Home > Alex, Uncategorized > The Allais paradox – Part 2

The Allais paradox – Part 2

Last week we introduced the Allais paradox, a decision problem in which the majority of people select mutually exclusive choices, thus highlighting irrationalities in human decision-making. Several experimental results suggest that humans try to avoid losses more than they seek gains, prefer certainty to uncertainty, place too much emphasis on the small probabilities and less weight on the larger ones. These behavioural patterns do not apply to every single individual, but are mere generalisations gained via the experimental evidence. What does this mean to the business world?

Frequently, it means that in certain situations where risk is desirable, managers seek to minimize it as to not suffer any consequences of failure. For example, actions that are done on repetitive basis, such as setting the budget, are very prone to “this specific situation syndrome”, i.e. they take each budget individually, not as a combination. As a consequence they try to minimize their chances of running over budget and thus inflate it, but in the long run (say 10 years) a greater level of risk is desirable for the organisation. That is because even if in 2-3 years budget was underestimated, in the other 7-8 years more resources were freed to cover the consequences of those overruns. You might say that no manager would stay in the same work place for 10 years and do the same sort of budget decisions, but this is about generalised behavioural trends and different people in the same position might do the same. What’s more as a senior executive with 10 managers reporting to you, you should actually want such a level of risk that 2-3 managers do run over budget, but those overruns should be compensated by the other 7-8 who did not. If all 10 managers did not go over budget, it likely means that your budget targets are such that resources are frozen, but could have been used more productively.

So why do we tend to punish budget overruns again?

Alex

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