Exprimental economics helps solve complex business problems

How do you predict demand from your distributors? Would you try demand simulation, predictive analytics, or a complex mathematical model? Try experimental economics. Wired points us to a story (found via Techdirt) of Kay-Yut Chen who is an experimental economist at HP solving the complex demand forecast problems.

One of Chen's recent projects involved finding a way for H.P. to more accurately predict demand from its nine distributors, who collectively sell as much as $3 billion worth of H.P.'s products. The problem? Its distributors' forecasts for demand were frequently off by as much as 100 percent, wreaking havoc on H.P.'s production planning.

Chen's solution to the planning problem, which H.P. intends to test soon with one distributor, was to develop an incentive system that rewarded distributors for sticking to their forecasts by turning those forecasts into purchase commitments. In the lab, the overlap between distributors' forecasts and their actual orders using this system increased to as high as 80 percent. "That's pretty astonishing given that the underlying demand is completely random," Chen says.

The human beings are terrible at making rational decisions and the complex problems such as demand forecast cannot really be solved by complex modeling algorithms or predictive analytics. Applying the economics of incentives to such problems is likely to yield better results. Freakonomics explains the creative use of economics of incentives in great depth. Dan Ariely writes in Predictably Irrational about people predictably making irrational decisions and how it breaks the rules of traditional economics and free markets that are purely based on demand and supply ignoring the human irrationality.

There is a lesson for an enterprise software vendor to design human-centric software that supports human beings in complex decision management process. Good news is that I do see the enterprise software converging towards social computing. Topics such as security that have been considered highly technical are being examined with a human behavior lens ranging from cognitive psychology to anthropology of religion.

I would welcome a range of tools that could help experimental economics gain popularity and dominance in the mainstream business. For instance behavior-based AB testing can be set up in a lab to test out hypothesis based on experimental economics and the results of the experiment could be directly fed to a tool that reconfigures an application or a website in real-time.