Friday, February 8, 2008

Gains, Losses and Reference Points

I think no academic research has more relevance to mediation than Prospect Theory. If a mediator is sensitve to the principal tenets of Prospect Theory, there is a far greater chance that the mediator can convert party intransigence into movement towards settlement.

Falling under the general rubric of Behavioral Economics and developed by Nobel Prize winning psychologists and economists such as Daniel Kahneman, Amos Tversky and Richard Thaler, Prospect Theory examines what really concerns and motivates people who make real life decisions under conditions of risk or uncertainty...such as whether to settle a conflict. Prospect Theory's single most important surprise to me, as a mediator, is that parties are not really concerned with the actual end result of any decision. To a greater extent, parties care about the subjective value that they perceive that result to have, and this subjective value is determined by whether the end result is perceived to be a gain or loss.

Here's the rub....the same end result can be perceived to be a gain or a loss, depending upon the party's reference point.

At the risk of oversimplication, Prospect Theory holds, with relevance to mediation, that when people evaluate risky prospects, value is not assessed in the abstract based upon some end result but rather in terms of whether there has been a gain or loss relative to some reference point, and losses loom larger than corresponding gains such that there is risk seeking in trying to avoid losses and risk aversion in trying to achieve gains.

Risk aversion with respect to gains and risk seeking with respect to losses can be illustrated by the following problems posed to two different groups of subjects.

Problem 1. You are given $1,000. You are now asked to choose between A: 50% chance of winning $1,000 (and 50% chance of winning nothing), or B: a certain win of $500. 86% of the subjects chose B, the certain gain of $500 over the 50% chance to win $1,000, although the probablistic value of each choice is the same, an end result of $1,500.

Problem 2. You are given $2,000. You are now asked to choose between C: 50% chance of losing $1,000 (and 50% chance of losing nothing), or D: a certain loss of $500. 69% of the subjects chose C, the 50% chance to lose nothing over the certain loss of $500, although the probabilistic value of each choice is the same, an end result of $1,500.

So, the end results A, B, C and D each had equivalent end results (probabilistic value of ending with $1,500), but their respective perceived values are different, depending upon whether a loss or gain is entertained. Of course, whether a loss or gain is entertained depends upon the subject's reference point.

This example from Prospect Theory is relevant to mediators on many levels. First, a mediator has to be sensitive in the settlement of a conflict to exchanges of value between parties; the value being lost is more dear than the value being gained, even where the parties agree that the end result is appropriate. A corollary to this concept is that in any offer and counteroffer scenario, the party increasing an offer to pay the other party (and thereby incur an out of pocket loss), views that loss as being more valuable, a greater concession, than a decision by the other party to reduce its ask by a comparable amount (and thereby forgo a comparable gain). In effect, a $100 climb uphill is harder than a $100 slide downhill.

On a deeper level, though, I believe that many parties in conflict cling to their ex ante expectations prior to conflict, which is a different reference point than they find themselves in settlement ex post the conflict, so that even gains when measured from the reference point of conflict are in fact viewed by parties as losses when measured from the reference point of expectation held prior to conflict.

Especially when parties are negotiating a settlement in the shadow of litigation, a plaintiff's best alternative to a negotiated settlement (BATNA) is measured by the probabilistic return the plaintiff expects from litigation. In litigation, the plaintiff is seeking to be restored to its position ex ante the conflict, or to be placed in the position the plaintiff would have been in had the defendant performed, by being awarded damages equal to the benefit of the plaintiff's bargain. Any settlement offer made ex post the conflict, when measured from the ex ante reference point of what the party expects the court will award (which may be an unrealistically high value), is a loss, even though that offer is a gain when viewed from the reference point of the settlement conference room.

In such a situation, a mediator can try to bring a party back to the reference point of the settlement discussion, a reference point that is ex post the conflict, by engaging in reality testing and going over all of the risks and transaction costs of litigation, and by contrasting this with the quick and certain gain offered through settlement. But in so doing, the mediator will have to be patient, knowing that the party must make the Janus-faced decision of perceiving the gain, rather than perceiving the loss.

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