Richard Thaler, the founding father of behavioral economics, sat in a room with 20 executives and their CEO. To each of the twenty managers, he posed the following question:
“Suppose you were offered an investment opportunity for your division that will yield one of two payoffs – 50% chance that it will make a profit of $2 million, and a 50% chance it will lose $1 million. Will you take it?”
Only 3 out of 20 executives raised their hand.
He then asked the CEO in the room how many of those bets he would take. He answered without a second thought that he would take all of them.
When Thaler asked one of the executives why he wouldn’t take the bet, he mentioned how if such a project succeeded, he might get a pat on the back and a bonus of three-months income. But if the project failed, he was liable to get fired. He rightly did not want to risk his job on the flip of a coin. The incentive structures firms have in place often prevent managers from taking worthwhile risks. No wonder so many firms struggle to innovate.
Although the financing for all the projects comes from a common pool, each executive is made to consider his or her project’s budget as its own account, and is judged as being a success or a failure based on their individual performance. In the process, the company, as a collective, loses out by not taking several good bets. This mismatch of incentives between owners and management within a company is what economists call the principal-agent problem.
A firm’s basket of projects resembles an insurance portfolio. Although some projects might end up as disasters, the firm should stand to gain on the whole. Perhaps the insurance industry can offer CEOs lessons on how to design such incentive structures.
Inspiration: Misbehaving – Richard Thaler