invest your money. And most people say, "OK, I'll play."

Now lets look at a different version of this raffle. Imagine Elroy owns nine tickets and there's one left. Do you want it? Most people won't play this raffle. You know the odds of winning haven't changed, but it's now easy to imagine who's going to win. It's easy to see Elroy getting the check. You can't say to yourself, "I'm as likely to win as anybody," because you're not as likely to win as Elroy. The fact all those tickets are owned by one guy changes your decision to play, even though it does nothing whatsoever to the odds. 

It turns out the value of buying a lottery ticket is not winning. The average lottery buyer buys about 150 tickets a year, so the buyer knows full well he or she is going to lose, and yet she buys 150 tickets a year. Why is that? It's because the anticipation of possibly winning releases serotonin in the brain and actually provides a good feeling until the drawing indicates you've lost.

Estimating odds, as difficult as it may seem is easy compared to trying to estimate value. For example, trying to say what something is worth, how much we'll enjoy it, and how much pleasure it will give us. Lets look at errors in value. How much is a Big Mac worth? Is it worth 25 dollars? Most of you have the intuition it's not and you wouldn't pay that.

Deciding whether a Big Mac is worth 25 dollars requires you ask one, and only one question. “What else can I do with 25 dollars?” Imagine you are travelling on one of those long-haul flights to Australia and realized they're not going to serve you any food. Somebody in the row in front of you has opened a McDonalds bag and the smell of golden arches is wafting over the seat. Some people might think, I can't do anything else with 25 dollars for 16 hours. I can't even set it on fire. Suddenly, 25 dollars for a Big Mac sounds like a good deal.

On the other hand, if you're visiting an underdeveloped country and 25 dollars buys you a gourmet meal, it's exorbitant for a Big Mac. We become sure the answer to the question was no, before being told anything about the context, because most of us compared the price of a Big Mac to the price you're used to paying. Rather than asking, "What else can I do with my money?" Comparing this investment to previous investments. This is a systematic irrational error people make. You knew that you paid three dollars in the past, making $25 outrageous.

For example, one of the most common tricks in marketing is to say something used to be higher, giving you the impression it is now a good deal. When people are asked about two different jobs: a job where over three years you make 60K, then 50K, then 40K, showing you're getting a salary cut each year, compared against a job where you make 35k then 45k then 55k in which you're getting a salary increase over three years, people like the second job better than the first, despite the fact they're all told they make much less money. Why? Because they had the sense declining wages are worse than rising wages, even when the total amount of wages is higher in the declining period.

A further example is to imagine a $2,000 Hawaiian vacation package on sale for $1,600. Assuming you wanted to go to Hawaii, would you buy this package? Most people say they would. Here's a slightly different story. A $2,000 Hawaiian vacation package is now on sale for $700, so you decide to mull it over for a week. By the time you get to book it, the best fares are gone. The package now costs $1,500. Would you buy it? Most people say, no. Why? Because it used to cost $700, and there's no way I'm paying $1,500 for something that was $700 last week.

This tendency to compare to the past is causing people to pass up the better deal. In other words, a good deal that used to be a great deal is not nearly as good as an awful deal that was once a horrible deal.

Here's another example of how comparing to the past can befuddle our decisions. Imagine you're going to the theater. In your wallet you have a ticket, for which you paid 20 dollars. You also have a 20-dollar bill. When you arrive at the theater, you discover somewhere along the way you've lost the ticket. Would you spend your remaining money on replacing it? Most people answer, no. Now, let's change one thing in this scenario. You're on your way to the theater, and in your wallet you have two 20-dollar bills. When you arrive you discover you've lost one of them. Would you spend your remaining 20 dollars on a ticket? Well, of course, I went to the theater to see the play. What does the loss of 20 dollars along the way have to do with it?

Along the way, you lost something. In both cases, it was a piece of paper. In one case, it had a U.S. president on it and in the other case it didn't. What difference should it make? The difference is when you lost the ticket you say to yourself, I'm not paying twice for the same thing. You compare the cost of the play now 40 dollars to the cost it used to be 20 dollars and you say it's a bad deal. Comparing with the past causes many of the problems behavioral psychologists identify in people's attempts to assign value. Even when we compare with the possible, instead of the past, we still make certain kinds of mistakes.

Retailers knew this long before anybody else did, and they use this wisdom to help you, and spare you the undue burden of money. If you were to go into a wine shop and you had to buy a bottle of wine, and you see wine for 8, 15 and 30 dollars, what would you do? Most people don't want the most expensive; they don't want the least expensive. They will opt for the item in the middle. If you're a smart retailer, you will put an expensive item nobody will ever buy on the shelf, because suddenly the $30 wine doesn't look as expensive in comparison.

Comparison changes the value of things. Here's why that's a problem. When you get the $30 bottle of wine home, it won't matter what it used to be sitting on the shelf. The comparisons we make when we are appraising value, where we're trying to estimate how much we'll like things, are not the same comparisons we'll be making when we consume them. This problem of shifting comparisons can bedevil our attempts to make rational decisions.

In an experiment subjects are asked the simplest of all questions. How much will you enjoy eating potato chips one minute from now? They're sitting in a room with potato chips in front of them. For some of the subjects, sitting in the far corner of a room is a box of Godiva chocolates, and for others is a can of Spam. The items in the room change how much the subjects think they're going to enjoy the potato chips. Those who are looking at Spam think potato chips are going to be quite tasty and those who are looking at Godiva chocolate think they won't be nearly so tasty. What happens when they eat the potato chips? You don't need a psychologist to tell you when you have a mouthful of greasy, salty, crispy, delicious snacks, what's sitting in the corner of the room makes not a bit of difference to your gustatory experience. Nonetheless, their predictions are perverted by a comparison that then does not carry through and change their experience.

Imagine you want to buy a car stereo. The dealer near your house sells this particular stereo for 200 dollars, but if you drive across town, you can get it for 100 dollars. So would you drive to get 50 percent off, saving 100 dollars? Most people say they would. They can't imagine buying it for twice the price when, with one trip across town, they can get it for half off.

Now, let's imagine instead you wanted to buy a car that had a stereo, and the dealer near your house had it for $31,000. But if you drove across town, you could get it for $30,900. Would you drive to get it? At this point, most people say, no, I'm not going to go across town to save 100 bucks on the purchase of a car.

This kind of thinking drives economists crazy, and it should. Because this 100 dollars you save doesn't know where it came from. It doesn't know what you saved it on. When you go to buy groceries, it doesn't say, ‘I'm the money saved on the car stereo,’ or, ‘I'm the money saved on the car.’ It's money. If a drive across town is worth 100 bucks, it's worth 100 bucks no matter what you're saving it on. People don't think that way. That's why they don't know whether their mutual fund manager is taking 0.1 percent or 0.15 percent of their investment, but they clip coupons to save one dollar off of toothpaste.

The problem of shifting comparisons is even more difficult when these choices are arrayed over time. People have a lot of trouble making decisions about things that will happen at different points in time. What psychologists and behavioral economists have discovered is, people use two simple rules. So let me give you two easy problems, and then a third, hard problem.

Here's the first easy problem. You can have 60 dollars now or 50 dollars now. Which would you prefer? All of us, I hope, prefer more money, and the reason is, we believe more is better than less.

Here's the second problem: You can have 60 dollars today or 60 dollars in a month. Which would you prefer? Again, an easy decision, because we all know now is better than later. What's hard in our decision-making is when these two rules conflict. For example, when you're offered 50 dollars now or 60 dollars in a month. This typifies a lot of situations in life in which you will gain by waiting, but you have to be patient. What do people do in these kinds of situations? Well, by and large people are enormously impatient. They require interest rates in the hundred or thousands of percent in order to delay gratification and wait until next month for the extra 10 dollars. Most people think more is better than less. 60 is better than 50, and they think now is better than later.

Conclusion

Our brains were evolved for a different world than the one in which we are living. They were evolved for a world in which people lived in small groups, rarely met anybody who was terribly different from themselves, had rather short lives in which there were few choices and the highest priority was to eat and mate today.

The Bernoulli’s formula tells us how we should think in a world for which nature never designed us. That explains why we are so bad at using it, but it also explains why it is so terribly important we become good, fast. We are the only species on this planet that has ever held its own fate in its hands. We have no significant predators, we're the masters of our physical environment and the reasons that normally cause species to become extinct are no longer any threat to us. The only things that can destroy us and doom us are our own decisions. If we're not here in 10,000 years, it's going to be because we could not take advantage of the gift given to us and because we underestimated the odds of our future pains and overestimated the value of our present pleasures.

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