How much would you be willing to pay for a $20 bill? Seriously. How much?
In my strategy class, I hold up a crisp $20 bill and ask students: How much would you be willing to pay for this $20 bill? I then bet them I can get one, if not several of them, to pay more than $20 for the bill. I explain that I will auction the $20 bill to the highest bidder, then add that the second highest bidder will also pay me. The bidding begins low and slow, but quickly progresses to more than $10. Usually by this point, the bidding is between two or three students who quickly realize that they are on the hook for more than they are willing to lose. It is then that the bidding accelerates to $20 and beyond. I stop the auction and face a usually stunned classroom. “How the #$%@ did that just happen?”
This exercise demonstrates some fundamental business principles. First, the decision to pay more than $20 for the bill reflects escalation of commitment. But, why does this happen? For one, people have a natural desire to consider costs already incurred i.e., sunk costs. The hope is that such costs will be recovered if the action continues. Another cause is that people often overestimate their ability to control the future, thus giving them the “illusion of control.” Other reasons include a preference for completion and resolution, the tendency to believe that you are the only one that sees an error in judgment, and some personal identification with the prior commitment.
The exercise also demonstrates that winners can sometimes lose—a phenomenon behavioral economists call winner’s curse. In a competitive environment, an auction market often escalates into a bidding war that may cause the winning bidder to overpay for the item. A winner’s curse can be especially damning when the item is difficult to valuate, such as an acquisition target, a parcel of land to be developed sometime in the future, or a contract for services. Even when the value is explicitly known—$20 perhaps—the winning bidder may be the loser.
So how can these issues be avoided? In a recent article in Harvard Business Review, Freek Vermeulen and Niro Sivanathan discuss a few tactics. Agree to a set of decision rules in advance, which will keep you from acting on impulse. Encourage dissenters to speak up and protect them afterwards. Employees are more likely to challenge a course of action if they feel validated and safe. Force yourself to consider alternatives. For instance, play the “devil’s advocate” and try to convince yourself that your current course of action is wrong. Doing so will help you to see errors in judgment and avoid costly mistakes.
Assistant Professor of Management
Department of Management