Rational Decision Making

Rational Decision Making
Understanding generational differences can provide valuable insight into the perspectives that shape the behaviors
of individuals born at different periods of time. But such knowledge does not answer a more fundamental question
of interest to students of strategic management, namely, why do CEOs make bad, unethical, or other questionable
decisions with the potential to lead their firms to poor performance or firm failure? Part of the answer lies in the
method by which CEOs and other individuals make decisions. Ideally, individuals would make rational decisions
for important choices such as buying a car or house, or choosing a career or place to live. The process of rational
decision making involves problem identification, establishment and weighing of decision criteria, generation and
evaluation of alternatives, selection of the best alternative, decision implementation, and decision evaluation.
Rational Decision-Making Model
While this model provides valuable insights by providing an ideal approach by which to make decisions, there are
several problems with this model when applied to many complex decisions. First, many strategic decisions are
not presented in obvious ways, and many CEOs may not be aware their firms are having problems until it’s too
late to create a viable solution. Second, rational decision making assumes that options are clear and that a single
best solution exists. Third, rational decision making assumes no time or cost constraints. Fourth, rational decision
making assumes accurate information is available. Because of these challenges, some have joked that marriage
is one of the least rational decisions a person can make because no one can seek out and pursue every possible
alternative—even with all the online dating and social networking services in the world.
Decision Biases
In reality, decision making is not rational because there are limits on our ability to collect and process information.
Because of these limitations, Nobel Prize-winner Herbert Simon argued that we can learn more by examining
scenarios where individuals deviate from the ideal. These decision biases provide clues to why individuals such
as CEOs make decisions that in retrospect often seem very illogical—especially when they lead to actions that
damage the firm and its performance. A number of the most common biases with the potential to affect business
decision making are discussed next.
Table 10.9 Decision Biases
Nobel prize winner Herbert Simon argued that we can learn much about decision making by examining where we
deviate from ideal decisions. We summarize a number of the most common decision biases below.
Anchoring and adjustment bias occurs when individuals react to arbitrary or irrelevant numbers when setting financial or other
numerical targets.
Availability bias occurs when more readily available information is incorrectly assessed to also be more likely.
Escalation of commitment bias occurs when individuals continue on a failing course of action even after it becomes clear that this may be
a poor path to follow.
Fundamental attribution error occurs when good outcomes are attributed to personal characteristics (e.g., intelligence) but undesirable
outcomes are attributed to external circumstances (e.g., the weather).
Hindsight bias occurs when mistakes seem obvious after they have already occurred.
Judgements about correlation and causality bias occurs when individuals make inaccurate attribution about the causes of events.
Misunderstandings about sampling bias occurs when individuals draw broad conclusions from small sets of observations instead of
more reliable sources of information derived from large, randomly drawn samples.
Overconfidence bias occurs when individuals are more confident in their abilities to predict an event than logic suggests is actually
Representativeness and framing bias occurs when the way information is presented alters the decision an individual will make.
Satisficing occurs when individuals settle for the first acceptable alternative instead of seeking the best possible (optimal) decision.
Anchoring and adjustment bias occurs when individuals react to arbitrary or irrelevant numbers when setting
financial or other numerical targets. For example, it is tempting for college graduates to compare their starting
salaries at their first career job to the wages earned at jobs used to fund school. Comparisons to siblings, friends,
parents, and others with different majors are also very tempting while being generally irrelevant. Instead, research
the average starting salary for your background, experience, and other relevant characteristics to get a true gauge.
This bias could undermine firm performance if executives make decisions about the potential value of a merger or
acquisition by making comparisons to previous deals rather than based on a realistic and careful study of a move’s
profit potential (Table 10.9 “Decision Biases”).
The availability bias occurs when more readily available information is incorrectly assessed to also be more likely.
For example, research shows that most people think that auto accidents cause more deaths than stomach cancer
because auto accidents are reported more in the media than deaths by stomach cancer at a rate of more than 100
to 1. This bias could cause trouble for executives if they focus on readily available information such as their own
firm’s performance figures but fail to collect meaningful data on their competitors or industry trends that suggest
the need for a potential change in strategic direction.
The idea of “throwing good money after bad” illustrates the bias of escalation of commitment, when individuals
continue on a failing course of action even after it becomes clear that this may be a poor path to follow. This can
be regularly seen at Vegas casinos when individuals think the next coin must be more likely to hit the jackpot
at the slots. The concept of escalation of commitment was chronicled in the 1990 book Barbarians at the Gate:
The Rise and Fall of RJR Nabisco. The book follows the buyout of RJR Nabisco and the bidding war that took
place between then CEO of RJR Nabisco F. Ross Johnson and leverage buyout pioneers Henry Kravis and George
Roberts. The result of the bidding war was an extremely high sales price of the company that resulted in significant
debt for the new owners.
Providing an excellent suggestion to avoid a nonrational escalation of commitment, old school comedian
W. C. Fields once advised, “If at first you don’t succeed, try, try again. Then quit. There’s no point being a
damn fool about it.”
Wikimedia Commons – public domain.
Fundamental attribution error occurs when good outcomes are attributed to personal characteristics but
undesirable outcomes are attributed to external circumstances. Many professors lament a common scenario that,
when a student does well on a test, it’s attributed to intelligence. But when a student performs poorly, the result is
attributed to an unfair test or lack of adequate teaching based on the professor. In a similar vein, some CEOs are
quick to take credit when their firm performs well, but often attribute poor performance to external factors such
as the state of the economy.
Hindsight bias occurs when mistakes seem obvious after they have already occurred. This bias is often seen when
second-guessing failed plays on the football field and is so closely associated with watching National Football
League games on Sunday that the phrase Monday morning quarterback is a part of our business and sports
vernacular. The decline of firms such as Kodak as victims to the increasing popularity of digital cameras may
seem obvious in retrospect. It is easy to overlook the poor quality of early digital technology and to dismiss any
notion that Kodak executives had good reason not to view this new technology as a significant competitive threat
when digital cameras were first introduced to the market.
Judgments about correlation and causality can lead to problems when individuals make inaccurate attributions
about the causes of events. Three things are necessary to determine cause—or why one element affects another.
For example, understanding how marketing spending affects firm performance involves (1) correlation (do sales
increase when marketing increases), (2) temporal order (does marketing spending occur before sales increase),
and (3) ruling out other potential causes (is something else causing sales to increase: better products, more
employees, a recession, a competitor went bankrupt, etc.). The first two items can be tracked easily, but the third
is almost impossible to isolate because there are always so many changing factors. In economics, the expression
ceteris paribus (all things being equal or constant) is the basis of many economic models; unfortunately, the only
constant in reality is change. Of course, just because determining causality is difficult and often inconclusive does
not mean that firms should be slow to take strategic action. As the old business saying goes, “We know we always
waste half of our marketing budget, we just don’t know which half.”
Misunderstandings about sampling may occur when individuals draw broad conclusions from small sets of
observations instead of more reliable sources of information derived from large, randomly drawn samples. Many
CEOs have been known to make major financial decisions based on their own instincts rather than on careful
number crunching.
Overconfidence bias occurs when individuals are more confident in their abilities to predict an event than logic
suggests is actually possible. For example, two-thirds of lawyers in civil cases believe their side will emerge
victorious. But as the famed Yankees player/manager Yogi Berra once noted, “It’s hard to make predictions,
especially about the future.” Such overconfidence is common in CEOs that have had success in the past and who
often rely on their own intuition rather than on hard data and market research.
Representativeness bias occurs when managers use stereotypes of similar occurrences when making judgments or
decisions. In some cases, managers may draw from previous experiences to make good decisions when changes
in the environment occur. In other cases, representativeness can lead to discriminatory behaviors that may be both
unethical and illegal.
Framing bias occurs when the way information is presented alters the decision an individual will make. Poor
framing frequently occurs in companies because employees are often reluctant to bring bad news to CEOs. To
avoid an unpleasant message, they might be tempted to frame information in a more positive light than reality,
knowing that individuals react differently to news that a glass is half empty versus half full.
Satisficing occurs when individuals settle for the first acceptable alternative instead of seeking the best possible
(optimal) decision. While this bias might actually be desirable when others are waiting behind you at a vending
machine, research shows that CEOs commonly satisfice with major decisions such as mergers and takeovers.
Key Takeaway
• Generational differences provide powerful influences on the mind-set of employees that should be
carefully considered to effectively manage a diverse workforce. Wise managers will also be aware of
the numerous decision biases that could impede effective decision making.
1. Explain how a specific decision bias mentioned in this chapter led to poor decision making by a
2. Are there negative generational tendencies in your age group that you have worked to overcome?
Burk, B., Olsen, H., & Messerli, E. 2011, May. Navigating the generation gap in the workplace from the
perspective of Generation Y. Parks & Recreation, 35–36.
Fogg, P. 2008, July 18. When generations collide: Colleges try to prevent age-old culture clashes as four distinct
groups meet in the workplace. Education Digest, 25–30.
Rathman, V. 2011. Four generations at work. Oil & Gas, 109, 10.

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