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.  

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