The Science Behind Negotiations
The human side of negotiations
We already discussed the theory of bounded rationality, which dethroned the concept of "homo economicus," making rational choices and demonstrating perfect economic behavior.
When we encountered the prospect theory, we found new explanations and insights into buyers' and sellers' behaviors, which may be helpful for any practitioner of negotiations and relationship management.
The prospect theory proves that not discounts and favors make the efficient buyer-seller relationship, but trust and value.
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Behavioral science lays the basis for negotiations.
The prospect theory by Kahneman and Tversky belongs to behavioral economics, which applies psychology to explain our choice decisions under risk.
Negotiations are a subset of such choice decisions. Therefore, science will help us understand our behavior and avoid typical mistakes and traps.
Let's start with two basic concepts of the prospect theory (so-called heuristics or mental patterns)- reference dependence and loss aversion.
Reference dependence of our decisions
We judge the outcomes of a choice not by the final state of wealth but as gains or losses defined relative to a neutral reference point.
Similarly, we evaluate the outcome of an economic transaction by comparing the final price to our reference estimate. It can be based on the last purchase price, average market price (e.g., in the housing market), or even the competing brand price adjusted to our perception of the quality difference between them.
Therefore, we judge the success of an economic transaction by gains or losses relative to the reference point.
Loss aversion
Loss aversion is the second pillar of prospect theory. It assumes that the negative effect of loss is more significant than the positive one of a comparable gain for us.
Consequently, we prefer avoiding losses to acquiring gains.
Another interesting repercussion of loss aversion is the endowment effect, which values goods we possess more than similar ones we don't.
Negotiation traps explained by the prospect theory
Some consequences of the prospect theory can be beneficial for understanding buyer's and seller's behaviors and crafting an intelligent negotiation plan.
Framing
Our decisions are influenced by how they're presented. We're more likely to accept the positively framed offer, which elaborates on associated gains, than the negatively framed one highlighting losses.
Reference point adaptation
This point relates to negotiating parties' behaviors depending on the declining or growing market.
Parties may or may not adapt their reference points to the market price movement in negotiations. This adaptation is more likely for the party to gain from the market fluctuation than to lose.
This research suggests that the reference point adaptation is twice as rapid in a growing market than in a declining market.
Therefore, homeowners in the declining market are reluctant to sell, as 61% only partially adapt their reference, and 14% are not adapting and measure the loss against the initial buying price.
Perhaps we must consider appropriately adapting our reference to either gain or loss upon market changes. Otherwise, we risk being stuck in the limbo of ever-growing "disutility," i.e., frustration and pain.
Anchoring and first offer
Whether or not to throw the first offer in negotiations is still debated.
Naturally, this offer (so-called anchor) will become an alternate reference point, affecting the outcome of negotiations.
However, if it is over-aggressive, it may derail the negotiation process due to our loss-aversive nature.
A reasonable first offer is a good tactic, which requires a sound negotiation plan and tactics, i.e., knowing your opponent, market prices, having a well-prepared BATNA (Best Alternative to Negotiated Agreement), etc.
The difference in order elasticity in loss and gain situations
It is natural to adjust the ordering quantity in case of price changes. Since we "feel" losses much more than gains, our actions will result in different elasticity of orders for similar values of loss and gain.
In other words, the business customers forced to purchase at a higher (lower) price than the reference price are more likely to buy lower (higher) quantities beyond the decrease in magnitude than would be predicted by the price level alone.
This research confirmed that the price reduction of 10% would lead to an order quantity increase of 8.5%. Similarly, in a 10% price increase, the order quantity would shrink by 25%.
This is a signal for salespeople who believe that the reasonable price increase would improve their margins or that the final discount would equally reflect the order volume to protect the revenue.
Buyer's and seller's information asymmetry
Obviously, the buyer's and seller's level of detail about the object of trade is asymmetric.
Unlike the buyer, the seller knows the cost of the object (self-cost or initial buying price) and its proper condition.
On the one hand, this may lead to seller manipulation by disclosing some "favorable" information and keeping bad ones. The buyers need to understand that and not manipulate their judgment.
Perhaps buyers need to rely more on independent sources of information - market price indicators, independent evaluators, and quality inspectors.
On the other hand, in the presence of both good and bad news about the object of trade, the seller must realize that the effect of bad news would overcome the good ones, as the perceived loss is more powerful than the gain. So, complete transparency may backfire on the seller.
Interestingly, disclosing more recent information produces a more powerful effect than dated one. For example, buyers are nearly two times more receptive to information about an alternative offer than the initial buying price.
George Akerlof, a 2001 Nobel prize winner, wrote his article "The Market for Lemons: Quality Uncertainty and the Market Mechanism" in 1970. In it, he explained the notion of quality uncertainty, where information asymmetry causes bad car ("lemons") sellers to completely degrade the overall quality in the market.
He raised the importance of trust in the seller's ability and willingness to certify the quality of sales objects, which differentiates merchants from entrepreneurs.
Relationships affect price sensitivity.
Apparently, a solid buyer-seller relationship diminishes the effect of price discounts. Long-term customers take commercial incentives for granted while exaggerating the impact of price increases.
This leads us to the importance of value delivery. Economic actors must seek value beyond traditional price encounters, and no discounts would fortify the collaboration.
How to improve one's negotiation skills
This selection of findings from the prospect theory is subjective to the author's experiences. The entire palette is way richer!
Yet this research raised a few important observations that may appear helpful for the audience.
- Trust differentiates entrepreneurs from merchants. The quality of goods sold isn't just a moral obligation but a matter of survival of legit products under the pressure of "lemons." Bad money drives out good money, as Gresham's law suggested in 1860.
- Our internal reference price estimates the LOSS or GAIN deal, not external references or special discounts. Negotiations are meaningless without the parties' alignment on the reference price.
- In negotiations, we should be mindful of the information asymmetry and carefully judge any information selectively shared with us (or leaked). The chances are high that the data is used to manipulate us towards the less beneficial deal that we would eagerly accept in the face of that information. Some generic types of manipulations are:
- Anchoring - providing us false price indications to adapt our reference point towards a more favorable position for them;
- Framing - working not on an offer itself but the way that stimulates it is presented to stimulate our loss-aversion;
- Availability - providing particular reference cases that support the seller's preferred outcome.
- Contrast - give a few options based on which the seller's desired result is the most favorable for the buyer.
- Disaggregating gains/aggregating losses - as per our psychological nature, we favor multiple smaller gains over a bigger one. On the contrary, we're less discouraged by one significant loss than a sequence of smaller ones. This can also be used to manipulate offered concessions.
- A bad deal cannot be offset by a comparable good deal, as we suffer the loss much more than we celebrate the gain.
- The longer we work with a salesperson, the more we take good things for granted. This is an essential reminder for procurement people, who advocate for long-term collaboration and then tend to undermine its benefits simply as per their human nature.
Importantly, before approaching the negotiation table, we need to understand what choices we will make—rational or boundedly rational ones.
Consequently, we should apply the relevant negotiation tools, as explained below.
It also helps us understand our mental negotiation patterns and avoid typical mistakes and manipulations.
More information on this and other exciting topics can be found in "The Technology Procurement Handbook." It represents 23 years of experience, billions of dollars worth of successful sourcing projects, and 1000s of hours spent on research, analysis, and content creation for the most demanding professional readers.
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