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strategy and business
 / Summer 2005 / Issue 39(originally published by Booz & Company)


Reinhard Selten: The Thought Leader Interview

Exploring this counterintuitive lesson, Professor Selten repeats a computerized version of the coin game multiple times with his students, offering them a chance to learn from their mistakes. Looking closely at their behavior, Professor Selten has discovered that many people, after winning and overpaying once or twice, prudently adjust their bid downward in the next round of bidding. With these lower, less competitive bids in play, the jar may go to a lucky bidder who actually manages to turn a profit. In the following round, the disappointed bidders respond with more aggressive, upwardly adjusted bids, which makes the system once again more likely to produce a winner’s curse. Such behavior demonstrates why changes in organizations and markets alike can take a long time to take root. People alter their behavior through continual feedback mechanisms — responding in each round to their experience in the previous round, but failing to discover the “optimal” yet counterintuitive strategies needed to win in the long run.

Throughout his academic career, Professor Selten has been an active international consultant to both industry and government, and a prolific author of academic publications. In 2001, he edited Bounded Rationality: The Adaptive Toolbox (MIT Press) with Gerd Gigerenzer, and most recently, in 2004, he edited Human Behaviour and Traffic Networks (Springer Verlag) with Michael Schreckenberg. He spoke with strategy+business about the implications of his work during a  colloquium on managerial decision making at the Batten Institute, which is based at the Darden Graduate School of Business Administration at the University of Virginia in Charlottesville.

The Defaulting Mind

S+B: Why is it so hard for your students to learn from their mistakes in the coin jar experiment?

SELTEN: In order to learn from your mistakes, you first have to recognize that you have made a mistake: You cannot learn from a mistake unless you see that it was a mistake. Of course, if it is clear to you that you made a mistake, you may learn from it, but it is not so clear in most cases, especially when the outcome of your action is uncertain.

S+B: Are you saying that experience is not a good teacher?

SELTEN: Experience is very important. Of course it is! However, the ways in which decision makers take experience into account — and therefore the outcome of any decision-making process — are different from the kinds of rational optimization assumed in economic theory. Traditional economics assumes that before you make a decision, you go through some rational calculations, which then yield a recommendation. The idea of optimization is a very attractive fiction. But it is a fiction. In actual fact, people are often not at all influenced by such calculations before the fact, but only after the fact. We call this “ex-post rationality.”

S+B: What do you mean by “ex-post rationality,” and why is it important?

SELTEN: In many situations, decision makers adjust their behavior by thinking about how different actions in the past could have yielded a better outcome. These alternatives, reinforced in the decision makers’ minds, become default actions to apply in future situations. When making decisions in those future situations, no optimization or rational calculations are involved, and instead, the decision maker simply follows the rules he has developed in the past — just like many of the subjects in my experiments about the winner’s curse.

S+B: This sounds very mechanistic.

SELTEN: In a sense it is; most decisions are made through some routine behavior because you cannot in a split second run through complex computations. When time is of the essence, you can only react to a routine program that is internalized in your mind, often by ex-post rationality.

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