Wednesday, April 02, 2008

Irrational behavior

One of the cornerstones of economic thinking in recent decades has been that consumers, companies, and markets are driven by rationality. Each player acts in its own interests, and the result is to the overall benefit of all. And it mostly works.

Some economists, however, point out that not all behavior is rational. Or that behavior that is rational in one role might be irrational when a player shifts roles. This mostly comes from a school of thought called behavioral economics and popularized in the book, Freakonomics.

We can see this happening in our business in, for example, channel-stuffing. We all know that channel-stuffing makes no sense. What value is there in selling 100,000 units to a major customer who doesn’t need them? Certainly you make your numbers for this quarter, but at great cost (customers aren’t going to take units they don’t need unless you cut them a great deal), and you’ve just put yourself in a really big hole for the next quarter.

Totally irrational, right? Yes, to the supplier. But not necessarily to the employee who made the deal. His or her interests may be very different – e.g., quarterly bonuses. And the longer-term negatives might be of less interest to someone who may move along to another position or another company (with a record of meeting tough objectives).

Corporate policies in trade promotion are also sometimes not entirely rational, either. As long ago as the early nineties, I recall advising clients and readers that rather than slanting their trade promo programs entirely toward their biggest customers, they should consider taking steps to try to ensure the survival of smaller customers. A sharply diminished customer base, after all, would be likely to result in lower prices.

Totally rational: Fewer customers means increased bargaining power for those customers means lower prices. I’m not claiming to be a genius for seeing this – it was apparent to anyone watching the scene unfold. Which means that everybody did what I was suggesting, right?

Er … no. Actually, they did the exact opposite, because it was in their short-term interests to build sales the quickest, easiest way – through bigger customers.

None of which is to say that analyzing markets and making plans based on assumptions of rationality is necessarily wrong, simply that we must remember that companies are made up of people, and that people are sometimes … irrational.

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