Article

Behavioural Economics: A New NHRD Network Journal

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Driver of Strategic HRM © 2020 National HRD
Network, Gurgaon
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DOI: 10.1177/2631454120977240
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Sanket Sunand Dash1

Abstract
Strategic human resource management (SHRM) aims to leverage a firm’s human resource base to cre-
ate economic value for an organisation. In order to create economic value, firms must understand the
actual behaviour of economic agents. Behavioural economics aim to understand the real, as distinct
from theoretical, behaviour of humans when making economic choices. Hence, behavioural econom-
ics is central to a firm’s implementation of SHRM. However, despite the strong theoretical relationship
between SHRM and behavioural economics, the actual research on the use of behavioural economics is
fragmentary and inadequate.
This article traces the roots of behavioural economics to prospect theory and identifies the basic
concepts—comparison to a reference point, risk aversion and loss aversion—underlying prospect the-
ory. The applications of these basic concepts in HRM are elucidated and the current research linking
behavioural economics to HRM is presented.With respect to HRM, the current research on behavioural
economics is most relevant to compensation management. Based on the discussion regarding applica-
tion of behavioural economics in HRM, the article concludes by identifying future areas of research
in the application of behavioural economics to HRM and scope for mutual exchange of knowledge
between researchers and practitioners.

Keywords
Behavioural economics, strategic human resource management (SHRM), prospect theory, loss aversion,
compensation management

In their comprehensive definition of human resource management (HRM), Bratton and Gold (2017)
focused on the ability of HRM to achieve competitive advantages for an organisation by formulating and
deploying a comprehensive and internally coherent set of employee policies, practices and programmes.
However, in actual practice, the human resource (HR) departments of many organisations are mired in
day-to-day operational practices such as recruitment, selection, appraisal, compensation and benefits
management and are unable to completely integrate these practices with each other or with the broader

1
IIM Rohtak, Sunaria, Rohtak, Haryana, India.

Corresponding author:
Sanket Sunand Dash, IIM Rohtak, Sunaria, Rohtak, Haryana 124010, India.
E-mail: sanket.dash@iimrohtak.ac.in
2 NHRD Network Journal

objectives of the organisation. This article posits that organisations can leverage the insights of
behavioural economics to better align HR strategy with organisational strategy.
Behavioural economics, as a term, lacks a precise and comprehensive definition. Broadly speaking, it
grew from the use of psychological experiments to describe actual economic behaviour (Pete, 2014).
Behavioural economics helps understand the actual behaviour of economic agents, especially when it
differs from predicted theoretical behaviour. The core insight of behavioural economics is that actual
human beings are not purely rational, utility-maximising entities (caricaturised as homo economicus)
and, hence, behave in ways that are deemed irrational by economists. Moreover, the deviations from
rational behaviour are not random but systematic and universal and, hence, can be generalised across
cultures. Some of the most well-known diversions from rational choice include loss aversion, mental
accounting and bounded rationality.
The key insight of behavioural economics that human beings cannot be reduced to purely utility-
maximising agents has been at the heart of most progressive HRM initiatives. Early organisational
scholars like Elton Mayo realised the need to look at employees from a more holistic perspective and
have recommended the use of non-monetary benefits such as recognition, skill enhancement and
interesting work. However, for some inexplicable reasons, most HR managers have not managed to
translate the multiple insights of behavioural economics that have emerged since the publication of
Tversky and Kahnemann’s (1974) seminal piece on behavioural economics titled ‘Judgment under
Uncertainty: Heuristics and biases’.
The article aims to inform practising HR managers about the core concepts in behavioural economics
and translate those insights into actionable behaviours for practising managers. After identifying the
insights and actionable behaviours, the article suggest ways to align those behaviours with organisational
strategy in order to maximise the organisation’s competitive advantages. The article relies on a mix of
literature review and case studies of successful implementation to communicate its objective.

Brief Overview of Advances in Behavioural Economics

The origin of behavioural economics might be traced to the concept of bounded rationality that was
introduced by the polymath Herbert Simon in the seminal paper on the appropriateness of the theory of
rational choice (Simon, 1955). Simon (1955) suggested that the economists’ understanding of rational
choice was not realistic because it assumed that the decision-making entity, whether an individual or a
firm, had infinite computational resources; a stable set of preferences and the payoffs of all actions were
predictable in advance. To explain realistic decision-making, Simon later introduced the term ‘bounded
rationality’. Today, the concepts of bounded rationality have become integral to organisational theory
and organisations’ role as economic agents (Radner, 1996).
Simon’s theory of bounded rationality had much in common with the insights of prospect theory that
constitutes the core of behavioural economics. Both prospect theory and the theory of bounded rationality
highlighted the shortcomings in standard economics theory. These include the conceptualisation of
humans as utility-maximising activities or the sharp distinction between economic and non-economic
activities. However, bounded rationality and prospect theory also differ on crucial issues. Bounded
rationality highlights the role of satisficing behaviour and organisational politics in decision-making,
while prospect theory underlines the biases due to which individuals’ behaviour becomes asymmetric in
periods of risk and uncertainty. As prospect theory builds on individual behaviour, it becomes challenging
to scale up its insights to organisational level.
Dash 3

Core Concepts in Prospect Theory and Relation to Human Resource Management

Prospect theory builds upon three interrelated assumptions (Bendor, 2001). The first assumption is that
decisions are made with respect to a reference point. The second assumption is that people are risk-
averse about protecting gains and risk-seeking about reducing losses. Risk averseness about gains means
that people try to protect their gains and eschew risks. However, when people face losses, they actively
pursue risky behaviours in an attempt to minimise their behaviours. The third assumption is loss aversion,
that is, people value the loss of x units of money more than the gain of x units of money.
All three assumptions have important implications for HR professionals. As the decisions are made
with respect to a reference point, employees are likely to model their behaviours and evaluate the
fairness/unfairness of a decision with respect to their chosen reference points. The insight that people
compare themselves with others is not new to HRM literature and forms the conceptual underpinning of
equity theory (Huseman et al., 1987). Equity theory suggests that employees feel distressed when they
perceive the ratio of their outcomes/benefits to their inputs/efforts to be less than the corresponding ratio
for a referent other (Oself/Iself<Oreferent/Ireferent). Prospect theory extends this line of thinking by extending the
domain of relativistic decision-making to all decisions made in a social context. Because employees
make decisions based on comparison to reference points, organisations can try to nudge employees to
choose those employees/organisations as reference points that are in line with organisational goals.
The second premise of prospect theory regarding display of risk-aversion behaviour in protecting
gains and risk-seeking behaviour in reducing losses is pertinent in motivating competent employees for
stretch assignments and designing employee compensation and benefits. Studies have concluded that
people perceive threats as potential losses and opportunities as possible gains (Highhouse & Yuce, 1996).
Hence, if employees perceive themselves in a gain situation compared to their reference point, they are
likely to eschew opportunities that can lead to a potential fall in their gains; for example, a high-
performing employee might reject opportunities for stretch assignments if they feel that there is some
possibility of them making less money or having slower growth due to their accepting the said assignment.
Because of risk-aversive behaviour in gain situations, this behaviour can occur even when taking the
stretch assignments has large potential benefits in terms of both compensation and designation. As
execution of organisation strategy is usually dependent upon a competent employee taking up risky
projects and executing them, the risk-aversive behaviour of high performers can stymie
organisational growth.
To reduce the display of risk-aversive behaviour by high performers, HR can formulate policies that
limit the potential downside to employees from any risky undertaking that the organisation may want
them to undertake on its behalf. The current volatile, uncertain, complex and ambiguous(VUCA)
environment for business requires organisations to be innovative and invest in risky ventures. If high-
performing employees are convinced that they would not face negative repercussions for taking risky
assignments, they will be more inclined to participate in the same for personal and professional growth,
thereby aligning organisational and personal growth.
Besides reducing the naturally risk-aversive behaviour of employees to improve employee proactivity,
which in turn improves organisational proactivity (Lee et al., 2019), organisations must also ensure that
risk-seeking behaviours in loss situations do not lead to undesirable behaviours. As employees perceive
threats as loss situations, employees may feel increasingly threatened by pay-for-performance plans if
their expected payout is below their identified reference point as the threat of income loss is likely to be
perceived as an actual loss. To remedy the loss, employees can indulge in highly risky behaviour that
may include downright unethical behaviour or other behaviours that are organisationally undesirable.
4 NHRD Network Journal

These threats have increased in the current business and economic milieu where pay-for-performance
plans have become more widespread and achievement of predetermined targets has become more
difficult due to depressed economic conditions arising from the current pandemic. When confronted with
potential losses, risk-seeking behaviour may also partly explain the failure of pay-for-performance plans
in both the private and public sectors (see Langbein, 2010).
The third assumption of prospect theory is that people in general are loss-aversive and, hence, exhibit
greater sensitivity to losses as compared to equivalent gains (Tom et al., 2007). Loss aversion explains
why formally risk-less choices are considered risky by the decision-maker (Tversky & Kahnemann,
1991). An example of loss aversion in risk-less choices is the endowment effect that describes how
people ascribe a higher than market value to goods they have acquired randomly (Kahneman et al.,
1991). Although loss aversion as a concept has been extensively researched and validated (Tom et al.,
2007), the implications of loss aversion on HR practices have sadly been ignored. One immediate
consequence of loss aversion is the need to use suitable language while framing policies as logically
equivalent statements do not have similar valence in the readers’ mind. Specifically, HR personnel
should avoid framing policies that create the illusion of ownership in employee minds as they would be
unwilling to relinquish them for objects of comparable market value.

Enabling Strategic Human Resource Management Through Behavioural

Economics: Role of Complementarities
Strategic HRM (SHRM) refers to the branch of HR that posits that HR policies and practices can be
construed as part of a bigger HR system, and the ability of HR policies and practices to contribute to
organisational effectiveness depends upon the level of alignment between HR practices, and between
HR strategy and organisational strategy (Arthur & Boyles, 2007). SHRM scholars and practitioners tend
to adopt three modes of theorising—universalistic, contingency and configurational (Delery & Doty,
1996). Among the three approaches, the role of complementarities is highest in the configurational
approach that asserts the importance of having a coherent set of mutually interacting and reinforcing HR
systems. Complementary HR practices are conceptually similar to the complementary goods postulated
in economic literature that bring synergistic benefits to user and, hence, consumption of one leads to
increased consumption of the other (Mukhopadhyay et al., 2011).
Although the literature on SHRM assumes the complementary nature of HR practices, few studies
have focused on the economic analysis of HR practices and mathematical validation of the synergistic
effects of HR practices. This lack of focus might be attributed to the predominance of neoclassical
economics and the belief that different HR practices, especially the practices related to recruiting and
incentive design (Englmaier & Schüßler, 2015), are independent of each other. However, in real life,
applicants’ motivation to join a firm is dependent upon multiple idiosyncratic factors like incentive
systems (Delfgaauw & Dur, 2007) and level of corporate social responsibility (Jones et al., 2014). Unlike
the predictions of neoclassical economics theory, individuals’ social preferences have a role in determining
their motivation for a job (DellaVigna, 2009). Much of these results are well-known to HR practitioners
and researchers, but they have not been formulated in the language of economics. Behavioural economics,
which serves as bridge between psychology and economics, can help do the same.
Some of the concepts that can explain the phenomena of people choosing to enter or continue in an
organisation providing lower wages are the concepts of identity and reciprocity. When people identify
with an organisation, they get converted from an outsider to an insider, and hence, they are willing to
accept lower wages as they derive utility not only from their own well-being but also from the well-being
Dash 5

of the identified organisation (Englmaier & Schüßler, 2015). When individuals feel that the organisational
behaviour towards them is fair and just, they reciprocate with actions that reduce their personal pay-off
but lead to better organisational outcomes. Similarly, behavioural economics helps provide the framework
to identify which benefits are good substitutes for monetary benefits. From an organisational perspective,
a good benefit is one that provides equivalent utility compared to direct monetary compensation, but the
costs of providing them are less. The rest of the section discusses specific areas of human resource
management that can be improved by adopting insights from behavioural economics. The specific
insights derived from behavioural economics can not only help improve HRM practices but also create
a more systemic way of thinking that uses universal principles of human behaviour to understand the
impact of their decisions across functions. Compensation management is the branch of HRM most likely
to use economic analysis to create optimum compensation packages and, hence, insights in behavioural
economics are applicable in this area

Behavioural Economics in Compensation Management

Since the 1990s, the economic analysis of the underlying principles behind human HRM has developed
into a separate discipline titled personnel economics (Backes-Gellner, 2004). Personnel economics can
be described as the intersection of HRM, labour economics and behavioural economics (Grund et al.,
2017). The use of laboratory field studies has been increasing in personnel economics, thereby suggesting
the increasing influence of behavioural economics on personnel economics, especially since the last
decade, that is, since 2010 (Backes-Gellner et al., 2008; Grund et al., 2017).
Economics is primarily concerned with the distribution of scarce resources, and in firms, this function
is carried out by the compensation management specialists. Hence, it is not surprising that the insights of
behavioural economics are specifically appropriate for compensation management. Behavioral
economics research has identified fairness of outcomes to self and others as an important decision
criterion underlying employees’ acceptance of compensation packages and provided support for the
hypothesis that equitable distribution of outcomes induces greater effort among team-members (Backes-
Gellner et al., 2008). The moderating role of gender differences on competitiveness have also been
supported, with females identified to be less competitive in general.
Economic theory assumes that human beings are utility-maximising agents and, hence, would choose
any outcome that promises a positive payback irrespective of the fairness of the outcomes. However, in
actual practice, people reject plans for distribution of surplus that they perceive as unfair even when their
choice results them in not receiving any part of the surplus (Fehr et al., 1996). The norms of fairness
affect not only the receiver but also the proposer. Even when the proposer has the right to unilaterally
decide on the distribution, they tend to allocate 30%–40% of the surplus to the other party rather than
allocate near zero amounts (Fehr et al., 1996). These inbuilt and universal norms of fairness are important
to HR professionals as they indicate that employee contracts should not be a tool for the profit
maximisation of both parties but take into account the fairness concerns of both parties.
Besides helping understand the dynamics of negotiations, behavioural economics also helps us
understand the allocation of effort in tournament-like structures where there are multiple contestants
(Moldovanu & Sela, 2001). Experimental studies conducted by Moldovanu and Sena (2001) identified
the link between participants effort and the degree of inequality in division of rewards. Participants
assigned to experimental conditions that simulated moderate inequality in assignment of rewards
displayed greater effort than participants assigned to conditions that simulated extreme inequality
(tournament-like conditions with a single winner) and comple equality. The tournament analogy is apt
6 NHRD Network Journal

for organisations because promotions also represent tournaments with multiple candidates and limited
number of advancement opportunities (Backes-Gellner et al., 2008). The low probability of promotions
can hamper the effort levels of personnel in extremely flat organisations and, hence, HR personnel may
need to create multiple advancement paths in these organisations rather than stick to a single corporate
ladder. HR personnel may also need to revisit their compensation packages and policies for promoted
employees to ensure that while the promoted employees are better compensated then before, the gap in
compensation between the promoted employees and other eligible employees is not large enough to
dissuade others.
Traditionally, women have been assumed to be more cooperative and less competitive than men.
Behavioural economics has helped us better understand the phenomena. Experiments conducted by
Gneezy et al. (2003) indicated that females were quite competitive in an all-female task but much less
competitive when asked to compete with males. Other studies (see Niederle & Yestrumskas, 2008)
indicate that females in general are less confident than males and, hence, high-performing females are
more likely to self-select into easier tasks in the absence of reliable feedback about their performance.
These studies indicate that firms can tweak their compensation packages based on the demographic
composition of their workforce and give potential candidates, especially female candidates, reliable
feedback about their ability in order to better attract females to their organisations.

Behavioural Economics and Other Areas of Human Resource Management

Behavioural Economics and Training
At the national level, one of the perplexing findings is the equilibrium levels at which different countries
have settled with respect to their skill levels (Marsden & Ryan, 1991). As skill levels are a good predictor
of overall productivity and outcomes, it is important to ensure that the overall spend on training and
effectiveness of training is high. Studies in Europe indicate the German dual system of education and
vocational apprenticeship outperforms the French and British systems of training (Backes-Gellner,
2004). Studies in behavioural economics indicate that knowledge of more efficient systems acts as a
nudge for decision-makers to adapt the same (Grunewald et al., 2017).

Behavioural Economics and Recruitment

In the recruiting process, firms and employees have limited information about each other and have to
make decisions in uncertain environments. Due to loss-aversion, recruits are likely to prefer firms who
have greater recognition among potential employees, leading to job vacancies in other firms. The
problem of job vacancy is likely to be exacerbated in tight labour markets (Backes-Gellner, 2004). To
overcome the same, firms need to conceptualise novel means of making potential candidates aware of
the actual working conditions. One possible way is to categorise attraction of potential candidates, in
addition to improvement of apprentice skills, as an outcome of apprenticeship programmes. This is an
example of complementarity of HR programmes (Ichniowski & Shaw, 2003), an area where insights of
behavioural economics are likely to have a large impact (Englmaier & Schüßler, 2015).

Behavioural Economics and Organisational Structure

Studies on the efforts of academicians in different countries with different academic systems have
generated a rich understanding of the relationship between promotion and efforts. Coupé et al. (2003)
Dash 7

found that output of academicians increases just prior to a significant promotion event and falls in the
immediate aftermath of the event in both the USA and Germany. However, this pattern is not noticed for
less significant pay rises. In the USA, there are two significant promotion events for academicians, while
there is only a single significant promotion event for German academicians, and the pattern is repeated
twice in case of US academicians. This suggests that organisational structures with a few significant
promotion events are better able to induce effort among employees than multiple promotions with low
significance of each. HR professionals can use this design to limit the number of promotions for each
career path. However, care must be taken to ensure that the number of prospective candidates per vacant
role does not become too high for a promotion event as it can lead to reduced effort (Moldovanu &
Sena, 2001).

Behavioural Economics and Team Effort

Organisations are increasingly turning to teams because they enable synergies to emerge due to
complementarity of skills among different members. However, there is always the danger of free riding
in teams. Backes-Gellner et al. (2004) studied the relationship between team size, peer pressure and free
riding in start-ups. The study identified peer pressure as a means of reducing free riding and suggested
that the intensity of peer pressure falls with increase in number of team members. The optimum amount
of peer pressure is achieved at team size of 3. The findings suggest that most teams in organisations are
too large to apply adequate peer pressure. HR can use these findings to recommend formation of smaller
teams and advise top management to form teams only when gains due to synergy are large enough.

Behavioural Economics and Future Practice-oriented Areas of Research

The growth in behavioural economics has been one of the most defining developments in social science
research over the last few decades. Scholars identified with behavioural economics such as Daniel
Kahnemann and Richard Thaler have been awarded with the Nobel prize in economics. As per
Mullainathan and Thaler (2000), behavioural economics is broadly based on the adoption of three
realistic constraints in the standard economic theory: bounded rationality, bounded will-power and
bounded self-interest. Although initially applied to explain real-life deviations from prescribed economic
behaviour in finance and savings, today, the domain of behavioural economics has become broader with
applications in multiple areas such as public policy, economic development, law and health care
(Diamond & Vartiainen, 2012).
One drawback of the rapid growth of behavioural economics as a discipline is the amorphous nature
of the research output that gets classified as behavioural economics. Tomer (2007) suggests that many
scholars in behavioural economics are sceptical regarding the existence of clear defining features of
behavioural economics. There are at least nine strands of behavioural economics including the Carnegie
Mellon School that focuses on bounded rationality; the Michigan School that focuses on Gestalt
psychology ;and the psychological economics school that focused on prospect theory (Tomer, 2007).
Other strands focus on evolutionary theory and behavioural finance, and there is a significant part of
behavioural economics literature that is difficult to classify (Tomer, 2007).
While the roots of behavioural economics lie in bounded rationality and prospect theory, especially
the latter, today a plethora of interesting results are getting classified under behavioural economics, and
there are almost no studies to guarantee the generalisability of these results across cultures. Behavioural
economics is distinguished from mainstream economics not in terms of its content but in terms of its
8 NHRD Network Journal

distinctiveness from mainstream economics on parameters such as narrowness, rigidity and individualism
(Tomer, 2007). Both bounded rationality and prospect theory identified universal deviations from
standard economic theory and, hence, the usefulness of their inputs is universally applicable. However,
the same is not true for all strands. Hence, one possible future direction for the discipline is the movement
towards greater formalisation. A more formalised presentation of behavioural economics would also
help practitioners identify the appropriateness of the base insights and ascertain the relevance of the
discipline to their working lives.
The lack of formalisation of behavioural economics is perhaps reflected in the paucity of studies that
focus on its implications on the working of commercial organisations, arguably the most important actor
in today’s world. One exception to the above is Bewley’s (2007) work on the rigidity of wages during
recessions. Bewley (2007) surveyed the wage levels in Northeastern parts of the USA that was facing
recessionary conditions in the early 1990s, leading to high unemployment. Classical economic theory
suggests that wages will move downwards during this period to match the increased supply of eligible
workers. However, in reality, there was negligible downward movement of wages, and this rigidity was
enforced not by employees but the top management, which is supposed to act in the interests of the
shareholders and reduce cost of operations to the bare minimum possible. This phenomenon happened
due to top management’s internalisation of the importance of fostering identity, providing conditions that
will generate positive reciprocity in future and maintaining a positive mood in the organisations.
Bewley’s (2007) study suggests that many practising managers have tacitly incorporated the insights
of behavioural economics in their working lives. Multiple studies conducted in Europe have validated
the conclusion of Bewley (2007) (e.g., Babecky et al., 2010). Thus, there is a scope for research work
that aims to analyse the actual practices of managers in light of the central assumptions and insights of
behavioural economics. Such studies would help convert the tacit knowledge of managers into explicit
knowledge and potentially improve the productivity and morale of employees as a whole by allowing
less experienced managers to imitate the working styles of their more sagacious peers.

Conclusion
The article identified the key concepts and insights of behavioural economics and surveyed the existing
literature for identifying the impact of behavioural economics on HRM. Despite the influence of
behavioural economics on social science research and the rapid development, there were only a few
papers that talked about the application of the insights of behavioural economics on the HR department.
Furthermore, many of the insights were extrapolated from studies conducted in non-commercial
organisations like academia and, hence, the applicability of these insights is questionable. Geographically,
the studies on the applicability of behavioural economics in HRM are concentrated in Germany, and a
greater dispersal of studies is required to ensure generalisability of the results.
In terms of HR functional areas, the focus of the studies has, unsurprisingly, been on compensation
management. Other functional areas of HR areas where insights of behavioural economics are applicable
include recruiting, training and development and organisational structure. A survey of literature also
indicates that many working managers have tacitly internalised the insights of behavioural economics
and, hence, there is a scope for research that translates these tacit insights into a more explicit form.

Declaration of Conflicting Interests

The author declared no potential conflicts of interest with respect to the research, authorship and/or publication of
this article.
Dash 9

Funding
The author received no financial support for the research, authorship and/or publication of this article.

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Bio-sketch
Sanket Sunand Dash is a faculty in the area of Organisational Behavior & Human Resource Management
(OB & HRM) at Indian Institute of Management Rohtak. He has completed Fellow Program in
Management (FPM) from Indian Institute of Management Ahmedabad. He worked as a senior analyst
with Deloitte US India for four years before joining the FPM program in IIM Ahmedabad. Before joining
IIM Rohtak, he was a faculty at Xavier School of Human Resources (XAHR), Xavier University
Bhubaneswar.