Please read Thinking, Fast and Slow by Daniel Kahneman, a psychologist and winner of the Nobel Prize in Economics. Kahneman has played a principal role in the development of Prospect Theory, which has changed our understanding of how real people make decisions, including decisions about investing in prospective innovation. One of the key components of Prospect Theory is that decision makers weight outcomes in a manner that is at odds with what we might consider strictly rational behavior.
For example, consider the following, staightforward relationship between underlying probability (on the x axis) and decision weights (on the y axis):
The preceding simply suggests that decisions are weighted according to the underlying probabilities of possible outcomes. In this Homo Economicus scenario, the expected value of a $1,000 payoff that has a 50% chance of occuring is $500. Furthermore, given the same potential payoff of $1,000, an increase in the probability from 50% to 60% increases the expected value of the bet by $100.
In the context of new product development, for instance, Homo Economicus perceives value in proportion to a reduction in uncertainty. Presumably, he would be willing to pay for marginal increases in the probability of a desired outcome such as revenue growth.
Prospect Theory, however, suggests that people aren't strictly rational. Our typical behavior reflects these general patterns:
- We tend to over-weight very low probabilities, which helps explain why people play the lottery. For example, the odds of winning the Montana Lottery Wild Card 2 jackpot is 1:1,359,288 per play. Two plays costs $1, and the jackpot as of the date of this post was $125,000. The expected payoff from a $1 bet, therefore is $125,000 x 2 x 1:1,359,288 - $1 = -$0.82. Homo Economicus wouldn't make that bet, but we humans do it all the time.
- We tend to under-weight near-certain probabilities. Let's say that there is a 95% chance that you will receive a $1,000 payoff tomorrow. Alternatively, you can receive a certain payment today. Homo Economicus wouldn't expect any less than $950. Humans, however, will, on average, accept less today for certain than the expected (but uncertain) value of $950 tomorrow.
- We tend not to discriminate among intermediate levels of probability. We humans can be overly sensitive to best case and worst case scenarios. However, we can be amazingly insensitive to in-between cases. If the underlying probability of a successful outcome were increased from 50% to 60%, a human, in contrast to Homo Economicus above, isn't likely to make the attribution of a 10% increase in value to the opportunity.
The preceding observations are reflected in the following S-shaped curve:
The preceding elements of Prospect Theory have a number of implications regarding innovation:
- Inventors who have little to lose but much to gain from the adoption of a candidate technology tend to over-estimate the likelihood of success and, consequently, will over-value their invention.
- Profitable companies who perceive the risk of loss (e.g. of brand reputation) tend to be risk averse. Consequently, they will often under-value promising, but still uncertain, concepts.
- Entrepreneurs who help resolve uncertainty (i.e. increase probability) tread dangerous ground: even a significant increase in probability to anything less than certainty may not result in a proportionate increase in perceived value. On the other hand, resolving uncertainty through the development of prototypes, market trials, etc. can be quite expensive. The risk of over-investment (from the narrow perspective of the entrepreneur), therefore, is significant.
As a Principal of Evergreen Innovation Partners, I've seen the above play out time and time again. The fast, intuitive thinking in which we humans engage doesn't always serve us well in the context of innovation. We exaggerate long odds, under-value near-certainty, and fail to assess intermediate probabilities and marginal increases in value with sufficient finesse. Over time, we engage in such behaviors to our collective disadvantage.