Topic : Anchoring effect

Cases:

Anchoring Expectations,

THE 3-D NEGOTITOR Anchoring Expectations It's easy to xete ol the first number put forth in o negot'ution, no matter how nrltitrtl'y it is. Here's how to leverage tll's tendency to your odvuttuge. I'I' DIVIII l. LIX III) III\" I. SEIEIIIIS rm to 'I'EIIS llt BUSINESS, Carl, a successful entrepreneur, decided to put his software-services consulting rm up for sale. Carl was unsure how much a buyer would be will- ing to pay for his company. He hoped for an offer of at least $40 million, but decided before entering negotiations that he'd settle for as little as $20 million. OmniData, a company in a related software-services sector, quickly emerged as a potential buyer. Carl was quite uncertain about the maximum OmniData would be willing to pay. Thus, while Carl knew that the zone of possible agreement (ZOPA)the set of outcomes that both he and OmniData would prefer to no agreement was bound at the lower end by $20 million, he didn't know about its upper end. OmniData engaged an invest- ment bank with signicant industry expertise as its rep- resentative in the sales negotiations with Carl and his team. The head banker opened talks by stating, \"We've made 19 acquisitions of software-services rms this year for OmniData and have paid no more than 10 to 12 times earnings, less a private company discount.\" This implied a selling price of $15 million to $18 million, well below Carl's walkaway price. The banker then pre- sented a seemingly thorough analysis of comparable in- dustry transactions that specically compared pricesf earnings (PIE) multiples and again showed a range of 10 to 12 times earnings. Carl's uncertainty about prospective bids led him to be taken off-guard by the banker's implied $15 million to $18 million anchor. He felt disappointed. His percep- tion of what was possible in the negotiation had shifted; now he sensed that the most he could get was $25 mil- lion. His perception of the ZOPA had been anchored by the investment banker's presentation. How does this an- choring occur? Cognitive psychologists have found that people system- atically assess uncertain quantities in unconsciously biased ways. In particular, we tend to irrationally xate on the rst number put forth in a negotiationthe anchorno matter how arbitrary it may be. Even when we know the anchor has limited relevance, we fail to sufficiently adjust our judgments away from it. Uncertainty is fundamental to the negotiation process. A clearer understanding of how you and others manage the unknown can keep you from making costly mistakes as a result of anchoring. Anchoring can be used defen- sively, to prevent your assessment of the ZOPA from being inuenced by extraneous information, and o'en- sively, to shape your counterpart's perceptions of the ZOPA and achieve negotiated outcomes you nd more attractive. Authoring and its 'Itlluence on negotiators Numerous studiesmany offering real monetary stakes to the subjects for supplying correct answershave shown that extraneous information can profoundly inuence our judgments in the face of uncertainty. In one of our experi- ments, we presented senior executives with a situation in which a supplier gets a one-time rush order for high-tech motorcycle headlamps from a Japanese manufacturer. The executives, taking on the role of the supplier, are asked to make the manufacturer a price offer. All of the executives receive identical sales scenarios (product, company, industry, nancial, and production data}, and all are told that the Japanese translator has been very difcult to understand and has made numerous mis- takes during the negotiation. Half of the executives are told that the translator appeared to ask for an offer in the $12 per unit range, but that when asked to clarify, he denied specifying any particular price. The other executives are told that the translator seemed to ask for an offer in the $32 per unit range, but that when asked to clarify, he de- nied mentioning any price at all In both scenarios, as they prepare to make an offer, the executives are instructed to regard the $12 or $32 suggestion as genuinely meaningless due to the translation problems. The average offer among executives who heard the meaningless $12 offer was $19.80 per unit The average offer among those who heard the meaningless $32 offer Anchoring Expeditions (continued) was $30.10. The irrelevant numbers $12 and $32 served as anchors, pulling offers in their direction. I"! POWER OF RANDOM NUMBERS In their rst experiment on anchoring, Daniel Kahne- man and Amos Tversky spun a wheel marked with in- tegers ranging from 0 to 100. Participants were asked whether they thought that the percentage of U.N. member countries that were from Africa was greater than or less than the number just spun on the wheel. They then were asked for their best estimate of the proportion in question. For one group of the subjects, the wheel stopped at 10. The vast number of these subjects said that the proportion of UN. member countries that were from Africa was more than 10%; on average, they guessed that the actual percentage was 25%. For another group of the subjects, the wheel stopped at 65. Almost all of these participants said that the proportion of the U.N. member countries that were from Africa was less than 65%. In contrast to the rst group, this group's average guess was that 45% of U.N. member countries were from Africa. The only difference between the two experimental conditions was the number on the wheel, yet the groups' best estimates differed by 20 percentage points! The number the subjects were given dramati- callHnd irrationallyanchored their assessments. Furthermore, we've found that our negotiators were typically unaware of the large effect of the meaningless offer on their price proposal. The sidebar \"The Power of Random Numbers\" on this page gives another example of how irrelevant data affects our decisions. Even negotiators with deep industry knowledge nd their assessments anchored by irrelevant data. Studies of real estate agents and German car mechanics show strong anchoring eeds when they are asked to make valuations of houses and cars, respectively. Similarly, when we asked general managers of a sports league to estimate a player's salary increase, their estimates were anchored by the com- ments of a clearly unknowledgeable sports-radio fan. How does anchoring inuence negotiated outcomes? Men you enter a negotiation, you typically don't know how the other side values its BATNA, or best alternative to a negotiated agreement, and she is typically ignorant about your walkaway point as well. As a consequence, both sides are uncertain about the ZOPA. 1When an anchor is intro- duced into the negotiation, it can shift perceptions of the ZOPA in its direction, thereby increasing the odds that any nal agreement will drift toward the anchor. The result? A nal agreement that's favorable to whomever \"dropped\" the rst anchor. Befonti'llg yoursoll ugtilsl uldlors There's no cure-all to preventyourself from beinganchored, though becoming aware of the risk and reducing uncer- tainty through preparation can help. In addition, anchoring rst makes it harder for the other side to anchor you. When the other side introduces an anchor, what should you do? You might try to diminish an anchor's impact by changing the metric under discussion. Return- ing to our opening story, Carl found himself anchored at a selling PIE multiple of 10 to 12, which implied a sale price between $15 and $18 million. At this point, he hired experts to negotiate the valuation issue on his behalf. The consultants accurately presented themselves as nan- cially sophisticated yet lacking deep knowledge of the software-services eld. Looking at the PIE multiples of comparable transactions, as the investment bank had done, would only drive the unfavorable anchor in even deeper, the consultants believed. Instead, they prepared a discounted cash-flow analysis to value Carl's company, using some fairly aggressive assumptions; this led to a valuation as a standalone company that was roughly double what OmniData had proposed. As they presented the valuation to OmniData and its investment banker, the consultants explained that, due to their limited industry expertise, they were open to persua- sion about some of the assumptions in their analysis. Soon the other side was anchored in the new metric of a stand- alone company valuation, analyzing the assumptions that went into the discounted cash-flow analysis. The tvvo par- ties began negotiating down from a high price rather than up from a low one. The transaction closed at a much higher Pf E multiple than any other in the industry in the previous two yearsbut very much in line with a more modest version of the original \"counter-analysis.\" By changing the metric from PIE multiples to stand- alone company valuation, the consultants \"unfroze\" the previously established anchor and established a new one. llsilg mars offensively There are a number of ways in which you can use anchors to your advantage in negotiation. In our July 2004 issue, Adam D. Galinsky argued in his article \"Should You Make the First Offer?\" that you should try to put an aggressive but not absurdly aggressiverst offer on the table. Be- cause anchors are especially inuential under conditions of uncertainty, the rst oer has a much bigger anchoring Anchoring Expectations (continued) effect than subsequent ones. In addition, because anchors might make a confident assertion to a potential buyer: "A shift negotiators' perceptions of the bargaining range, business broker advised us that we can sell for 25 times more aggressive offers tend to be more influential than less earnings." These assertions are not offers; they're anchors aggressive ones. that affect the other side's perceptions of the ZOPA. We agree that it is desirable to anchor first in many ne- Finally, you can also anchor by citing apparently com- gotiations, for several reasons. In negotiation, you are parable agreements as precedent. Consider the case of a trying to both learn about the ZOPA and influence the money manager preparing to negotiate her annual bonus. other side's perception of the ZOPA. While advance re- "While bonuses last year were 50% of salary," she might search can help you reduce your un- certainty about the ZOPA, you Anchors are especially tell her boss, "I recognize that this year will not be as good as last year." An- typically will have more to learn about other approach is to mention propos- the ZOPA once talks begin. As such, influential under conditions als made by more extreme elements of you will be vulnerable to being an- of uncertainty, so the first one's constituency. A prospective cus- chored. Therefore, anchoring first in price-oriented negotiations can be offer has a particularly tomer might tell a salesperson that, while he loves the product, his pur- both good offense and good defense. strong anchoring effect. chasing department is undoubtedly An overly aggressive offer, however, going to demand price cuts of 15% or risks derailing negotiations if it causes the other side to more. Such statements can have an anchoring effect with- question your credibility or to wonder whether agreement out requiring you to make an extreme offer that could is even possible. Because it is hard to know what your jeopardize talks. counterpart will view as absurd, anchoring with a rela- In our studies, we've observed that many negotiators tively inflexible, extreme offer increases the probability of successfully anchor talks by focusing not on a price or fi- reaching a stalemate. Anchoring instead with a flexible but hancial terms, but on a conception of the nature of the extreme offer gives you a lower-risk opportunity to favor- problem the negotiation is meant to resolve. We call such ably shape your counterpart's perceptions of the ZOPA. moves to define the problem meta-anchoring because they Carl's consultants, for example, prefaced their aggressive shape parties' expectations of the ZOPA at a higher level of offer by assuring OmniData that they were open to per- abstraction than any single number could. In our next ar- suasion about their assumptions, thereby making their ticle, we will take a closer look at meta-anchoring and offer more flexible. show you how to use it effectively in your negotiations. The most effective anchors further reduce risk because, rather than placing firm offers on the table, they merely in- David A. Lax, formerly a member of the Harvard Business School fac- troduce relevant numbers. A job applicant may state his ulty, is a principal of Lax Sebenius LLC. James K. Sebenius is the Gor- belief that people with his qualifications tend to be paid don Donaldson Professor at Harvard Business School and a member between $85,000 and $95,000 annually, or he might men- of the Executive Committee at Harvard Law School. They are co- tion that a former colleague just received an offer of authors of 3-D Negotiation: Creating and Claiming Value for the Long Term (Harvard Business School Press, forthcoming). $92,000. Similarly, someone hoping to sell her company They can be reached at negotiation@hosp.harvard.edu