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.