Behavioral Economics

In 2002, psychologist Daniel Kahneman of Princeton University won the Nobel Prize in economics. The award was noteworthy because it was the first time a psychologist had received this prize, and because it was an acknowledgement of the growing importance of “behavioral economics.” Behavioral economics is the branch of economics that incorporates insights from psychology to explain how people make decisions.

Classic economics suggests that sales and profits are leading indicators of how well a company is doing and will do. However, they are trailing indicators: By the time the sale is made and the profit shows up on the balance sheet, it is far too late to do anything about it. Customer engagement and employee engagement are the new leadership metrics to use because they incorporate the principles of behavioral economics. They are the leading indicators that give shareholders a true picture of a company’s future performance.

In Human Sigma: Managing the Employee-Customer Encounter, John Fleming and I summarize key observations from more than 20 years of research and consulting with service economy companies. In three concise points, these observations are:

• Customer behavior is highly emotional, and these emotions can be managed.

• Employees have a tremendous impact on customers’ emotions, for good or ill.

• Employee behavior is highly emotional, and these emotions can be managed.

We have learned that it is critical to monitor your employees and customers as closely as you would monitor your sales and profit.

Historically, economics and psychology have not gotten along well. From the earliest days, both psychology and economics have shared an interest in understanding human thought, feeling, and behavior. But for the past century or so, these disciplines have followed remarkably different paths in attaining that understanding.

The dominant model in economics asserts that people make decisions based on a dispassionate evaluation of the available evidence— i.e., the benefits of a certain course of action weighed against its costs. The right decision is the one that maximizes an individual’s economic gain and minimizes costs.

Adam Smith, the father of modern capitalism, however, suggests that human decision-making is a struggle between two opposing forces—the “rational man” and the “passions,”—i.e., that human decision-making is prone to all manner of errors and biases.

We use intuitive, emotional thinking more often than we realize. The separate systems we call “emotional” and “rational” are actually intertwined and interdependent. Neither system can exist nor function without the other, and understanding the organic underpinnings of feelings is key to understanding how and why people make decisions—and why they sometimes appear to defy logic.

Many anomalies in human decision-making have been documented. One example is the “endowment effect,” where people tend to demand a higher price to part with an object they already own than they would be willing to pay for it to begin with. The upshot of the endowment effect is that our brains place limits on how rationally we view the world around us and process the information we receive from it. The emergence of behavioral economics has been a defining development because it sheds new light on the psychological dynamics of human decision-making and how non-conscious, perceptual and emotional factors influence that process.

So if humans are driven more by their passions than their rational selves, how does this affect the tools companies use to evaluate and manage them as customers?

Most existing approaches to understanding customer requirements provide a poor perspective. As a result, it is not surprising that executives and managers continue to struggle to understand why satisfied customers defect to competitors and why authentic, organic growth remains elusive in many areas.

It is now possible to reliably monitor and react to the emotional factors that drive customer behavior and incorporate them into existing business processes. Several key discoveries have emerged that affect what companies should pay attention to when assessing the health of their customer relationships. The most basic discovery has been that customers possess a consistent set of emotional needs:

• Confidence: Can you be trusted?
• Integrity: Do you treat me the way I deserve to be treated?
• Pride: Do I want to be associated with you?
• Passion: Are you irreplaceable to me?

By fulfilling these core customer needs, any company can take advantage of the largely untapped, enormous potential for breakthrough improvements in customer retention, profitability and sustainable growth.