Many of the key strategic decisions made in businesses may result in wasteful allocation of resources or excess market entry. For example, close to 75% of those who choose careers in entrepreneurship would have been better off as wage workers, and almost 80% of angel investors never recoup their money, both indicating that too many (unskilled) people enter into these activities. Similarly, an average corporate acquisition is more likely to destroy value than to add value.
Many of the key strategic decisions made in businesses may result in wasteful allocation of resources or excess market entry.
Why does this happen? One possible answer that we study may lay in systematic biases that decision makers exhibit when making business entry decisions. We focus on the behavioral drivers of market entry in strategic business contexts with two characteristics that are virtually omnipresent. First, these settings are inherently ambiguous. That is, we know what might happen, but we don’t know the chances that they might happen. Ambiguous situations can be contrasted with risky ones when we know the chances of what will happen, for example when playing roulette. Second, the ambiguity in such settings, and the associated payoff, is likely to be perceived by decision makers as related to their own skills, often in comparison to rivals.
These characteristics imply that at least two distinct behavioral mechanisms could explain entry into the ambiguous, skill-based markets on which we focus in this study: overconfidence -- believing that one’s chances of success are higher than what they really are -- and having a positive attitude toward ambiguity.
Like many before us we use a laboratory setting to make more precise claims about causality. We rely on a novel experimental treatment where we change the level of confidence that individuals have about their own skills, and the level of ambiguity.
Decision makers are ambiguity seeking when the result of the competition depends on their own and others’ skills.
We find that decision makers are ambiguity seeking when the result of the competition depends on their own and others’ skills. That is, decision makers are more willing to gamble with their money on competitions where the distribution of outcomes is shrouded by a lack of knowledge about what will happen, rather than when they have precise data on the chances of success. When outcomes of competitions are more unknown, having the opportunity to believe that your own ability affects results appears to make them more attractive.
Similarly, we also show that overconfidence only affects entry in skill-based competitions and does not appear in games that are chance based.
Both overconfidence and ambiguity seeking can therefore explain why individuals enter into entrepreneurship taking huge risks with their savings, or why mergers and acquisitions often do not pay off.
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