Prospect Theory in Negotiation
Application of Daniel Kahneman Nobel Prize winning Economic theory in Negotiation
Prospect Theory is a heuristic model that can help in determining how the situational factors in the negotiation setting affect loss aversion and in turn impacts negotiation outcome.
All negotiation contexts have a certain element of risk involved, not only in economic terms but also in normative terms as represented by psychological biases, perspectives, and expectations from the counterpart in a negotiation setting. The central tenants of Prospect theory address this issue under conditions of risk.
Prospect theory is the seminal work of Daniel Kahneman and Amos Tversky. The theory was presented in 1979 and is the foundational theory of Behavioural Economics.
Kahneman was awarded the 2002 Nobel Memorial Prize in Economic Sciences for his avant-garde work in applying the psychological insights of judgement and decision making to Economic theory. Unfortunately, Tversky died in 1996, he was acknowledged but not awarded the Nobel Prize. Since 1974, Nobel Prizes are not awarded posthumously.
It is an alternative theory to the Utility Theory which focused on maximizing economical gains and making rational choices but had severe empirical flaws as an individual’s actual behaviour is different from the anticipated behaviour and is often not rational while making decisions in negotiation settings or bargaining.
Prospect theory states that individuals’ actual behavior is irrational as opposed to their rational behavior, in the presence of uncertainty, when making decisions.
The theory posits that negotiators tend to bring their subjective biases in negotiations when evaluating losses and gains, thereby, giving more weightage to losses as compared to gains.
For instance, a $ 10,000 single gain in a negotiation deal is more valuable than an equivalent gain of $ 20,000 initially and then losing $ 10,000 afterward. In both cases the net gain is $ 10,000 and economically rational choice according to utility theory is maximizing gains and if that was the initial aspiration point of the counterpart then he/she should be happy but prospect theory states that it is the opposite, losses are valued more and weighted far more than gains in a negotiation setting, therefore to concede before and then cut afterward, is seen unfavourably by the counterpart even if the end goal was what the counterpart desired in the first place. It is all about perspective.
Therefore, individual decision-making is based on reference points that are situation-specific based on gain or loss of money in probable terms rather than on absolute terms.
Prospect theory lies on a few assumptions.
1.Individuals give more weight to losses as compared to gains and they demonstrate a risk aversive behaviour when it comes to gains of money and is risk acceptant when avoiding losses. This is called Loss aversion.
For instance, in a bargaining deal, if there is a 100 percent chance of getting $ 10,000 and a 96 percent chance of getting $ 10,500, then individuals will choose the former choice of $ 10,000 because it is less risky and thus, safe. Conversely, if there is a 96 percent chance of losing $ 10,500 and a 100 percent chance of losing $ 10,000, then individuals will choose the former in this case and are ready to accept a bigger loss of $ 10,500 with a 96 percent probability to avoid loss. Therefore, probabilities are non-linear.
Loss aversion plays a key role in negotiation and bargaining because both parties are hesitant to make concessions as they consider their concession as losses than the gains from counterparts’ concessions. Hence, they are unlikely to reach optimal outcomes as was the case with the US-China trade war between Donald Trump and Xi Jinping’s negotiation fall out.
To offset the perceived losses, the gains must be twice as much received by the other party in terms of monetary or other non-monetary value which holds significance to the counterpart which is an unfair expectation to start with and is unlikely to reach a conflict resolution.
In line with the argument is the concept of Concession Aversion which states that if the other side offered the concession first then it must be rejected as it must be invaluable. For instance, some racist employers in the US gave Juneteenth paid holiday to employees after the George Floyd homicide case and Black Lives matter movement but black employees still boycotted the companies as they were not given the holiday before the incident.
2. The second assumption is that individuals are more likely to invest their time and money in outcomes that are certain than in probabilities in a negotiation setting. This is called the Certainty Effect.
Moreover, negotiations that are premised on gains are more likely to take a shorter amount of time than those that are premised by losses.
Trade negotiations are usually enthused by gains and hence are shorter than international peace negotiations for instance between Israel and Palestine or India, Kashmir, and Pakistan.
An example of this is a long-term trade negotiation between the United States and Japan over apples for over thirty years where the US negotiated with the Japanese government to let the US open its apple market in Japan which was only estimated to be 15 million US dollars a year. The WTO had to intervene finally, each party looked at their immediate loss and their concession and not the ultimate benefit, a perfect example of prospect theory and a failed negotiation outcome.
3. Prospect theory also relates to how people frame their problems around some reference point.
The ‘Judgmental Approach’ to negotiation framing in negotiations has a profound impact with positively framed negotiators giving more concessions, tending to be happier and more optimistic in negotiation outcomes than negatively framed negotiators.
Overconfidence in negotiation even when both parties are in the zone of possible agreement might hinder the negotiation because it will make the overconfident party make fewer concessions.
Furthermore, no theory is without limitations. Prospect theory has its drawbacks.
1.The first problem with Prospect theory is the problem of aggregation i.e. it applies to individual decision making and not to groups.
2. The second problem encountered is that it is not a theory of framing.
3. Third, there is no strategic interaction between players as in the game theory.
To overcome these cognitive biases, the Prospect theory, furnishes a few solutions.
1. To overcome the challenge of risk aversion, the party can provide the counterpart a list of options and choices where the party is willing to compromise so that an optimal solution can be reached.
2. A second option is strategic framing, also what the politicians refer to as spin, i.e. to emphasize the gains and not losses, and if losses are to be discussed then to consider it as the cost paid for the gain.
3. The third solution is the Certainty Effect which is represented via the weighting function in Prospect Theory where moderate or high probability events are underweighted, and low probability events are overweighted. For instance, in the context of international negotiations, goodwill created by mediators between countries like India and Pakistan, China and the US, Palestine and Israel, plays a huge part in building trust in negotiations by minimizing losses for each side.