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Irrational people produce irrational contracts

June 4, 2013

There is a small, but growing, understanding that improving the performance of  trading relationships depends not only on a sense of economics, but also greater understanding of psychology.

I have frequently made the point that today’s contracts and relationships would benefit from more effective economic analysis. In particular, I have urged increased use of behavioural assessment. For example,  liquidated damages, or onerous indemnity clauses, or unbalanced performance measures are terms which often undermine the results we are seeking. We structure and negotiate agreements without stopping to think what behaviors they will induce.

Further evidence of the importance of psychology in decision-making comes from an article in The Financial Times ((June 1st, ‘Beware the irrational side of your inner self’). While this focuses on investment decisions, many of the observations carry over into the world of contracts – which are, in essence, a form of investment. Apparently there is a growing science of ‘behavioural finance’, led by psychologists who have plenty of evidence that ‘we are far from rational when we invest’. Decisions are distorted by in-built biases and prejudices, which result in limited reflection or analysis.

The psychologists refer to the massive influence of ‘framing’ (which I am pleased to say receives substantial attention in the IACCM learning program). For example, we are innately attracted to high potential gains and tend, when these are on offer, to downplay the potential scale or probability of loss (an observation reflected in ICCPM’s work ‘A Conspiracy of Optimism’). On the other hand, human behaviour is generally risk-averse when there is a high degree of uncertainty. For example, if we are asked to gamble $100 with a 50/50 chance of doubling our money, most will reject the offer. However, our willingness to gamble again soars once we have actually lost $100 (and merely have the hope of recovering it).

Even brief examples such as these illustrate the tensions within organizations when they are considering contracts and the value of trading relationships. We have those who are seeing high potential gains and ‘framing’ accordingly. Groups like Sales inevitably see things this way, since they have bonuses to win, with little if any downside  from a poor decision. There is evidence that business executives fall into the same trap, especially for large deals. On the other side, we have groups such as contract management and Legal ‘who assign less weight to opportunities that are merely probable in favour of those where outcomes are certain’. Since every deal has a degree of uncertainty, our inclination is to focus on protection, even though we may be increasing the chances of failure. We are skeptical and resistant to new techniques. For example, ‘relational contracting’ can be used both to improve partner selection – thereby reducing the initial uncertainty – and to increase the quality of governance – leading to a higher probability of success.

A final point of interest is that the behavioural scientists observe how rare it is for organizations and individuals to learn from past experience. This again reflects an issue observed from IACCM research. Few organizations seek to undertake portfolio analysis. They do not look at contract performance in a holistic way, to see what patterns emerge.  In fact, there is a tendency to insist that every deal, every relationship is different and therefore offers no meaningful insight to what might happen in future contracts. That way, we maximize on-going uncertainty and continue to justify our in-built prejudices and biases.

So the real challenge seems to be that even when we identify solutions that can lead to better contracts and more productive trading relationships, how do we get anyone to listen?

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