19 Jun THE IRRATIONAL MIND

We are fast approaching FY15 and already business owners are conjuring the launch of strategic paradigms as a propellant into accelerated stratospheres of profit for the new financial year.  Leveraged buyouts, consolidations, wholesaling negotiations, value chain initiatives, technical innovations, financial restructuring, expenditure paralysis…but do we have the cognitive ability to make such acute assessments on a founded rational basis?  As business champions and self-qualified experts you would think so.  But empirical evidence may say otherwise.

An interesting article by Ross Gittins over Easter captivated my attention that cumulated from a simple quiz.  I would like to share it with you to assess your own cognitive abilities.

You’ve won a free ticket to see an Eric Clapton concert (which has no resale value).  Bob Dylan is performing on the same night and is your next best alternative activity.  Tickets to see Dylan cost $40.  On any given day you would be willing to pay $50 to see Dylan.  Assume there are no other costs of seeing either performer.

Question: What is the “opportunity cost” of seeing Clapton?  Is it $0, $10, $40 or $50?

Procuring the correct answer will exemplify your rational self-preservation.   If not, then a slight ego readjustment may need to follow suit. The answer will follow soon enough but the context is clear.  It explains that if we can’t make a simple economic assessment at a basic consumer level, what chance do we have at a technical enterprise level?  Business activities and investment decisions are an ongoing pragmatic process that spurs projected expectations about performance and qualifies the decision making matrix.  This process defines rationality.  No one in their right mind would expense $x dollars to derive a lower marginal utility if it could be applied elsewhere and attain a higher value, right?  Behavioural economics is a conundrum that policy makers, captains of industry and the consuming masses continually wrestle with and interact on a daily basis and by default by pure activity create trillion dollar GDP economies.   A 5% err on a trillion dollars is $5,000,000,000.  Would that assist in fixing our deficit?

Let’s see how we fared on the quiz above.  The opportunity cost of a decision is the value (benefit) of the next best alternative.  When you go to the Clapton concert you forgo the $50 of benefit you would have received from going to the Dylan concert.  But that is the gross benefit.  You also forgo the $40 of cost, so the net benefit you forgo is $10.  So the correct answer is $10.

This question was raised at a conference with 200 professionally qualified economists and almost 80% got the answer wrong.  More than a quarter said $50.  The next most popular answer was $40.  Many claimed $0 was the quantified answer.  Only 22% got the answer correct.

This should come as a shock as it denotes a story line of incredibility.  If some of the sharpest economic minds cannot conclude how to best allocate their limited time and money that is available to them, what hope does that give us mere mortals?

So I pose the question.  Would you be willing to expend $5,000 upfront to save $10,000 per annum for the next 10 years?  You would be surprised by the results.

Have a great weekend.