1 Business System Analysis & Decision Making - Lecture 7 Zhangxi Lin ISQS 5340 July 2006

2 Chapter 5: The Nonrational Escalation of Commitment The Unilateral Escalation Paradigm The Competitive Escalation Paradigm Why Does Escalation Occur? Integration

3 Situations You bought a mutual fund two years ago. Your financial advisor told you that this is a safe mutual fund with good potentials. In last year it grew 2% and this year it remains almost the same level even other alternative choices of mutual funds have grown more than 10% in the last year. Are you going to keep it because it may be time for this fund to grow, or you are to sell it? You have been sitting in front of a slot machine for an hour and you have plus in two $20 bills, and now the balance is less than $2. This was a good machine as you played last time. You know slot machines are sometimes making gamblers happy though most time do not. Now it could be the hunch time or it will continue to devour another $40. Are you going to change a new machine?

4 The Unilateral Escalation Paradigm The mechanism underlying escalation is self- justification. Groups are less likely than individuals to escalate commitment.. However, it a group does, it tends to do so to a greater degree. It is difficult to separate initial decision from related future decisions. Our decisions tend to be biased by our past actions. There is a natural tendency to escalate commitment, particularly after receiving negative feedback.

5 The Competitive Escalation Paradigm – Company Acquisition The case of company acquiring Company C worth of $1.2billion to A or B If A acquires C, B will lose $0.5 billion, and vise versa. If A and B compete, both will lose $0.5 billion $1.1b (0, 0) No $1.2b $1.3b No $1.7b (0.1, -0.5)(-0.5, 0) $1.6b (-0.5, -0.4) (-0.5, -0.5) AAA B

6 The Competitive Escalation Paradigm The difference between the cases of competition escalation and unilateral escalation Using a game theoretic model we can study the final outcome with certainty for the competition escalation case. We fall under the escalation because of bounded rationality. In the case of USAir acquisition case, AA and United did a good job by not taking any action to the offer. There is some uncertainty in the unilateral escalation case.

7 Why Does Escalation Occur? Perceptual biases We pay more attention to confirming that disconfirming information. We need to search for more disconfirming information to make right decisions. Establish monitoring system Judgmental biases Risk averse to positively framed problems and risk seeking for negatively framed problems Need to access the new decision from a neutral reference point Impression Management We tend to provide confirming information to others and try to appear consistent to others. Competitive Irrationality If the final outcome is certain, check it before do it.

8 Chapter 6: Fairness in Decision Making Two cases Salary of an MBA graduate Building material price raise after a hurricane Outline of the chapter When do we accept the role of supply and demand? The influence of ultimatums Concern for the outcomes of others

9 When do we accept the role of supply and demand? Case 1: Salary cut/increase Case 2: Raising price for the popular model of car The problem of the perception of unfairness of the price: negative effect on future business Individuals are very concerned with departure from the status quo – fairness judgments affect the behavior of others

10 The influence of ultimatums Case: splitting $5,000 between Mark and you Mark makes the offer You make the offer How to forecast the outcome in order to make a feasible offer? A smaller share of a larger pie vs. a larger share of a much smaller pie For Discussion You got an excellent business idea and invite your friend Mark to be the partner. Mark is an IT guru and should be qualified as a CTO. This will complement your knowledge as you are only good in marketing and creating new ideas. Since Mark has been layoff for three months you believe this will be a good opportunity to Mark. Regarding the shares of the company ownership, you believe you hold 80% of the share and Mark will take 20% because 1) you created this opportunity, 2) you will do a lot managerial work and take more risk, and 3) Mark will be better off than his current status. How will Mark consider this opportunity? What will be his judgment of fairness?

11 How to share the award among your team members? Your team has been awarded $20,000 for the excellent performance in last year in conducting an important project for your company. The project will last for another two years. You are asked to split this money among your teammates. How will you split it? Evenly or not evenly? You, as the team leader, has contributed a lot to the success of the project. Should you allocate more to yourself? You got 3 coupons for a one-week vacation in Hawaii. While there are 5 members in your team, how will you handle this? Texas Tech University allocated 2% salary raise for BA faculties in 2007 academic year. How should this be allocated further too 80 faculty members? See Ocean’s Eleven

12 Concern for the outcomes of others People make comparisons of salary within a firm and to other firms in the industry, not across industry. A common question: Who is happier, a person living in a wealthy country with more inequality and a person living in a poor country with much better equality? Kathy is a PhD student in a Finnish university. She is from China. She is in the market now. She is facing two choices: Stay in Finland with a teaching job paid 50,000 euro/year. This is the market salary level in Finland. Work for Nokia Beijing with a salary of 55,000 euro/year, while her peer Finnish colleagues make 80,000 euro/year, the latter taking into the account of compensation working abroad. The Nokia HR manager told her since she is a Chinese and she may not get the extra compensation. Also living cost in Beijing is much lower than that in Finland. Which choice should she take?