The Next Discpline Applied Behavioral Economics PDF
The Next Discpline Applied Behavioral Economics PDF
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The Next Discipline
“Applied behavioral economics is the mathematical description of the role human nature plays in just about . . . everything.”
— Jim Clifton, CEO, Gallup
For years business leaders have struggled to com- human nature by recognizing that people simply are
prehend the apparent irrationality of employee and not the rational maximizers of economic gain assumed
customer behavior and the impact it has on business by classical economic theory. Instead, employees and
performance. To make sense of how employees and customers must be seen as people first, and employ-
customers behave, leaders must first begin to under- ees and customers second. That means they are subject
stand human nature and accept that human beings to all the inherent contradictions, flaws, and emotions
do not always act in rational ways. In today’s hyper- that come with being human.
competitive global business environment, the secret to
driving higher levels of growth and profitability lies in
Gallup research revealed that a study
understanding the powerful role human nature plays in
group of 10 companies that applied these
the marketplace and in the workplace.
principles outperformed peers by 85% in
Fortunately, there is an emerging management disci- sales growth and more than 25% in gross
pline based on principles of behavioral economics that margin during a recent one-year period.
can help business leaders and executives make sense
of the economic behavior of real people and serve as
Quirks in the System
a platform for effective management solutions. This
is because behavioral economics complements tradi- Economics has traveled a long — and not particularly
tional economic theory by filling in the gaps left by the easy — road to arrive at the emerging science of behav-
realities of human nature. As a result, it can provide ioral economics. Early on and throughout much of its
business leaders with insights they otherwise would not history, classical economics has embraced the rational-
have and solutions they never would have considered. agent model that characterizes Homo economicus, the
figurative species of human, as a rational and dispas-
Gallup research revealed that a study group of 10
sionate maximizer of economic gain. This view holds
companies that applied these principles outperformed
that people make economic decisions based on a cool
peers by 85% in sales growth and more than 25% in
and rational evaluation of all of the available evidence
gross margin during a recent one-year period. The key
— the benefits of a certain course of action weighed
to achieving this kind of financial performance is for
against its costs — before arriving at a decision. The
leaders to accept and work with human nature rather
right decision is the one that maximizes an individual’s
than against it. They must abandon outmoded views of
economic gain and minimizes his or her costs.
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But there are quirks in the system that we need to
take into account — situations in which real people’s Our emotional, cognitive, and
behavior does not conform to predictions of classical perceptual processes place limits on
economics. These “anomalies” make it all the more sur- how rationally we can view the world
prising that the core assumption of the rational-agent around us. . . . These limits have a
model has not changed much in the past 250 years in profound effect on the decisions we
spite of a mountain of evidence illustrating its flaws. make — and subsequently on the way
For example, people often use simple, efficient rules of organizations need to think about how
thumb called heuristics — what Financial Times col- their employees and customers make
umnist John Authers calls “mental short-cuts that help decisions and ultimately behave.
[people] survive in the hurly-burly of normal life” — to
make decisions, such as the tendency to overestimate
Other anomalies in human decision making have
the likelihood of an event based on how typical the
been documented, such as the endowment effect — first
event is. This often occurs in situations where people
documented by economist Richard Thaler — whereby
must estimate probabilities. For example, people will
people place greater value on objects they own com-
routinely guess that someone who wears tweed jackets
pared with objects they do not own. That is, people
and is described as shy and bookish is more likely to
tend to demand a higher price to part with an object
be a classics professor than a truck driver, even though
they already own than they would be willing to pay
there are substantially more truck drivers than classics
to buy it from someone else. Another is the tendency
professors in the world.
for human decision makers to be loss averse. That is,
Or there is the simulation heuristic — the tendency to people feel more pain from losses than pleasure from
estimate the likelihood of an event actually occurring gains of equal size. For example, individuals tend to
based on how easy it is to imagine it happening. For be reluctant to accept the prospect of a 50-50 chance
example, you will be much more angry and frustrated if of gaining or losing money unless the amount to be
you missed a flight by five minutes than if you missed gained is at least twice the amount to potentially
it by an hour because it is easier to imagine a scenario be lost.
in which you could have made the flight.
Literally dozens of these heuristics and biases have
been documented in the cognitive and social psycho-
logical literature and behavioral economics literature
— far too many to describe here. But the upshot is that
our emotional, cognitive, and perceptual processes place
limits on how rationally we can view the world around
us and use the information we receive from it. These
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limits have a profound effect on the decisions we make Gallup, applied behavioral economics is the mathe-
— and subsequently on the way organizations need to matical description of the role human nature plays in
think about how their employees and customers make just about . . . everything. This definition spans the full
decisions and ultimately behave. spectrum of issues from how customers and employ-
ees create real growth for organizations to how citizens
What Is Behavioral Economics?
and institutions build stable and viable societies.
For the past 30 years, behavioral economics — led by such
No matter which definition you prefer, it is clear that
notable scientists as Daniel Kahneman, Robert Shiller,
behavioral economics is now coming of age and exerting
Richard Thaler, Angus Deaton, George Loewenstein, and
an impact in a wide variety of spheres, including pub-
many others — has documented many of the flaws in
lic policy and healthcare. For example, a recent study of
classical economic theory by challenging its foundational
radiologists found that attaching a patient’s photograph
premise — that individuals will always behave rationally
to his or her medical file elicited a more personal, empa-
to achieve the best possible outcome. Instead, behavioral
thetic response from the radiologist, resulting in longer,
economics emphasizes the role of psychology and the
more thorough reports containing summaries, additional
interplay among rational, perceptual, and emotional pro-
recommendations, and more incidental findings than
cesses in human decision making and economic behavior.
a typical report. Within the public policy sphere, new
In fact, some have suggested that economic decision mak-
applications of behavioral economics principles can be
ing is up to 70% emotional and 30% rational.
found in the Obama administration’s economic plans
and senior appointments.
Behavioral economics challenges Now that many within academics and government have
the central premise of classical begun to recognize the need for a more comprehensive
economic theory — that individuals
(and we would argue, accurate) perspective on human
will always behave rationally to
economic behavior, it is time for business leaders — espe-
achieve the best possible outcome.
cially those charged with understanding and managing
customer and employee experiences — to do the same.
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behavior that regard human beings as dispassionate With this in mind, we contend that relying solely on
brokers of objective information. traditional financial metrics as indicators of organi-
zational health is problematic for two reasons. First,
neoclassical economics suggests that sales, profit, and
At Gallup, our goal is to take the the like are leading indicators of how well an organi-
discoveries made within the academic zation is doing and will do. However, they are, in fact,
discipline of behavioral economics trailing indicators — by the time the sale is made and
and apply them to management the profit shows up on the income statement, it is far
and business problems.
too late to do anything about it. These indicators sim-
ply cannot address the issue of what caused a given
level of performance in the first place. Second, any
Evolving Our “Institutions of Data”
incremental benefits of accounting or other financial
Driving higher levels of growth and profitability in efficiencies have largely already been realized. Further
today’s business environment requires not only that substantial gains in performance based on attention to
organizations develop a mastery of applied behavioral neoclassical economic metrics are relatively unlikely,
economics, but also that they put the right perfor- and additional enhancements offer little in the way of
mance metrics in place. Not surprisingly, there has been competitive advantage for most firms.
an evolution in what constitutes the “right” institu-
The next wave of metrics to emerge were tied to process
tions of data to manage our businesses. Until recently,
improvement and quality management — Six Sigma,
capitalism has been guided by neoclassical economics.
lean manufacturing, and Total Quality Management,
This institution of data — stock price, earnings per
for example. They worked well to improve output qual-
share, profit, and growth — is what business leaders all
ity and wring inefficiencies and costs out of business
trained upon to steer their organizations, divisions, and
processes, making organizations more efficient, effec-
departments — and to some extent, it served global
tive, productive, and profitable. Although mastering
business leaders quite well. Although these kinds of
this second discipline also continues to be a prerequi-
financial measures continue to be mainstay indicators
site to driving higher levels of financial performance
of organizational performance, developments in the
in today’s economic environment, the same concerns
global economy and the financial markets since the
that apply to using financial metrics as indicators of
beginning of 2008 have underscored the limitations of
organizational health also apply to those that focus on
neoclassical economic theory. It is becoming clear that
process improvement and quality management.
neoclassical economics — in isolation of developments
in other fields such as networks and complex interac- Like financial metrics, much of the benefit of focusing on
tions, psychology, and econometrics — may have led us process and quality metrics now tends to be maxed out and
down the wrong path. the big gains harder to find. While quality is necessary and
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declining quality is likely to be a leading indicator of future powerful linkages to financial performance outcomes.
declines in company performance, improvements in qual- These leading indicators, in turn, can help managers and
ity are no longer likely to provide a significant competitive executives take corrective action before declines in finan-
advantage for most companies. Likewise, for many organi- cial performance occur.
zations, incremental improvements in operational efficiency
Deploying the right kind of metrics is a necessary first
may continue to provide some cost-reduction benefits, but
step. The next step is to build a human capital manage-
in our view they, too, will yield little in the way of additional
ment strategy around the effects of human nature on
competitive advantage.
performance. This is achieved by identifying the innate
talents of current and prospective employees and posi-
tioning them in the roles that maximize their greatest
For many organizations, incremental
strengths (the ability to consistently provide near-per-
improvements in operational efficiency
may continue to provide some cost- fect performance in a specific task). This strategy allows
reduction benefits, but in our view your organization to build a solid emotional infrastruc-
they, too, will yield little in the way of ture based on the human nature of your employees to
additional competitive advantage. enable consistent and sustained high performance.
We believe that the next big institution of data will be Our work with organizations around the globe has
found in developing new sets of leadership initiatives led us to the conclusion that every company has an
and metrics around behavioral economics, because the enormous — but largely untapped — potential for
gains to be found are much larger than in any other area breakthrough improvements in employee productivity,
and because this potential is largely untapped. Mastery customer retention, and real growth and profitability
of this third discipline — applied behavioral econom- by understanding and leveraging how human nature
ics — holds the promise of realizing breakthrough drives business performance. This unrealized potential
improvements in employee productivity, customer reten- represents an internal economy with its own unique set
tion, and real growth and profitability. But precisely how of rules and dynamics — an emotional economy —
should insights from behavioral economics be applied that can be measured and managed to improve business
in business? Metrics based on the application of behav- performance. Most importantly, the emotional economy
emotionally engage your employees and your customers Before organizations can harness the power of applied
— provide true leading indicators of future financial per- behavioral economics, they must build an institutional
formance, indicators that have demonstrated direct and capability of understanding how the emotional economy
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works in their organization and in the larger market- 4. There is vast variation in both employee
place. Next, they must align their business processes and and customer engagement from location to
location and team to team within the same
key performance metrics with this capability to fully
organization.
leverage the insights afforded by a behavioral econom-
ics perspective. Finally, they must deploy these insights 5. The ability to engage employees depends on
identifying the unique strengths they bring
effectively to manage and optimize their employee and
to their roles, selecting and positioning them
Figure 1 for success by ensuring their strengths fit their
roles, and providing them with an engaging
workplace and manager.
If we were to summarize the key observations from our who are rationally satisfied. Emotionally satisfied custom-
work with organizations around the world, it would ers have a strong emotional attachment to the organization
look like this: while rationally satisfied customers do not. Our research
reveals that emotionally satisfied customers deliver signifi-
1. Customer behavior is influenced more by
cantly enhanced value to an organization, for example, by
emotion than reason, and these emotional
dimensions can be measured and managed. buying more products, spending more for those products,
returning more often, and staying longer with the business.
2. Employees have a tremendous impact on
Rationally satisfied customers, on the other hand, behave
customers’ emotional engagement, for good or ill.
no differently than customers who are dissatisfied.
3. Employee behavior is influenced more by
emotion than reason, and these emotional This pattern is not limited to customer satisfaction
dimensions can be measured and managed. responses; in fact, we see the same pattern for customer
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advocacy. Findings from a large number of case stud- crucial business performance metrics, including cus-
ies suggest that customers who describe themselves tomer retention, cross-sell, share of wallet, frequency of
as strong advocates for an organization’s products or purchase, profitability, and relationship growth.
services — those who provide the highest “likelihood
The resulting work suggests that there are four key
to recommend” ratings — also fall into two distinct
dimensions, as illustrated in Figure 2, to a customer’s
groups: those who are emotional (even passionate)
emotional attachment to an organization (along with
advocates and those who are merely rational advocates.
the more rational foundational elements typically asso-
ciated with customer satisfaction). Each dimension
Emotionally satisfied customers deliver represents a specific set of activities that meet custom-
significantly enhanced value to an ers’ emotional needs.
organization . . . by buying more
The first dimension of emotional attachment is
products, spending more for those
Confidence. Is this organization trustworthy? Can its
products, returning more often, and
employees be trusted do what they say they will do
staying longer with the business.
day in and day out? Confidence is the foundation on
which higher levels of emotional attachment are built.
Emotional advocates have a strong emotional attach- But confidence alone is not enough to build long-
ment to the organization while rational advocates do term, sustainable, and emotionally connected customer
not. Our research reveals that emotional advocates — relationships. Beyond confidence lies Integrity, the
like their emotionally satisfied counterparts — deliver essential dimension of fair play. Does this organization
significantly enhanced value to an organization, buy treat me the way I deserve to be treated? If some-
significantly more products, spend significantly more thing goes awry, can I count on this organization to fix
for those products, and give a greater share of their total it quickly? The next emotional requirement is Pride, a
spending to the business. Rational advocates, on the sense of positive association and identification with the
other hand, behave no differently than customers who organization. Customers feel pride not because of what
would not recommend the organization to others. their association with an organization says to others,
but more importantly, because of what it says to them
So if these two traditional standby metrics fail to deliver
about themselves. The ultimate expression of a strong
as advertised, how can we accurately gauge customer
emotional attachment is Passion. Passionate custom-
sentiment? Taking a cue from behavioral economics,
ers describe their relationship with the organization as
scientists at Gallup developed a method to measure —
irreplaceable and a perfect fit. Passionate customers are
reliably and accurately — the emotional connections
customers for life and are worth their weight in gold.
between customers and the organizations that serve
them. Our research also sought to demonstrate the link- As illustrated in Figure 3, our research revealed that
ages between this measure of customer engagement and across organizations of different types, customers who
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Figure 2
Overall Satisfaction
Likelihood to Recommend
Likelihood to Continue
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Employee Behavior Is Influenced More by Figure 4
Emotion Than Reason
Employee Engagement Hierarchy
Just as engaged customers are among an organiza- Financial Outcomes
100%
tion’s most profitable patrons and passionate advocates, How can Growth
we grow?
engaged employees are an organization’s most produc-
Teamwork
tive and efficient workers. Engaged employees want Do I belong?
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There Is Vast Variation Within the bank branch, local office, or sales team — the local
Organization level where employees spend most of their time, where
customer interactions occur, and where the customer
Consider the following: An apparel retailer claims to
experience is created. Because most managers’ spheres
be an industry leader in customer satisfaction, citing
of influence are circumscribed and local, the metrics
an independent study of customers in the category.
they rely on to manage must also be focused locally.
A retail bank announces that it has won an award for
Local measurement and feedback also permit the iden-
being one of the country’s best places to work for the
tification of teams and locations that excel at managing
fifth year in a row. While each of these claims may be
their own local emotional economies. These optimized
legitimate, candid conversations with customers who
locations can provide critical guidance to the rest of
shop in the store’s different locations or visit differ-
the organization on how to manage these elements of
ent bank branches will inevitably reveal a large range
the emotional economy that are important and dif-
in the quality of the customer-employee encounter
ficult to replicate. Nonetheless, local performance
at those organizations. Within the same retailer, one
variation is a scourge to organizations that aspire to
store location may deliver exceptional service while
high performance.
another struggles to drag customers through the door.
Within the bank, some branches may be exceptional Identifying Strengths, Selection, Fit to Role,
places to work while others are oppressive. In fact, the and Great Managers
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For new employees, this means deploying a disciplined validity, we believe it fails to convey the true multi-
selection process to match prospective employees’ dimensional nature of the interdependencies among
strengths to the demands of their roles. This will employee and customer engagement and overall orga-
increase their likelihood of success and their ability to nizational financial performance.
perform at the level of excellence. For existing employ-
Employee engagement does have a direct and mea-
ees, a manager’s goal should be to use each person’s
surable relationship to — and impact on — customer
unique strengths to maximum effect, rather than trying
engagement. But the ways in which employee and
to change the things that are difficult or even impos-
customer engagement interact to enhance an organiza-
sible to change. Employees whose supervisor focuses
tion’s financial vigor are more complex than a simple
on their strengths during performance reviews are
linear chain of factors. This is because the combined
more than 2½ times as likely to be engaged as those
impact of engaging an organization’s employees and
whose supervisors focus on their weaknesses. Gallup
customers simultaneously is substantially greater
has researched this topic for more than 35 years, study-
than the effects of engaging employees or custom-
ing more than 6 million people in the process, and we
ers separately. Employee engagement and customer
have found that individuals and organizations have
engagement interact to drive even higher levels of
much more potential for growth in areas of great
financial performance. This Performance Optimization
strength than in areas of weakness. By individualizing
model (Figure 5) suggests that gains in team-level
your organization’s approach to selecting and manag-
financial performance can be driven exponentially by
ing employees and working with human nature rather
simultaneously optimizing both employee and cus-
than against it, you’ll unlock their maximum potential
tomer engagement. In fact, “optimized” teams within
and your maximum profitability.
an organization — those that are in the top 50% of
Optimize: Employee and Customer teams on both employee and customer engagement
Engagement Interact to Drive Performance
— generate a 240% boost in financial performance
Conventional views of the relationships among compared with teams that fail to engage their employ-
employee attitudes, customer requirements, and finan- ees and their customers. Furthermore, optimized teams
cial performance have emphasized their sequential also significantly outperform those that scored high on
nature. You can think of these variables as successive one but not the other of these metrics.
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Figure 5 Contact Us
70% 240%
Van Allen at 202.715.3152 or sarah_van_allen@
boost boost gallup.com.
1.0 70%
boost
Conclusion
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