Behavioral Economics at the Workplace - Part 1

Behavioral Economics is the science of how humans and not ‘econs’ (people who are only driven by economic logic) make decisions. Over the last couple of decades, the behavioral economists with their best-selling books like Thinking Fast and Slow, Nudge, Predictably Irrational, Misbehaving, Influence and many more have infused the key concepts of the subject into everyday conversations. Understanding behavioral economics has far reaching implications on we evolve our workplace as Human Resource Professionals.

In this two part series, I explore four common workplace scenarios through the lens of concepts from behavioral economics.

1. Internal Job Postings through the lens of Prospect Theory and Endowment Effects:

One of the core propositions of Prospect theory[1] is that people are far more aggrieved at losses and far less happier at gains, even when the quantum of loss and gain utility is the same. This loss aversion is a primary driving factor behind many decisions that we take. Endowment Effect derives from prospect theory and suggests that people overvalue things they own, regardless of their market value.

Look at a common challenge that many organizations face – how to get more employees apply for Internal Job Postings, particularly from a business line/ geography/function with higher status to lower status. Let’s understand the payoffs from the perspective of the employee and the manager. For the employee, there is a gain in the newer experiences which a challenging role can provide, which is weighed against the loss of familiar peers and managers. ?Generally, it is uncertain as to whether the move will ensure that the employee is really considered for promotions, or better roles in the future. At the same time, the experienced loss is high – like leaving a stable set-up, secure variable compensation, goodwill in the existing environment and more. For the manager too, the potential gain in releasing a trained employee to another role is minimal, but the loss is large – it may take a long time to acquire and train a good resource, and may lead to more workload for the manager or his team in the interim.

Alternative - This payoff structure can be changed in a few ways.

For the system to work, the potential gain for the employee must be made stronger through organization policies like – ensuring that all candidates due for promotion have multi—function / BU experience and minimizing any financial loss by standardizing or protecting variable payouts. These make it easier for employees to view the choice with a higher upside and protected downside, making the decision easier.

Senior leadership can make facilitating job rotations as a key expectation from their managers, and provide recognition for those who enable this. Additionally, the loss for the manager can lowered by defining and running standard processes which minimizes training time needed for a new employee and keeping a pool of pre-identified talent or buffer manpower for replacements.

Organizations who effectively manage job rotations also separate the responsibilities of hiring and filling positions with the head of departments, and training and grooming the employees with the middle managers. This means that managers have limited freedom to hire their own team, but instead are expected to work with team members allotted to them, which in turn also makes it easier for them to accept team movements. In comparison, when managers hire team members themselves, the perceived value of the existing employee is over-estimated due to endowment effect, which then makes team releases far more psychologically challenging.

2. Organizational Budgeting through the lens of Mental Accounting:

Another interesting concept is fixed buckets in mental accounting, where the mind allocates a certain budget of money or time for certain activities, and then treats them as being far less fungible across buckets. This is commonly deployed in personal finance, where individuals may have specific budgets for specific expenses. Often leads people to take on higher credit card debt shopping even when they have a large home or education loan to pay, or buying expensive gasoline when prices fall, even while trying to meet the food budget[2] .

This concept can often elicit wry smiles from middle managers who can recount countless tales where there were budget cuts in one part of the business, but excessive spending (or so they thought) in other parts of the business. Sometimes this is seen in manpower allocation where one part of the business goes through lay-offs while another part sees aggressive hiring. It could also happen in technology funding in one part of the organization, without investment in other inter-dependent parts. I remember a perplexed plant head once asking - 'how can one reduce repairs and maintenance expenses for machinery which is 20 years old - apart from not repairing the machinery, which would mean production losses'? It was a situation of an overheads reduction exercise without understanding past context. At times, function specific heuristics creep up like ‘sales brings revenues and hence never be downsized’, or ‘it is okay to reduce learning budgets, but recruitment is critical for business to continue’ or ‘the plant teams need to be adequate manned, but finance and HR teams should be rightsized’ and so on. Another common one is a fixed % increase over last year, which works great in regular times, but can lead to confusion and heartburn if there were any exceptional mitigating circumstances, or if the future outlook expected is different.

Alternative: Countering fixed buckets in mental accounting in a critical skill that leaders learn to master. The first step counter faulty mental budgeting is often by viewing data in a larger perspective - and bringing in past and future contexts and linking it back to strategic choices.

Another technique is to club similar categories of expenses across functional budgets or looking at the broader or narrower cuts of the numbers. This data can be tricky to find, particularly in larger, more siloed systems.

Often, one needs to balance between absolute and percentage values of increases or cuts, to counter unreasonable asks like cutting 10% of overheads budget, when 80% of overheads is manpower costs! Finally, sometimes the opportunity cost can be highlighted – simply telling a leader to choose version 12 of the annual budget by explaining that the additional savings from version 13 would be much lower than the team’s time and effort required to create it!

Concluding Thoughts:

Dan Ariely famously remarked that – “wouldn’t economics make much more sense if it were based on how people actually behave, instead of how they should behave?”. Replace economics with human resources, and the statement continues to make sense, doesn't it?

More coming in Part II.

Note - A version of this article was published in Kaustubham, 2021, the Human Resource Management Journal from TISS.

References :-

[1] https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/prospect-theory/

[2] https://ideas.repec.org/p/nbr/nberwo/18248.html