Thursday, 1 December 2016

Tips for Brexit Negotiators #1 - The Endowment Effect

By Richard Ayres

We humans have a range of shortcuts (or heuristics) built into our decision making process. Usually these rules of thumb are useful (like not eating food that smells funny). Sometimes these shortcuts are not so useful (like that time you doubled down on red at the roulette table after five blacks in succession).

The interesting thing is that all these heuristics are somewhat systematic, so we can account for them if we make ourselves aware of them (and take advantage of them in others who aren't).

The endowment effect stems from our natural feeling of loss aversion. We tend to value things more highly once we own them than we do before we own them. This is why a car salesman will try to get you to take his car for a test drive. Once you have been behind the wheel you start to think about the downside of not having the car instead of the upside of having it. Your reference point changes, and with it so does your valuation of the item in question.

And so it is with the EU. We are currently in the EU and so feel loss aversion at the thought of leaving it. During the referendum the Vote Leave campaign attempted to counter this by asking "If the UK were not already a member of the European Union, would we vote to join it?".

This has a serious implication for Brexit negotiations. It doesn't matter if you voted Leave or Remain, you are likely overvaluing EU membership. So, if you voted Remain and think that the EU is a very, very good thing, you may want to adjust your appraisal down to very good thing. If you voted Leave, then you likely stopped reading this paragraph at the point where I said that EU membership is overvalued - in which case you are suffering from confirmation bias (and we can come to that another day).

Why is this a problem? Well, at some point our negotiators will be bartering with their EU counterparts and at this moment it is critical they know the value of what is being offered and what they are being asked to give up.

So how do we protect ourselves from the endowment effect? It turns out that Vote Leave had the right idea (about this - we make no comment on the rest of their campaign). We need to understand the world without the EU and make that our reference point. This will help us accurately value the options on the negotiating table next year.

This is what negotiators call the Best Alternative To a Negotiated Agreement or BATNA. It is the position we find ourselves in if we have no deal. We need to consider the best BATNA we can unilaterally achieve, and this includes all the things we can do to improve our lot (which is why, for example, you hear the government talk about dropping corporation tax to 10% and the Economists for Brexit advocating unilateral free trade). This is not unlike what some commentators call "Hard Brexit" so, no matter what kind of Brexit you want, understanding this position is still a necessary piece of work.

Negotiations have many facets. They are a mixture of hard analytics and soft personal interactions. The negotiators will each have their own concerns - pride, reputation, economics, stability, future goodwill and so on. They will have their own negotiating style. They will also each have aspirations of what they would like to achieve, what they think is realistic and what would be embarrassing to come home with. They will certainly feel pressure to come away with "something" rather than "nothing".  The problem is that the "something" on offer may be worse that walking away from the table.

It is essential that we understand, and plan for, a "Hard Brexit" (including all the things we would do subsequently do to improve our competitiveness) so that we enter the negotiations with a strong and credible BATNA, even if that is not our objective.

The FSNForum is following a negotiation-centric process to help inform the negations. Our research focusses on answering questions that are key to the negotiation - including understanding our BATNA.

If you would like to support us or otherwise contribute to our programme, please follow this link to join the FSNForum.

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