Costing Uncertainty

This week’s blog is based on a discussion I had with my spouse recently while booking a vacation. It touches on an important negotiation principle: valuing or costing uncertainty. Most labour negotiations involve some degree of uncertainty. The future state of the economy, the performance of the business and labour market conditions all provide sources of uncertainty that impact a negotiation.

Valuing Vacation

In the case of my spouse and I, we were talking about the cost difference between buying a vacation that would have a rescheduling fee (a firm booking) and one that was fully refundable (a flex booking). The cost of the flex booking would add $25 each for our family of four, and we would need to sacrifice a $50 credit once we arrived. If we booked firm and then needed to change our reservation the cost would be a $100 penalty for each of our four family members. If we had to cancel outright, the cost would be the full $1000 deposit. The vacation is eight months away and a lot can happen in eight months, so initially both my wife and I saw the problem like this:



Of course we wanted the flexibility and to avoid the $400 penalty! We have vacationed with this company before, so a full cancellation seemed like a remote possibility. But our first glance did not really consider how likely we were to need the flexibility provided by the smaller extra payment. In order to find the value of the option in a simple set it is best to work backwards to calculate a point of loss probability.

Cost of flex if selected = 4*25 + 50 = $150

Cost of firm if changed = $400

Cost of firm if cancelled = $1000

As I previously mentioned, an outright cancellation is a remote possibility, so I will set that aside for now. For our costing uncertainty problem we are left with two options to compare: a fixed $150 cost or a chance of a $400 dollar cost. The economically pure way to handle this is to simply divide the known cost of $150 by the chance cost of $400. The point of loss probability is 37.5%. If the chance of needing to reschedule the vacation is less than 37.5%, we should skip the extra cost and roll the dice. If it is over, then we would be wise to pay the definite cost of $150.

Evaluating the Chances

In Thinking fast, Thinking Slow Daniel Kahneman recalls a litany of study that support the haphazard nature of predictions, especially predictions that involve knowledge of a distant future state. In the example above, the eight months before the vacation put a lot of uncertainty into the equation. A feeling or conjured estimate of how likely I am to cancel is probably me really answering a simpler question like how badly do I want to go. These questions may be useful before booking but do little to help with the prediction.

Start with Base Lines

Since conjuring a best guess is a demonstrably terrible way to predict something, how can you arrive at a chance of something happening? The best way is to start with the base line and adjust from there. Simply put: your experience is likely to be average and even if it is not, you should still start from there.

Look Backwards

One of the best ways to modify the average is to look at what happened to you in the past. In my case, of all the family vacations we have ever taken, we have never wanted or needed to reschedule. My family is probably slightly less likely than average to reschedule a vacation.

In a labour contracts this looking back can be an important predictor for not only evaluating the chances of something happening but also can be a powerful tool of persuasion. Proposals that deal with conflicts that happened during the term of the last agreement will be seen as more important and the perceived value will be higher. Due to the psychological trap of recency, things that happened most recently will also be seen to be more important.

Look for an Algorithm

Formulating a decision rule for pressing vacation delaying items is probably not worth the effort. However if I formulated a list of delaying criteria (inflexible job demands, likelihood of having a new baby, degree of uncertainty about the vacation) and ranked the likelihood of each one and used the total score, it would likely be a more accurate way to predict the chances of needing to reschedule.

Think About Probability as a Range

The safest way to estimate a possibility is to consider the range of possibilities. When you are negotiating, considering means forecasting and deciding. Forecasting and deciding are two distinct steps. Lets look at the last table again:

Here the forecast is for a chance of rescheduling from 10% to 50%. This forecast includes the costing of different chances. If we were perfect rational actors or if the principals who we are negotiating for are perfectly rational, decision wouldn’t be needed. We would only need math. We and our principals are human, so a decision is required.

When paired with the range of costs for different points in that range, negotiators need to decide where they are comfortable. For me, with this, I was comfortable with risking a larger less likely loss figuring my chance of cancelation was less than 37.5% and I could stomach the $400 dollar loss if I was wrong. What is remarkable is that both my perfect econ self and my semi economical self led me to opposite conclusions of my initial read on the situation. This is due to the fundamental failure of the automatic way of thinking that Kahneman called system 1. Even better thinking becomes clouded when the numbers are close: at a cost of $40 for the flexible option, it would be harder to say no even if I projected my likelihood of changing plans at 5%. This uneconomical commitment would be made because losses hurt more than gains. This is called loss aversion.

Let’s talk about Loss Aversion

https://www.youtube.com/watch?v=HVNGJpoSuk8

When we talk about how to value things it is important to realize that in negotiation we are talking about the value to each of the parties in the negotiation. This difference in value helps the parties develop a zone of potential agreement. The parties leverage the sum of each of the items in a value to make it work for each of them. As in the case in nearly all negotiations, it is helpful to understand some psychology when trying to figure out how your other may value the deal, so you can structure a deal they will find desirable and provide you with maximum benefit.

Loss aversion is the human tendency to want to protect oneself from loss. An average person will work harder to protect themself from a loss of $100 than they would work to earn $100 dollars. This aversion has been demonstrated in the classroom, where student were told they started the term with 100% and lose marks for imperfect work out performed students who needed to earn their marks from zero.

Interestingly loss aversion also applies to shorter term games where people will generally make uneconomical choices. Consider a game where I would give you $42 or I would give you $100 if a coin toss lands on heads. Most people will pick the $42. Because if they flip and lose they will feel the loss of the $42 dollars more severely than the loss of the chance at $58 more dollars. The value of the coin toss is $100/2. It is the economically superior option that is virtually never selected. Framing proposals as a protection from loss and more specifics will be captured in a future blog post.

If you use this method to help in a negotiation, leave a comment and let me know how it went. Also please let me know if you have a different way of valuing uncertainty in the comments.

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