in uncertain environments
Ron Dye explains why business problems are bandit
stands poised between two slot machines. He knows one of them
has better payoff odds than the other, but he doesnt
know which machine that is.
got enough cash for 20 pulls of the handle. He chooses randomly
between the two machines for his first play. But what should
he do after that first choice?
his first play yields a payoff. Should he stick with
the winner? Or should he move to the other machine?
with the machine that produced the payoff may seem to be the
better strategy, says Ronald Dye, the Leonard Spacek
Professor and Chairman of Kelloggs Accounting Information
and Management Department. But that choice, he adds, has the
defect of not providing any information about the potential
payoff of the other machine. It may make sense to experiment
and try the other machine, if the number of times you intend
to play is large enough.
gamblers dilemma provide any insight into how business
decisions should be made? Dye says yes.
choice between slot machines has an effect on the gamblers
immediate payoff and on what the gambler learns about the
two machines, Dye says. Similarly, every important
business decision a manager makes has two effects. It influences
the firms profits, and it influences what the firm learns
about the environment that it operates in.
wishing to improve the marketing of a product, for example,
could expand the firms sales force or do more advertising.
Though the manager will never be certain which was the better
strategy, he or she can reduce that uncertainty by experimenting
with the different tactics.
this approach can be applied to almost any important business
decision, from deciding what supply chains to use to what
prices to set to what products to market.
best decision today may not be the one that maximizes todays
expected profits, based on what you know about the environment
you face today, he says. Instead, it may be the
one that gives you the most information about your operating
environment, so that your expected profits increase tomorrow.
example, you could pick a price for your firms product
today based on your best understanding of the market demand
for it today. Or, you can purposely pick a price that you
dont believe will be the most profit-maximizing price.
The information you gain about the products demand curve
from the latter choice may help you make better decisions
about how to price your product in the future.
from such experimentation can come from many places. For experimentation
in product pricing, product markets are the sensible place
to look. But for major business decisions, Dye says the capital
markets reaction may be a useful source of information.
wisdom generally asserts that managers have better information
about their strategies than the capital markets do,
Dye says. But the fact that senior managers are often
surprised by the market response to their strategic proposals
suggests that, at least sometimes, the capital market has
information the managers dont have. This is information
managers could exploit if they are willing to listen.
as one example the fall in computer maker Hewlett-Packards
stock price after it announced its plans last year to acquire
should have been a wake-up call to the firms senior
managers that their view of the desirability of the take-over
was in doubt, Dye says. They may have been sensible
to propose the takeover as an experiment and
equally sensible not to have tried to consummate the merger,
given the markets reaction.