The Psychology of Outsourcing, Part 10: Daniel Kahneman – Bridging Economics and Psychology

I’ll close this 10-part series with a bang: a Nobel Laureate in economics who also happens to be a psychologist, Daniel Kahneman.

Kahneman, a professor emeritus of Psychology at Princeton University, questioned the assumption of rationality behind the decision-making process and the “cognitive traps” that make it virtually impossible to think clearly about happiness and success.

He received the 2002 Nobel Prize in economic science for integrating insights from his psychological research into economic science, essentially “laying the foundation for a new field of research.” His main findings concern judgment and decision-making under uncertainty, where he showed how human decisions can depart from those predicted by standard economic theory.

He and his colleague Amos Tversky (who died in 1996) countered assumptions of traditional economic theory—that people make rational choices based on their self-interest—by showing that people frequently fail to fully analyze situations where they must make complex judgments. Instead, people often make decisions using rules of thumb rather than rational analysis, and they base those decisions on factors economists traditionally don’t consider, such as fairness, past events and aversion to loss.

For example, they found that people’s decisions can be swayed by how a given situation is framed. When Kahneman and Tversky asked people to hypothetically decide what procedure to take to cure a disease, most preferred a procedure that saved 80 percent of people to one that killed 20 percent.

They developed an economic model—called prospect theory—to better explain analogous economic behavior that’s difficult to account for with traditional models, such as why there are large, seemingly unprovoked fluctuations in the stock market.

Kahneman is especially powerful when he talks about decision-making by organizations. He says organizations should think of decisions like any other product, and apply quality controls. Too often they don’t do this. In a 2008 video interview with McKinsey he asked, “Are the talents of the people that surround the decision-making utilized effectively? In many cases the answer is no.” That’s because there is an “enormous amount of resistance to improving the quality of the decision making process—people feel threatened.”

Vested Outsourcing’s 10 Ailments that can disrupt or destroy an outsource relationship are similar to the “cognitive traps” that Kahneman talks about. Two that quickly come to mind are the Junkyard Dog Factor (Ailment 4) and Sandbagging (Ailment 6).

Outsource decisions in today’s volatile global economic climate are indeed highly complex and uncertain, especially where one side or the other acts with self-interest, inflexibility and/or incomplete knowledge of the business. Irrational or at least ineffective behavior—and outcomes!—is almost guaranteed in those instances.

We have all probably seen irrational behavior and decisions in outsourcing agreements. Kahneman demonstrated to economists that people can and do make irrational, rather than rational, decisions based on self-interest. Thanks to Kahneman’s integration of psychology and economics, we know more about how and why that happens and what it takes to avoid irrationality. One way is the Vested approach.

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