Mediation and the Science of Decision Making Part V: The Greater the Loss or Gain, the Less Any Incremental Change Matters

In previous posts, I've discussed the theory that individuals act rationally and the efforts of Daniel Kahneman, Amos Tversky, and others to disprove that theory. For example, as I discussed here, Kahneman and Tversky pointed out that people avoid risk when they stand to gain and seek risk when they stand to lose -- hardly rational behavior.  And as I discussed here, people evaluate losses and gains relative to their own reference points, which change over time, rather than to fixed reference points that apply equally to all.  

Another key element of Kahneman’s work is the principle of diminishing sensitivity to loss and gain.  The idea is this: the difference between a gain of $100 and a gain of $200 is $100.  The difference between a gain of $10,100 and a gain of $10,200 also is $100, but the incremental gain in the second example does not have the same impact as the incremental gain in the first.  In other words, for most people the difference between $100 and $200 is far more significant than the difference between $10,100 and $10,200.  

For example, Richard Thaler in 1980 posited that people would go out of their way to save $5 on a $25 purchase, but would not go out of their way to save $5 on a $500 purchase. Others have confirmed this in numerous studies in the years since. Kahneman and Tversky found that 68% of people would drive 20 minutes to save $5 on a $15 calculator (when they also were hypothetically buying a $125 jacket), but only 29% would do so to save $5 on a $125 calculator (and they also were hypothetically buying a $15 jacket). 

The total purchase price is $140 in each scenario, and the total savings is $5, but the human reaction is completely different.  That could not be less rational.  

Diminishing sensitivity to incremental change helps to explain the irrational risk avoiding / risk seeking behavior we discussed earlier.  Consider Denise, the salesperson who took the sure thing, even though she likely could have obtained more by taking more risk.  Part of her reason for accepting the settlement may have been her sense that the settlement offered was a large amount of money, and she would not gain dramatically from any incremental increase over and above that amount.  Her sensitivity to any potential increase diminished as her position improved. 

Diminishing sensitivity to loss also helps explain why Company C would choose to take its chances in court. When people face bad situations – for example, when they face a certain loss in settlement, as compared to a larger loss at trial that is not certain but is merely probable – diminishing sensitivity causes them to ignore the greater risk of going forward. In all likelihood, settlement is Company C's best course of action, but its diminishing sensitivity to the potentially greater loss at trial causes it to ignore that greater risk. In other words, it figures that if it is going to lose anyway, it might as well take a shot at trial, where it could lose zero, even if the odds of that outcome are relatively low.   

What all of this points to is this: the diminishing sensitivity to incremental loss and gain has a tremendous impact on the way that people make decisions. Those of us who work to help people resolve difficult situations must understand these cognitive errors in order to do the best job possible for our clients.  

Next time, we will discuss why the difference between a $10,000 loss and an $11,000 loss is much greater than the difference between $10,000 gain and an $11,000 gain:  Losses Loom Larger Than Gains. 

Words of Wisdom On the Practice of Law From Our Sixteenth President

Discourage litigation -- Persuade your neighbors to compromise whenever you can -- Point out to them how the nominal winner is often a real loser, in fees, expenses, and waste of time -- As a peace-maker, the lawyer has a superior opertunity of being a good man -- There will still be business enough --

Abraham Lincoln

Advice to Young Lawyers 

Undated

President Lincoln's hand-written notes can be seen here.  They are transcribed here.  Slate.com has an article here.  

Thank you to Carl Botterud for bringing this to my attention.  

Mediation and the Science of Decision Making Part IV: People Evaluate Gains and Losses Relative to Their Reference Points

I spoke earlier about the idea that individuals act rationally. In other words, they seek to maximize their satisfaction based on their preferences and the information available to them, in a way that changes little over time or in different contexts. One of the reasons that Daniel Kahneman won the Nobel Prize in 2002 is because he and his colleague, Amos Tversky, challenged this idea of rationality.  

For example, Kahneman and Tversky realized that -- contrary to modern economic theory -- gains and losses are not absolute. They are not perceived in the same for all people, and they are not perceived consistently over time. They change depending on one’s circumstances, or reference points. In Thinking, Fast and Slow, Kahneman illustrates this with a simple example. Hold one hand in a bowl of hot water and the other in a bowl of cold water, then put both in a bowl of room temperature water. One feels warm, the other cold. The starting (reference) point for each is different, and so is the perception of the ending point.  

Reference points play a very important role in financial situations. Consider Jack and Jill. Each has $5 million. Yesterday, Jack had $1 million, and Jill had $9 million. Classical economics holds that the $5 million has the same utility for each, and they are equally happy. But are they? Obviously not. Kahneman and Tversky, who brought human psychology to economics, recognized that Jack and Jill’s happiness depends not only on what they have, but also on what they had – their reference points. Jack is happy with his $5 million; Jill is not at all happy with hers.

This simple idea that reference points are relative and may change over time may seem obvious, but it revolutionized economic theory and it plays an extremely important role in understanding both how people make decisions in reality and how to help them make better decisions. 

In later posts, I will discuss the importance of reference points in mediation and the use of reference points to help seal the deal.  Next time: The Greater the Loss or Gain, the Less Any Additional Incremental Change Matters.

Mediation and the Science of Decision Making Part III: People Avoid Risk When They Stand to Gain and Seek Risk When They Stand to Lose

In my last post, I said that Kahneman and Tversky revolutionized economics by showing that people do not act rationally when making economic decisions. As I explained, classical economic theory predicts that people will analyze risk rationally, regardless of the circumstances.  As it turns out, people don't do this. Instead, they try to avoid risk when they stand to gain, but they seek risk when they stand to lose. 

Try this mental exercise, and you'll see what I mean.  

Which would you choose? (A) a sure gain of $750 or (B) an 80% chance of winning $1,000 and a 20% chance of winning nothing?

The rational choice theory predicts that people will choose Option B, which has the higher expected value. The expected value of an 80% chance of winning $1,000 is $800. That obviously is greater than the value of the $750 sure thing. Any rational person seeking to maximize his financial gain should choose Option B.

But if you are like most people, you chose Option A and you didn't even have to think about it. Your automatic reaction was that you would rather have the sure thing than take the gamble. If you did the math, you likely noticed that the gamble offered only an incremental gain over the sure thing, but it also left you with the possibility of getting nothing. You likely saw this and figured, “Why risk it?”

Now try this one. Which would you choose? (C) a sure loss of $750 or (D) an 80% chance of losing $1,000 and a 20% chance of losing nothing?

Here, the rational actor theory predicts that people will take the sure thing, which is more likely to minimize financial loss.  The gamble here, Option D, has an expected value of negative $800, versus the sure thing’s value of negative $750. Taking the risk here is the worse choice, rationally speaking.

But again, if you are like most people, you chose Option D, and again, you didn't even have to think about it. You had an instant and very negative reaction to the idea of losing $750. The thought actually caused a number of physical stress reactions that you probably did not notice: your pupils dilated, your heart rate increased, the hair on your arms rose slightly, and your sweat glands were activated. The gamble offered you the possibility, even if small, of owing nothing, and thinking about this possibility reduced your stress level. You decided to take your chances on the gamble, even if you realized that it was the worse option, rationally speaking.  

Put these two mental exercises together, and you see what Kahneman and Tversky found: when people stand to gain, they prefer to avoid risk; but when they stand to lose, they prefer to take risks.

If you go back to the examples that I gave in my first post, you can see that this risk-avoiding and risk-seeking behavior helps explain why Adam and Company C fail to take advantage of reasonable settlement opportunities. They have no option that leads to gain – or a sufficiently substantial gain in Adam’s case – and they choose to take the risk instead by taking their cases to trial. They do this even though they recognize that the odds of winning at trial are small, and the likelihood is that they will do worse than in a settlement.

This also helps why Denise takes a relatively low settlement offer when she likely could do better. Being in a position of likely gain, she seeks the certainty of the settlement, rather than risk everything at trial.  

Next week: Reference Points.  

Mediation and the Science of Decision Making Part II: People Act Rationally, Don’t They?

You may not have heard of Daniel Kahneman, but his work has had a tremendous impact on the way that we understand human decision making. Kahneman won the 2002 Nobel Prize in Economic Sciences for his work on this topic with Amos Tversky. (Tversky passed away in 1996, and they do not award the Nobel posthumously.) In his 2011 book, Thinking, Fast and Slow, Kahneman explains many of the factors that lead people to make the decisions that they do.

People act rationally, don’t they?

One of the pillars of modern economic theory is the idea that individuals act rationally: they seek to maximize their satisfaction based on their preferences and the information available to them, in a way that changes little over time or in different contexts. 

The “rational choice theory” holds that a person faced with a decision regarding money will choose the option that maximizes financial gain and minimizes losses. For example, given the choice between a gift of $50 and a gamble that offers a 75% chance of winning $100, a rational person should choose the gamble. The value or “expected utility” of the gamble equals the amount of the potential gain multiplied by its likelihood: in this case, the expected utility of the gamble is 75% of $100, or $75. Because the value of the gamble ($75) exceeds the value of the sure thing ($50), rational choice theory predicts that a rational person will choose the gamble. 

In the settlement context, the rational choice theory predicts that parties will evaluate their cases the same way, based on the likelihood of the anticipated outcomes. Remember Adam from last week? Although he had a weak case, he rejected a reasonable settlement offer, took his case to trial, and -- predictably -- lost. 

Adam should have evaluated his case by looking at the judgment that he was most likely to recover multiplied by the likelihood of achieving that judgment. So if he believed that he had a 10-20% chance of winning a $300,000 judgment, he should have evaluated the case as having a value of $30,000 to $60,000. If the defendant offered him a figure in this range, the rational choice theory predicts that he would accept it. 

But human beings in the real world do not make such rational decisions. Kahneman and Tversky revolutionized economics by showing that a number of behavioral patterns and cognitive errors play an important role in the way that people make decisions. Understanding these cognitive errors will improve your decision-making and your results in litigation and mediation. 

Next week, we will start looking at these cognitive errors.  

Mediation and the Science of Decision Making Part I: Introduction

Very frequently in mediation, as in life generally, we observe people making decisions that that seem irrational, overly emotional, too timid, or unnecessarily risky. Why? Why would intelligent, thoughtful, successful people take courses of action that seem to make no sense?

As it turns out, the field of behavioral economics holds a number of extremely interesting insights into these questions, as well practical lessons that we can use in mediation to help people make better decisions.

Over the next several weeks, I will post a series of short articles addressing these issues.

I'll start with some examples. As you read through them, consider whether you think these people are making the right decisions.

Adam files an action for sexual orientation discrimination and retaliation. Both sides agree that he likely has enough evidence to survive summary judgment, but serious problems with his credibility make success at trial extremely unlikely. If he can succeed, he has a possibility of recovering more than $300,000 in damages. Adam's attorneys tell the mediator in private caucus that Adam is a difficult client, and they do not want to take the case to trial. The defendant offers Adam a reasonable amount that reflects both the potential exposure and the small likelihood of such a result. Adam rejects the offer against the mediator's and his attorneys' advice, takes the case to trial, and loses.

Beth works as an executive for Company C, a mid-sized and growing company. After her termination, she files suit alleging quid pro quo sexual harassment, retaliation, and defamation. Beth has not been able to find a new job, and she has evidence that her former employer’s CEO has defamed her to potential employers. Beth has good evidence, including smoking gun emails that the company attempted to destroy. Three years after her termination, her economic damages are in the mid six figures, her emotional distress is well documented and credible, and the company and its CEO have strong financials, making substantial punitive damages a possibility. Beth's final demand at mediation is at the high end of the reasonable settlement range, with an indication of negotiation flexibility. The defendants realize that they face serious risks at trial, but they decide to take their chances, against their attorneys' advice. The jury brings back a seven-figure verdict, including punitive damages against both defendants, and the Court of Appeal affirms.

Denise is a highly-paid salesperson. She does not make policy decisions or supervise other employees. She is paid a salary plus quarterly bonuses (not commissions), and she works 15 to 20 hours of overtime per week. After she leaves the company, she brings a wage and hour claim for unpaid overtime compensation. Her attorneys calculate her unpaid wages at over $200,000. After Denise wins summary adjudication of the defendant’s exemption defenses, the parties engage in mediation. Late in the day, the defendant makes its “last, best, and final” offer of $50,000. Although Denise's attorneys feel very strongly that she will succeed at trial, and her claim (including penalties, interest, and attorney fees) now exceeds $400,000, Denise feels that the best choice is to take the sure thing and she accepts the offer.

Why would Adam and Company C reject reasonable opportunities to settle and instead take bad bets at trial? Conversely, why would Denise take a relatively low settlement figure, rather than pursuing a strong case at trial? 

Next week, we will start looking at the answers to these questions.