Wednesday, May 23, 2012

The Power of Anchoring and Rate Negotiation

Quick. A bat and a ball cost $1.10 together. The bat costs $1.00 more than the ball. How much does the ball cost?

Come on, come on.

Hurry up, answer.

Was your answer that the ball costs $0.10? That answer is wrong. If the ball cost $0.10 and the bat cost $1.00 more (i.e. $1.10), then together they would cost $1.20. For the bat and the ball to cost $1.10 together, the ball has to cost $0.05. (Did that just blow your mind?)

Don’t worry, I didn’t get it right either. Even years after I first heard this test, every time I hear it I still have to stop and work out mentally why this is. Getting it wrong doesn’t reflect badly on your intelligence, just on your condition as a hairless ape. Faced with a similar problem, Stephen Jay Gould wrote that even after knowing the correct answer, “a little homunculus in my head continues to jump up and down, shouting at me” the wrong answer. It is just that deceptively simple arithmetical exercises like this are done by the intuitive, quick-thinking part of your brain. If the problem used less round or larger numbers, you would be less likely to go wrong. Because then you would mobilize the more sophisticated—but lazier—part of your brain that makes more complex mathematical calculations.

The preceding brain teaser is an ingenious demonstration of cognitive biases (or malfunctions) that are built into our brains. The slower, lazier System 2 that lumbers along slowly to make calculations is a very recent product of evolution. Most of the time, our System 1 is in charge, which we share with other animals. It is quick, unreflective and superficial, because its main job is to flee predators and find food.

I’m reading Daniel Kahneman’s Thinking, Fast and Slow, an introduction by the Nobel-winning psychologist into the study of the systematic mental biases that dominate a significant part of our interaction with the world. Together with fellow Israeli psychologist Amos Tversky, Kahneman revolutionized the field of economics five decades ago by turning the idea of rational choice on its head.

One of the main quirks of the brain that these academics discovered is the phenomenon of anchoring. In experiments, it has been demonstrated that people who have been shown arbitrary numbers are influenced to use these numbers in making subsequent calculations that have absolutely nothing to do with the original number.

One example: a group of people see a wheel of fortune with numbers being spun. It always lands on 65. Then they are asked what percentage of the countries in the UN is African. On average, they respond 45%. A different group that is shown a wheel that always lands on 15 respond on average 25% to the same question. This means that even numbers which people know are random have an impact on their subsequent mental calculations. This anchoring effect has been demonstrated over and over in many different contexts. Some are funny: MBA students are told to recite their college ID number and it has an effect on different estimates they are asked to make. Others are more chilling: Judges are told to roll two dice and then sentence people for a misdemeanor. Systematically, the judges who rolled low numbers sentenced people to a couple of months, while higher rolls corresponded to sentences of seven months or more.

Leaving aside the disturbing aspects of our irrationality, it makes sense to exploit the phenomenon of anchoring when negotiating rates. Regardless of whether your initial rate is accepted or not, your opening proposal will act as an anchor on a negotiation. Moreover, regardless of where you start the negotiation, your counterpart will be keen on achieving a reduction. Conclusion: never start with the minimum at which you would do the project. Start at a high rate, because the client may ask for a reduction (and perhaps even need it psychologically). Give yourself leeway to reduce the rate a little in case you have to drop it a little to give the other person the illusion that he or she is a savvy negotiator. The use of anchoring is win-win. If you have to lower your original high bid, you still get to work at a rate that is acceptable to you, and the other party feels satisfied after having obtained a “discount.” If your original high offer is accepted, you get to work at a rate that is more than satisfactory for you. 

Miguel Llorens is a freelance financial translator based in Madrid who works from Spanish into English. He is specialized in equity research, economics, accounting, and investment strategy. He has worked as a translator for Goldman Sachs, the US Government's Open Source Center, and H.B.O. International, as well as many small-and-medium-sized brokerages and asset management companies operating in SpainTo contact him, visit his website and write to the address listed there. Feel free to join his LinkedIn network or to follow him on Twitter.


Gueibor said...

You might not be entirely aware of it, but I believe this is the exact point where you earn the right to produce all your subsequent posts in Yodaspeak.
I mean, by now I had come to expect clairvoyant-style insights from you, not to mention the awesome reading tips, but man... freaking Jedi mind tricks?
You're taking this to a whole new level.

Miguel Llorens M. said...

For your assiduous reading thank you, young master. Unfortunately, claim to be a Jedi I cannot. Forget one cannot that to play Jedi mind tricks to be a Jedi first one needs.