Introduction To Managerial Decision Making People example essay topic

C H A P T E R O N E Introduction to Managerial Decision Making Phar-Mor, Inc., the nation's largest discount drugstore chain, filed for bankruptcy court protection in 1992, following discovery of one of the largest business fraud and embezzlement schemes in U.S. history. Coopers and Lybrand, Phar-Mor's former auditors, failed to detect inventory inflation and other financial manipulations that resulted in $985 million of earnings overstatements over a three-year period. A federal jury unanimously found Coopers and Lybrand liable to a group of investors on fraud charges. The successful plaintiffs contended that Gregory Finerty, the Coopers and Lybrand partner in charge of the Phar-Mor audit, was "hungry for business because he had been passed over for additional profit-sharing in 1988 for failing to sell enough of the firm's services" (Pittsburgh Post-Gazette, February 15, 1996). In 1989, Finerty began selling services to relatives and associates of Phar-Mor's president and CEO (who has been sentenced to prison and fined for his part in the fraud). Critics claim Finerty may have become too close to client management to maintain the professional skepticism necessary for the conduct of an independent audit.

The Phar-Mor case is just one of many in which auditors have been held accountable for certification of faulty financial statements. Investors in the MiniscribeCorporation maintained that auditors were at least partially responsible for the's falsified financial statements; at least one jury agreed, holding the auditors liable to investors for $200 million. In the wake of the U.S. savings-and-loan crisis, audit firms faced a barrage of lawsuits, paying hundreds of millions in judgments and out-of-court settlements for their involvement in the financial reporting process of savings-and-loan clients that eventually failed. The auditing partners of Coopers and Lybrand, like partners of other firms held liable for such negligence, are very bright people. In addition, I believe that they are generally very honest people. So, how could a prominent auditing firm with a reputation for intelligence and integrity have overlooked such large misstatements in Phar-Mor's financial records?

How could auditors have failed to see that so many of their savings-and-loan clients were on the brink of failure? Critics of the profession suggest that auditor neglect and corruption may be responsible. In fact, very rarely do audit 2 o Chapter 1: Introduction to Managerial Decision Making failures result from deliberate collusion of the auditor with its client in the issuance of faulty financial statements. Instead, audit failures are the predictable result of systematic biases in judgment.

This book provides the tools to help you avoid these errors. By eliminating biases from your decision-making patterns, you can become abetter decision maker and protect yourself, your family, and your organization from avoidable mistakes. This book (Chapter 4, specifically) will provide evidence that it is psychologically impossible for auditors to maintain their objectivity; cases of audit failure are inevitable, even from the most honest of firms. Psychological research shows that expecting objective judgment from an auditor hired by the audit ee is unrealistic.

Although deliberate misreporting can occur, bias more typically becomes an unconscious, unintentional factor at the stage where judgments are made. When people are called upon to make impartial judgments, those judgments are likely to be unconsciously and powerfully biased in a manner that is commensurate with the judge's self-interest. Psychologists call this the self-serving bias (Messick and Sent is, 1985). When presented with identical information, individual perceptions of a situation differ dramatically depending on one's role in the situation.

Individuals first determine their preference for a certain outcome on the basis of self-interest and then justify this preference on the basis of fairness by changing the importance of attributes affecting what is fair. Thus, the problem is not typically a desire to be unfair, but our inability to interpret information in an unbiased manner (Diekmann, Samuels, Ross, and Bazerman, 1997). The self-serving bias exists because people are imperfect information processors. One of the most important subjective influences on information processing is self-interest.

People tend to confuse what is personally beneficial with what is fair or moral. We have begun a new century with a vast amount of knowledge about how to use technology to integrate data and make routine decisions. However, computers cannot make decisions involving values and risk preferences. Here, human judgment is required. What advice was available to Coopers and Lybrand? The material in this book would have introduced the firm's partners to a number of cognitive biases that are predictable and likely to affect auditor judgment.

Knowledge of these biases can be used to make more rational decisions. By identifying cognitive biases and suggesting strategies for overcoming them, this book gives managers the skills they need to improve their judgment. Although most managerial decisions concern considerably less than $985 million, situations that require careful judgment arise continually in our daily lives. Such judgment is a major component of managerial work at all levels of the corporate world. Many managers accept judgment as innate: "Some people have it and others do not". This attitude can waste critical human resources in organizations.

While decision-making skills may be partially innate, training can have a significant effect on the quality of managerial judgment. THE ANATOMY OF A DECISION Judgment refers to the cognitive aspects of the decision-making process. To fully understand judgment, we first need to identify the components of the decisionTheAnatomy of a Decision o 3 making process that require it. To get started, consider the following decision situations: o You are finishing your MBA at a well-known school. Your credentials are quite good, and you expect to obtain job offers from a number of "dot com" start-ups. How are you going to select the right job? o You are the director of the marketing division of a rapidly expanding consumer company.

You need to hire a product manager for a new "secret" product that the company plans to introduce to the market in 15 months. How will you go about hiring the appropriate individual? o As the owner of a venture capital firm, you have a number of proposals that meet your preliminary considerations but only a limited budget with which to fund new projects. Which projects will you fund? o You are on the corporate acquisition staff of a large conglomerate that is interested in acquiring a small-to-moderate-sized firm in the oil industry. What firm, if any, will you advise the company to acquire?

What do these scenarios have in common? Each one proposes a problem, and a number of alternative solutions. Let us look at six steps you should take, either implicitly or explicitly, when applying a "rational" decision-making process to each scenario. 1. Define the problem. The problem has been fairly well specified in each of the four scenarios.

However, managers often act without a thorough understanding of the problem to be solved, leading them to solve the wrong problem. Accurate judgment is required to identify and define the problem. Managers often err by (a) defining the problem in terms of a proposed solution, (b) missing a bigger problem, or (c) diagnosing the problem in terms of its symptoms. Our goal should be to solve the problem, not just eliminate its temporary symptoms.

2. Identify the criteria. Most decisions require the decision maker to accomplish more than one objective. When buying a car, you may want to maximize fuel economy, minimize cost, maximize comfort, and so on. The rational decision maker will identify all relevant criteria in the. 3.

Weight the criteria. Different criteria will be of varying importance to a decision maker. Rational decision makers will know the relative value that they place on each of the criteria identified (for example, the relative importance of fuel economy versus cost versus comfort). 4. Generate alternatives. The fourth step in the decision-making process requires identification of possible courses of action.

Decision makers often spend an inappropriate amount of search time seeking alternatives, creating a barrier to effective decision making. An optimal search continues only until the cost of the search outweighs the value of the added information. 4 o Chapter 1: Introduction to Managerial Decision Making 5. Rate each alternative on each criterion. How well will each of the alternative solutions achieve each of the defined criteria? This is often the most difficult stage of the decision-making process, as it typically requires us to forecast future events.

The rational decision maker will be able to carefully assess the potential consequences of selecting each of the alternative solutions on each of the identified criteria. 6. Compute the optimal decision. Ideally, after all of the first five steps have been completed, the process of computing the optimal decision consists of (1) multiplying the ratings in step 5 by the weight of each criterion, (2) adding up the weighted ratings across all of the criteria for each alternative, and (3) choosing the solution with the highest sum of the weighted ratings. The model of decision making just presented assumes that we follow these six steps in a fully "rational" manner. That is, decision makers are assumed to (1) perfectly define the problem, (2) identify all criteria, (3) accurately weigh all of the criteria according to their preferences, (4) know all relevant alternatives, (5) accurately assess each alternative based on each criterion, and (6) accurately calculate and choose the alternative with the highest perceived value.

There is nothing special about these six steps. Different researchers specify different steps-which typically overlap a great deal. For example, in a wonderful recent book on rational decision making, Hammond, Keeney, and Rai ffa (1999) suggest eight steps: (1) work on the right problem, (2) specify your objectives, (3) create imaginative alternatives, (4) understand the consequences, (5) grapple with your trade offs, (6) clarify your uncertainties, (7) think hard about your risk tolerance, and (8) consider linked decisions. Both of these lists provide a useful order for thinking about what an optimal decision-making process might look like. THE BOUNDS OF RATIONALITY In this book, the term rationality refers to the decision-making process that is logically expected to lead to the optimal result, given an accurate assessment of the decision maker's values and risk preferences. The rational model is based on a set of assumptions that prescribe how a decision should be made rather than describing how a decision is made.

In his Nobel Prize-winning work, Simon (1957; March and Simon, 1958) suggested that individual judgment is bounded in its rationality and that we can better understand decision making by explaining actual, rather than normative ("what should be done"), decision processes. While the bounded-rationality framework views individuals as attempting to make rational decisions, it acknowledges that decision makers often lack important information on the definition of the problem, the relevant criteria, and so on. Time and cost constraints limit the quantity and quality of available information. Furthermore, decision makers retain only a relatively small amount of information in their usable memory.

Finally, limitations on intelligence and perceptions constrain the ability of decision makers to accurately "calculate " the optimal choice from the information that is available. Together, these limitations prevent decision makers from making the optimal decisions assumed by the The Bounds of Rationality o 5 rational model. The irrational decisions that result typically reflect a reliance on intuitive biases that overlook the full range of possible consequences. Decision makers will forego the best solution in favor of one that is acceptable or reasonable.

That is, decision makers satisfie. Rather than examining all possible alternatives, they simply search until they find a solution that meets a certain acceptable level of performance. The field of decision making can be loosely divided into two parts: the study of prescriptive models and the study of descriptive models. Prescriptive decision scientists develop methods for making optimal decisions. For example, they might suggest a mathematical model to help a decision maker act more rationally. Descriptive decision researchers consider the bounded ways in which decisions are actually made.

Why use a descriptive approach when a prescriptive approach should lead to an optimal decision? My answer is that there is plenty of good advice available, and yet most people do not follow it. Why not? Because we fall victim to a variety of predictable errors that not only destroy our intuition, but also hinder our tendency to implement good advice. We need to understand these mistakes before moving on to wiser decision strategies.

Although the concepts of bounded rationality and are important in showing that judgment deviates from rationality, they do not tell us how judgment will be biased. These concepts help decision makers identify situations in which they may be acting on the basis of limited information, but they do not help diagnose the specific systematic, directional biases that affect our judgment. Fifteen years after the publication of Simon's work, Tversky and Kahneman (1974) continued what he had begun. They provided critical information about specific systematic biases that influence judgment. Their work, and work that followed, led to our modern understanding of judgment. Specifically, researchers have found that people rely on a number of simplifying strategies, or rules of thumb, in making decisions.

These simplifying strategies are called heuristics. As the standard rules that implicitly direct our judgment, heuristics serve as a mechanism for coping with the complex environment surrounding our decisions. In general, heuristics are helpful, but their use can sometimes lead to severe errors. A central goal of this book is to identify and illustrate these heuristics and the biases that can result the managerial setting.

I will use examples of a variety of heuristics and biases to explain how people deviate from fully rational decision process in individual and competitive situations. Recently, Thaler (2000) has suggested that there are three categories of ways in which human beings are quasi-rational. One category is Simon's concept of bounded rationality, which was developed by Kahneman and Tversky. Second, Thaler suggests that we have bounded willpower.

That is, we tend to give greater weight to present concerns than to future concerns, leading to a variety of ways in which our temporary motivations are inconsistent with long-term interests-for example, under saving for retirement (this will be developed in Chapters 4 and 7). Finally, Thaler suggests that our self-interest is bounded; unlike the stereotypic economic actor, we care about the outcomes of others (this will be developed in Chapter 6). Overall, this book is consistent with Thaler's view of the quasi-rational decision maker, affected by bounded rationality, bounded willpower, and bounded self-interest. 6 o Chapter 1: Introduction to Managerial Decision Making INTRODUCTION TO JUDGMENTAL HEURISTICS Consider the following example: While finishing an advanced degree in computer science, Marla Bannon put together a Web-based retailing concept that many of her colleagues consider to be one of the best ever developed. Although the product is great, Marla has far less skill in marketing her ideas, so she decides to hire a marketing MBA with experience in Web-based environments to formalize the business plan she will use to approach venture capitalists.

Marla follows the heuristic of limiting her search to new MBAs from the top six management schools. How would you evaluate Bannon's strategy? If we evaluate this strategy in terms of the degree to which it follows the rational model outlined earlier, Bannon's heuristic of limiting her search to six schools will be deficient, because her search will not be complete. Her heuristic may eliminate the best possible candidates from consideration if they do not attend one of the top schools.

However, the heuristic also has some benefits. While it could eliminate the best choice, the expected time savings of focusing on only six schools may outweigh any potential loss resulting fromBannon's limited search strategy. For this reason, this job search heuristic could produce more good decisions than bad ones. In fact, economists would argue that individuals use heuristics such as this because the benefit of time saved often outweighs the costs of any potential reduction in the quality of the decision. Heuristics provide time-pressured managers and other professionals with a simple way of dealing with a complex world, usually producing correct or partially correct judgments. In addition, it may be inevitable that humans will adopt some way of simplifying decisions.

The only drawback of these heuristics is that individuals frequently are unaware that they rely on them. Unfortunately, the misapplication of heuristics to inappropriate situations leads people astray. When managers become aware of the potential adverse impact of using heuristics, they will be able to decide when and where to use the mand, if it is to their advantage, eliminate certain cognitive repertoire. People use a variety of types of heuristics. The poker player follows the heuristic " never play for an inside straight". The mortgage banker follows the heuristic "only spend 35 percent of your income on housing".

Although an understanding of these specific heuristics is important to the poker player and mortgage banker, our concern in this book is with more general cognitive heuristics that affect virtually all individuals. Thus, the heuristics described next are not specific to particular individuals; rather, research has shown that they can be applied across the population. The three general heuristics that we will focus on are (1) the availability heuristic, (2) the representativeness heuristic, and (3) anchoring and adjustment. The Availability Heuristic People assess the frequency, probability, or likely causes of an event by the degree to which instances or occurrences of that event are readily "available" in memory Introduction to Judgmental Heuristics o 7 (Tversky and Kahneman, 1973). An event that evokes emotions and is vivid, easily imagined, and specific will be more available than an event that is unemotional in nature, bland, difficult to imagine, or vague. For example, a subordinate who works in close proximity to the manager's office will receive a more critical performance evaluation at year-end than a worker who sits down the hall, since the manager will be more aware of the nearby subordinate's errors.

Similarly, a product manager will base her assessment of the probability of a new product's success on her recollection of the successes and failures of similar products in the recent past. Peter Lynch, the former director of Fidelity's Magellan Fund (one of the two largest mutual funds), argues in favor of buying stock in firms that are unavailable in the minds of most investors (for example, due to their blandness) because the more available the stock is, the more overvalued it will be. The availability heuristic can be a very useful managerial decision-making strategy, since instances of events of greater frequency are generally revealed more easily in our minds than less frequent events. Consequently, this heuristic will often lead to accurate judgment.

This heuristic is fallible, however, because the availability of information is also affected by factors unrelated to the objective frequency of the judged event. These irrelevant factors can inappropriately influence an event's immediate perceptual salience, the vividness with which it is revealed, or the ease with which it is imagined. The Representativeness Heuristic When making a judgment about an individual (or object or event), people tend to look for traits an individual may have that correspond with previously formed stereotypes". A botanist assigns a plant to one species rather than another by using this judgment strategy", wrote Nisbett and Ross (1980, p. 7). "The plant is categorized as belonging to the species that its principal features most nearly resemble". In this case, the degree to which the unknown plant is representative of a known species of plant is the best information available to the botanist.

Managers also use the representativeness heuristic. They predict a person's performance based on an established category of persons that the focal individual represents for them. They predict the success of a new product based on the similarity of that product to past successful and unsuccessful product types. In some cases, the use of the heuristic is a good. In other cases, it leads to behavior that many of us find irrational and morally reprehensible-like discrimination.

A clear problem is that individuals tend to rely on such strategies even when information is insufficient and when better information exists with which to make an accurate judgment. Anchoring and Adjustment People make assessments by starting from an initial value and adjusting to yield a final decision. The initial value, or "anchor", may be suggested from historical precedent, from the way in which a problem is presented, or at ion. For example, managers make salary decisions by adjusting from an employee's past year's salary. In ambiguous situations, a trivial factor can have a profound effect on our decision if it serves as an anchor from which we make adjustments.

Frequently, 8 o Chapter 1: Introduction to Managerial Decision Making people will realize the unreasonableness of the anchor (for example, "the other firm was paying her only $22,000 a year"), yet their adjustment will often remain irrationally close to this anchor. Dawes (1988) points out that after having a good meal in a restaurant, we have an unrealistically high expectation for future meals at that restaurant as a result of anchoring. (The section on regression to the mean in Chapter 2 will clarify why you might more rationally reduce your expectations in the future.) The key conclusion is that, regardless of the basis of the initial value, initial value tend to be insufficient (Slavic and Lichtenstein, 1971; Tversky and Kahneman, 1974). Thus, different initial values can yield different decisions for the same problem.

AN OUTLINE OF THINGS TO COME The main objective of this book is to improve the reader's judgment. How can the book help improve Marla Bannon's judgment? First, we must identify the errors in her intuitive judgment, making her aware of biases that are likely to affect her decision. This awareness will improve her current decision-making process and lead to more beneficial outcome. However, Lewin (1947) suggests that in order for change to occur and last over time, the individual must do more than simply be aware of imperfections. For change to be successful, Lewin argues, it is necessary to (1) get the individual to "unfreeze" existing decision-making processes, (2) provide the content necessary for change, and (3) create the conditions that "refreeze" new processes, thus making the change part of the manager's standard repertoire.

This book will attempt to unfreeze your present decision-making processes by demonstrating how your judgment systematically deviates from rationality. You will also be given tools to allow you to change your decision-making processes. Finally, the book will discuss methods that you can use to refreeze your thinking to ensure that the changes will last. Nisbett and Ross (1980, pp. xi-xii) write: One of philosophy's oldest paradoxes is the apparent contradiction between the greatest triumphs and the dramatic failures of the human mind. The same organism that routinely solves inferential problems too subtle and complex for the mightiest computers often makes errors in the simplest of judgments about everyday events. The errors, moreover, often seem traceable to violations of the same inferential rules that underlie people's most impressive successes...

How can any creature skilled enough to build and maintain complex organizations, or sophisticated enough to appreciate the nuances of social intercourse, be foolish enough to mouth racist cliche's or spill its lifeblood in pointless wars? While Nisbett and Ross refer to the general population, the essence of their question defines a fascinating issue for the field of managerial effectiveness. This book views managers as intelligent employees who have been generally successful, but whose decisions are biased in ways that seriously compromise their potential. The reader will see how habit forces us into a set of hard-to-break heuristics, imposing constraints on our decision-making effectiveness. An Outline of Things to Come o 9 Before individuals can change their decision-making processes, they must be convinced that elements of their cognitive repertoire could use improvement-that is, the unfreezing process must occur. The reader might ask, "Why should I change my existing decision-making processes when I've been so successful throughout my managerial career?" In response to this very appropriate question, I include a number of experiential decision-making items that encourage the reader to personally identify with the biases that are discussed.

In presenting this material to MBA and executive students in a classroom setting, I have found that many individuals are initially offended by being "tricked" by an "ivory-tower" academic. It might be helpful to clarify at the outset that my intention is not to insult the reader, but to help identify and communicate biases that generally affect human judgment. Perhaps one reason for my personal interest in this material lies in my discomfort with the fact that many of these "evil" biases affect my own personal judgment. Chapters 2 through 7 focus on individual decision making. In these chapters, little attention is given to the fact that many managerial decisions are made in conjunction with other individuals.

Instead, the focus is simply on how individuals approach decisions. Chapters 8 and 9 reexamine judgment in the context of negotiation. Chapter 10 summarizes the book's arguments and focuses on how to incorporate the changes suggested throughout into the reader's decision-making processes. Specifically, the remaining chapters will focus on the following: Chapter 2.

This chapter identifies and illustrates a series of specific biases that affect the judgment of virtually all managers. These biases are caused by the three heuristics described in this chapter. Quiz items and short scenarios demonstrate these biases and emphasize their prevalence. Chapter 3.

Most management students are formally taught about the concept of risk in a microeconomics or statistics course. These courses typically treat risk from prescriptive perspective, by suggesting rational methods for making decisions involving risk. This chapter expands on this approach by examining the psychological factors that explain how managers deviate from "rationality" in responding to uncertainty. Chapter 4. Are there biases that are created by the self-serving motivations of individuals, rather than by purely cognitive mistakes?

This chapter complements the presentation of cognitive biases in Chapters 1, 2, 3, and 5 with an overview of "motivated biases". Chapter 5. There is much evidence that managerial decision makers who commit themselves to a particular course of action may make subsequent in order to justify their previous commitment. This chapter examines the research evidence and psychological explanations for this behavior. We will see how escalation has a significant effect in a variety of managerial domains, including new product development, bank loans, and performance appraisal. Chapter 6.

When do people care about fairness? When will individuals outcomes in order to maintain fairness? This chapter examines how we think about fairness and explores inconsistencies in our assessments of fairness. 10 o Chapter 1: Introduction to Managerial Decision Making Chapter 7. Perhaps the research area that has been most influenced by decision research has been behavioral finance. In the last decade, we have learned a great deal about the mistakes that investors commonly make.

This chapter will explore these mistakes and apply the messages of the book to help readers become wiser investors. Chapter 8. This chapter outlines a framework to help the reader think about two-party negotiations. The focus is on how you can make decisions to maximize the joint gain available in a two-party decision-making situation, while simultaneously thinking about how to obtain as much of that joint gain as possible for yourself. Chapter 9.

This chapter looks at the judgmental mistakes we make in negotiations. The resulting framework shows how consumers, managers, salespersons, and society as a whole can benefit simultaneously by de biasing their negotiations. Chapter 10. The final chapter evaluates five explicit strategies for improving judgment: (1) acquiring expertise, (2) de biasing, (3) taking an outside view, (4) using linear models, and (5) adjusting intuitive predictions. This chapter will teach you how to use the information in this book to create permanent improvements in your future decisions..