Thursday, October 24, 2013

Mediation and the Science of Decision Making: Conclusion

Daniel Kahneman and Amos Tversky revolutionized economics by changing the focus from hypothetical “rational actors” to real people, who frequently make bad decisions as a result of behavioral patterns and cognitive errors of which they are not aware. Learning to recognize these patterns and errors will help you be more successful in all decision-making processes and in all negotiations. And a mediator who understands these patterns and errors and how to deal with them will do a better job helping the parties resolve their cases.

Here are the links to all eleven installments of this series: 
Part I: Introduction 
Part II: People Act Rationally, Don’t They? 
Part III: People Avoid Risk When They Stand to Gain and Seek Risk When They Stand to Lose 
Part IV: People Evaluate Gains and Losses Relative to Their Reference Points 
Part V: The Greater the Loss or Gain, the Less Any Incremental Change Matters 
Part VI: People Hate Losing More Than They Love Winning. Losses Loom Larger Than Gains. 
Part VII: States of Change -- The Possibility and Certainty Effects 
Part VIII: Set Your Reference Points Before You Begin Negotiating 
Part IX: Think Like A Trader 
Part X: Shift Reference Points And Use The Endowment Effect To Close The Deal. 
Part XI: Do The Math, With Pencil And Paper.

Tuesday, September 17, 2013

Mediation and the Science of Decision Making Part XI: Do The Math, With Pencil And Paper.

We talked last time about using the endowment effect and shifting reference points to help close deals.  But how do you actually do that?  One good way is by showing the parties the numbers: "What will you gain by resolving the case?  What will you lose if you don't?" 

Some people are very good at math and can run numbers in their heads. Others require a calculator or adding machine. In any case, all of us are subject to the cognitive errors identified by Kahneman, and it can be very difficult to identify and compensate for these errors when called upon to make important decisions. 

One of the best ways to help people avoid these errors is to work through the numbers with them as they make their decisions. And because most people are not great at doing math in their heads, it helps to work through the numbers on paper, or on a white board, which is particularly good for this purpose. Putting the numbers on paper makes them more concrete, increases the likelihood that the parties will adopt them as reference points – even if they differ from their original reference points – and helps the parties evaluate them rationally, rather than emotionally. 

For example, while a party typically will evaluate a $50,000 settlement intuitively as a loss or gain relative to his existing reference points, he typically will not evaluate its expected value relative to a 50% chance of a $100,000 judgment at trial. Explaining and walking through this type of calculation makes the settlement more real, increases the likelihood that the party will adopt it as a reference point, and helps the party accept or reject it on rational, rather than emotional, grounds.  

Thursday, August 15, 2013

Mediation and the Science of Decision Making Part X: Shift Reference Points And Use The Endowment Effect To Close The Deal.

Very frequently, the parties to a negotiation will set reference points that do not overlap or allow for easy resolution. The plaintiff may have a bottom line of $200,000, while the defendant has a top dollar of $100,000. The likelihood of mutually exclusive reference points is greater in employment lawsuits, which frequently are zero-sum-games. A zero-sum-game is a situation in which the only issue to be resolved is how to allocate a limited resource, in this case money. (Some employment actions are not zero-sum-games, as where the parties will continue to be involved with each other in the future, and there may ways to “grow the pie,” rather than just dividing it.)  

In a zero-sum-game, where the parties’ reference points do not overlap, resolution is possible only if a party accepts a loss relative to his or her reference point. This "loss" may be the plaintiff accepting less than her bottom line or the defendant paying more than her top dollar. Frequently, both parties must accept such losses in order to get a deal done. As we have seen, people have a very hard time doing this. (See People Hate Losing More Than They Love Winning. Losses Loom Larger Than Gains.)  

A skilled mediator can help the parties move toward resolution by helping them shift their reference points. Shifting reference points involves what behavioral psychologist Richard Thaler dubbed the “endowment effect.” Thaler, a collaborator of Kahneman and Tversky, found that, contrary to rational choice economic theory, people frequently like to keep what they have, even when offered a fair price in exchange. This is particularly true for the things that people hold for their own use or enjoyment, things like nice bottles of wine, tickets to a sold out concert, or a coffee mug with one’s college logo on it.  

In mediation, the endowment effect comes into play when the parties begin to see themselves as already enjoying the benefits of a settlement. For the plaintiff, the benefits of settlement may include the peace of mind of not having to testify at deposition or trial or being able to pay off credit cards used for living expenses after a termination. For the defendant, the benefits may include cutting litigation expenses and being able to focus on running the business, rather than defending the litigation. 

The trick for the mediator is to help the parties see the benefits offered by resolution and then adopt those benefits as their new reference points. Once the parties accept the new reference points, they will be reluctant to give them up, making resolution more likely.  

Next time, another useful tool for closing deals: Do The Math, With Pencil And Paper.

Tuesday, July 30, 2013

Mediation and the Science of Decision Making Part IX: Think Like A Trader

Last time, we looked at one way to use behavioral economics to help our clients make better decisions in mediation by setting reference points before we begin negotiating.  Today we discuss another way to do better in any negotiation: thinking like a trader.  

Most attorneys have a great deal of experience with negotiation and may even consider themselves to be professional negotiators. (Interestingly, Kahneman and Tversky found that even professionals make the same cognitive errors as the rest of us, but we will put that aside for the moment.) 

Most parties do not have the same level of negotiation experience as their lawyers. And even if they do, the stress of litigation and mediation leaves them less capable of making rational economic decisions. Although there are benefits to long days of mediation, experienced negotiators know that 12 or 14 hours of mediation can reduce one’s ability to think clearly and make good business decisions. Especially at the end of a long day, parties need to understand the impact that cognitive errors have on them.  

Kahneman and Tversky tested ways to help people be less sensitive to these cognitive errors. They found first that professional traders in the financial markets – people who make decisions on gambles for a living – are more tolerant of losses and as a result suffer from fewer cognitive errors when making financial decisions. 

Amazingly, one simple way to help people make better decisions is to tell them to “think like a trader.” Participants in experiments become less risk averse, and their emotional reaction to loss (as measured physiologically) decreases when given this simple advice. In other words, simply asking people to “think like a trader” gives them a better framework for analyzing their choices and helps them make better, more rational decisions.   

A simple yet powerful tool that works well when it's time to close the deal. Next time, another tool for closing deals: Shifting Reference Points And Using The Endowment Effect. 

Tuesday, June 11, 2013

Mediation and the Science of Decision Making Part VIII: Set Your Reference Points Before You Begin Negotiating

We have seen that behavioral economics holds valuable insights into the way that people make decisions. Specifically, behavioral economics teaches that behavioral patterns and cognitive errors play a tremendously important, if seldom recognized, role in decision-making. 

Now we get to the fun part: learning to use behavioral economics to help our clients and ourselves make better decisions, not just in mediation, but in every negotiation.  

Lesson One: Set Your Reference Points Before You Begin Negotiating. 

Reference points are extremely important in every negotiation. They can be the key to an effective negotiation strategy, but they also can stand as an obstacle to a good settlement. Effective negotiators know how to use them to drive negotiations and to help close deals. 

In Thinking, Fast and Slow, Nobel Prize winner Daniel Kahneman explains that people frequently adopt their goals as reference points. In golf, for example, par is a reference point. A birdie (one shot under par) represents a gain, and a bogey (one shot over par) represents a loss relative to the reference point, par. 

We have seen that people dislike losing more than they like winning, and they work harder to avoid a loss than to make a gain. Economists who have studied golf (yes, there are such people) have found that professional golfers prove this point: they do far better when putting for par (avoiding a bogey, which is a loss relative to par) than when putting for birdie (making a gain over par). Whether the putt is easy or hard, at every distance from the hole, professional golfers are 3.6% more successful when putting for par than when putting for birdie. Over the course of a 72-hole tournament, this easily can be the difference between winning and losing. 

Like golfers, parties frequently set reference points prior to a negotiation. Plaintiffs in mediation frequently know the “bottom line” number below which they will not move, and defendants frequently know their “top dollar. These “walk-away” numbers become the parties reference points. A settlement that improves upon one’s reference point creates a gain; one that does not creates a loss. (It may seem strange to refer to a defendant who pays less than its top dollar as experiencing a gain, but remember that we are speaking of results relative to reference points, and even cold water can feel warm to a hand that has been sitting in a bowl of ice water.) 

Because people work harder to avoid losses than to make gains relative to their reference points, all parties should establish their reference points before they start negotiating. Plaintiffs should know their bottom line, and defendants should know their top dollar before the mediation starts. Surprisingly, many parties walk into mediation with no reference points, thinking only that they want to do “the best they can.” 

Experienced negotiators will set not only the walk-away numbers beyond which they will not move, but also goals that are better than those walk-away numbers. Parties who set “shoot-for” numbers as their reference points typically do better than those who only formulate walk-away numbers. 

For example, a defendant who decides that it will not pay more than $100,000 but has the goal of settling for $80,000 will settle for closer to $80,000 than one who only sets its top dollar number. The same goes for plaintiffs: one who establishes a shoot-for that is higher than her bottom line will recover more than one who does not. The reason for this is simple: once the party sets a shoot-for number as her reference point, she will work very hard to defend it, as anything that falls short will be seen as a loss.  

Setting one's reference points before the negotiations start is a simple strategy that will produce demonstrable results in your next mediation. 

Next time: Think Like A Trader. 

Thursday, May 23, 2013

Mediation and the Science of Decision Making Part VII: States of Change -- The Possibility and Certainty Effects

Consider this. You have a chance to win $1,000. Your chances improve by 5% in each step below. Is the news equally good in each case? 
Step A: Going from 0% to 5% 
Step B: Going from 5% to 10% 
Step C: Going from 60% to 65% 
Step D: Going from 95% to 100%
The answer of course is no. Step B (going from 5% to 10%) and Step C (going from 60% to 65%)  are merely quantitative in nature, and we perceive them as representing relatively minor incremental gains. (A 65% chance feels the same as a 60% chance, doesn't it?)  

Step A, the change from 0% (no chance) to 5% (a small chance) is far more significant. It creates a possibility that did not exist before, the possibility of winning $1,000. Kahneman calls this qualitative change the “possibility effect.” He explains that it leads people to give highly unlikely events (like the 5% chance of winning $1,000 or the infinitesimally small chance of winning the lottery) greater weight than their mathematically expected value. In other words, the expected value of a 5% chance of winning $1,000 is $50 (5% x $1,000 = $50), but we experience the value as something substantially higher. Similarly for the lottery. The mathematical value of a lottery ticket is less than the $1 we pay for it, but the possibility of winning a huge sum causes many of us to ignore the mathematical reality and buy the ticket.

Step D, the change from 95% to 100%, also is qualitative. It changes the possibility of gain into a certainty. Not surprisingly, Kahneman calls this the “certainty effect.” Like the possibility effect, the certainty effect has a disproportionate impact on decision-making. People give outcomes that are almost certain (like a 95% chance of winning $1,000) less weight than they should using expected values. Thus, the expected value of a 95% chance of winning $1,000 is $950 (95% x $1,000 = $950), but we experience the value as something substantially lower. 

Don't believe it? Try this. Would you pay $925 or $940 for a 95% chance at winning $1,000? It feels too risky, doesn't it? 

(Those who are not afraid of a little math may consider this: the possibility and certainty effects are mirror images of each other. The possibility effect leads us to over-value the 5% chance of winning the $1,000. Given a 95% chance of winning, the certainty effect leads us to over-value the 5% chance that we will not win. In other words, we over-estimate the negative value of the possibility of losing. But they said there wouldn't be math in law school, so I'll move on.)  

How do the possibility and certainty effects impact parties at mediation? Consider again the examples that I gave in my first post.  

Adam has a very small chance of winning at trial, but if he does win, he could recover a substantial amount. He falls victim to the possibility effect, foregoing a reasonable settlement to chase the possibility -- no matter how small -- of a substantial recovery at trial. 

Company C makes a similar mistake. It faces a high likelihood of a very bad result at trial, but it rejects the opportunity to settle in a reasonable range before trial. Instead, it seizes on the possibility -- small though it may be -- of winning at trial.  

Both Adam and Company C make the mistake of over-valuing small possibilities. Like a person who buys a lottery ticket, These mistakes result from a combination of the possibility effect and loss aversion (discussed here).  

Also consider Denise. She accepts an offer that is relatively small, compared to the very high likelihood that she will obtain more at trial. Like Adam and Company C, she is influenced by loss aversion, but for her it is combined with the certainty effect. She gives the likelihood of a favorable result less weight than she should because it is a mere possibility, rather than the certainty that she craves. At the end of the day, she achieves certainty, but she gives up the very likely probability that she would have done better at trial. 

Now that we have seen some of the cognitive errors that affect people when they make decisions, we can turn to the question at hand: How do we use this knowledge to achieve better results in mediation?  Stay tuned.  

Monday, April 22, 2013

Mediation and the Science of Decision Making Part VI: People Hate Losing More Than They Love Winning. Losses Loom Larger Than Gains.

A third principle of Daniel Kahneman’s work, together with the idea that people evaluate losses and gains relative to their reference points (discussed here) and the idea that people have a diminishing sensitivity to losses and gains (discussed here), is the idea that losses loom larger than gains. Kahneman traces this to the evolutionary need to be alert to danger.

Remember how the body reacts to the idea of financial loss? The idea of financial loss induces the classic fight or flight response because we perceive it as a risk to our well-being. The idea of gain, however, does not induce an equal but opposite visceral reaction.  

To illustrate the idea that losses loom larger than gains, ask yourself whether you would take the following gamble on the toss of a coin: If the coin shows heads, you win $150; if it shows tails, you lose $100. Would you take the bet?  

The simple math shows that this is a good bet. You have a 50% chance of winning $150 and a 50% chance of losing $100, so the expected value of the gamble is $25.  Here are the numbers : (50% x +$150) + (50% x -$100) = $75 - $50 = $25. 

Despite the math, most people would reject this gamble. You probably felt this yourself when you considered the gamble, and it made you feel nervous. In fact, most people require a potential gain of more than two times the potential loss in order to accept the gamble. In other words, I would have to offer you $200 or more to get you to accept a 50% chance of winning $100.  In mixed gambles – that is, situations in which both gains and losses are possible – this imbalance causes people to make extremely risk-averse choices. 

Consider a typical business dispute. Each party is making a claim against the other, so each party faces both the possibility of gain and the possibility of loss. The science suggests that both are likely to be relatively risk averse and make more conservative decisions. 

(As you read this, did you think of a notable business lawsuit in which the parties seemed to show no desire to avoid risk? The Bratz dolls case came to my mind as I wrote it. If you had a similar thought, you likely concluded that the science is wrong on this point about mixed gambles. Your reaction is a function of what Kahneman calls "associative memory," a powerful source of cognitive errors that Kahneman discusses at length, but that will have to wait for another day.) 

In contrast to the typical business law suit, in most employment actions, only the employee has claims against the employer. Further, the law typically allows a successful employer to recover its attorney fees in limited situations, if at all. Because the employee typically does not face this type of potential loss, the typical employment law case is not a mixed gamble, and the employee may feel free to make decisions that entail greater risk. 

However, as we will see next time, even an employee in this type of litigation will be influenced by the risk of loss.