Naremon Thepchai Theatre production of Arthur Miller's 'Death of a Salesman', 1971(Source: Wikimedia Commons)|
Ideas for Leaders #423

Do Your Managers’ Responses to Market Results Damage Profits?

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Key Concept

Self-serving biases can lead managers to make less than optimal decisions when faced with poor results. This can hurt profits as their biases lead to the wrong quality and price responses to market results. However, forward looking executives can take steps to pre-emptively counter those biases when they make their initial price and quality improvement decisions.

Idea Summary

Many managers believe that quality is something that they as managers and decision-makers can control. Quality is internal and stable, unlike prices, which are subject to changing market conditions. Although prices are set internally, of course, these outside market pressures effectively, in the view of managers, take price decisions out of their hands (for example, one recent study showed that 95% of managers in Europe blamed irresponsible actions by their rivals for price competition).

This disparate view of quality and price helps to explain manager reactions to either positive or negative results. Managers, as with most people, tend to think well of themselves. As a result, when results are positive, managers will gravitate to the explanation that makes them look the best: the quality of the product. In the face of negative results, however, self-serving managers will be quick to blame the factor over which they believe they have little or no control: prices.

Following up on these self-serving explanations, managers respond accordingly. In response to positive market results, they ratchet up the factor that they believe contributed to these results: they will push for higher quality. The reverse is true: in response to negative market outcomes, managers will respond by lowering prices since, in their minds, the root cause of the poor outcome lies in the price structure.

The bias of self-serving managers can hurt a firm’s profitability. Rather than looking at the true cause of poor market outcomes (perhaps, for example, it was the greater quality of a rival’s product that explains its success), the managers default to self-serving explanations, whether they are accurate or not.

Business Application

What can companies do to eliminate the negative impact of manager biases?

First, it’s important to differentiate between managers and a firm’s senior executives or ‘principals’. Managers will make short-term adjustments in response to market outcomes; principals make the long-term price and quality decisions.

Researchers also differentiate between myopic principals, who do not foresee the actions of their managers in response to market outcomes, and forward-looking principals who anticipate these biased actions.

A simplified timeline helps explain the difference between the two types of principals. The timeline begins with principals making quality and price improvements, which lead to certain results in a first period. Managers then make adjustments based on those results, which lead to the results for the second period.

Myopic principals don’t anticipate that the managers’ adjustments are based on self-serving biased opinions about quality and price and not on the actual situation. The result is less-than-optimal adjustments and lower profits in the end.

Forward-looking principals anticipate the biased reactions of the managers. As a result, they deliberately skew the results. Specifically, if they believe that their own companies might have low quality-price margins (known as type L firms), they will initially implement higher than necessary price and quality improvement. If they consider their firm to have high quality-price margins (known as type H firms), they will initially implement higher than necessary quality improvement but lower than necessary prices.

In other words, forward-looking principals take into account the anticipated response to managers in the second period when they set their pricing and quality levels in the first period.

Managerial self-serving bias can lead managers to make less than optimal decisions when faced with poor results. Executives can take pre-emptive measures to counterbalance those decisions when they make their initial price and quality improvement decisions.

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Authors

Institutions

Source

Idea conceived

  • May 2013

Idea posted

  • August 2014

DOI number

10.13007/423

Subject

Real Time Analytics