The economic analysis underlying corporate decision making: what economists do when confronted with business realities—and how they might improve

Business Economics, July, 2004 by Hugh Schwartz

In many enterprises, nothing as systematic as a hurdle rate was relied upon to authorize minor investments in on-going projects. This resort to heuristics in lieu of a calculation could be rational given the cost of a more rigorous assessment. The general lack of periodic checks to assure the adequacy of the mental shortcut used, however, would seem to reduce the process to one best characterized as quasi rational. That the general area of criteria for investment is of concern can be seen from the fact that a quarter of the entities represented were in the process of reevaluating them.

RECOMMENDATION 8. Business economists should draw up guidelines for dealing with "hurdle rates." (5)

Another heuristic that is difficult to pin down is that entailed in making acceptance of a project contingent on the participation of a particular individual or team instead of on a quantitative analysis (consider the acquiescent behavior of some banks and investors in dealing with Long Term Capital Management, a firm with two Nobel Prize Winners and perhaps the world's most renowned bond salesman). Only a few suggested resort to such a heuristic, however, and just as many insisted that a highly qualified team was not enough to justify a project (though it is not clear if those who rejected the use of such a heuristic in principle would do so in given business situations). I found it even more difficult to understand what exactly is involved by: 1) certain heuristics used to value intangibles (not only those alleged as synergies to justify mergers and acquisitions, but even those unquestionably present in point-in-time evaluations of enterprises), 2) "horizon scanning" (an essential component of decision making in technologically advanced industries), and 3) the criteria used to readjust enterprise areas of investment emphasis over time.

Even though heuristics are used in combination with elements of more precise calculation, there is seldom an effort to document precisely what is involved in a given rule of thumb and the context of the situation in which it is used. Written records are almost never kept of the biases involved.

RECOMMENDATION 9. Documentation on heuristics and the contexts in which they are applied should be done on a routine basis so that experience can be more usefully applied in making future decisions and in improving heuristics.

Only occasionally did the economists interviewed maintain that their colleagues insisted that they not record such information. It seems strange that while modification of the details of technological relationships and traditional econometric models are carefully noted, little is done to document and justify the nature of often essential--but clearly second-best--alternatives to models of a more optimizing character. As a consequence, the heuristics used are not necessarily the best available. While the use of heuristics has the potential for contributing to a rational decision-making process, often the decision-making process actually employed that uses heuristics is only quasi rational. Incorporation of a second best heuristic in the midst of an otherwise standard rational calculation can significantly alter the results. Admittedly, learning from the experience of the heuristics is difficult because the nature of the decisions calling for the application of heuristics can vary greatly.