Is the psychology of high profits detrimental to industrial renewal?
Experimental evidence for the theory of transformation pressure
Lennart Erixon and Louise Johannesson
September 2014
Abstract
The theory of transformation pressure maintains that productivity growth and innovation are stimulated
by a decline in actual profits. Cognitive and emotional factors explain why established firms are more
productive and innovative in bad times. In periods of increasing profits firm actors governed by historical
relativism, the peak-end rule and overconfidence will opt for the status quo. In the following profit
recession actors become more alert, calculating and creative favoring a transformation, especially if they
fear that the survival of the firm is at stake.
The theory of transformation pressure was tested by an experiment where undergraduate students in
macroeconomics acted as managers for an established company. The experiment sheds light on the
students’ investment and strategy choices under varying profit conditions. The theory was only partly
confirmed by the experiment. There are arguments in both industrial economics, psychology and
neuroscience for a qualified theory of transformation pressure. Productivity is enhanced by moderate
pressure or by periodic shifts between hard pressure and good opportunity.
JEL classification: B52; E32; L21; O31
Key words: transformation pressure, bounded rationality, economic psychology, productivity growth,
innovation, status quo bias
L. Erixon
Department of Economics, Stockholm University, S-106 91 Stockholm, Sweden
e-mail: [email protected]
phone: +46 8162136, fax: +46 8159482
L Johannesson
Research Institute of Industrial Economics (IFN), Grevgatan 34, S-102 15 Stockholm, Sweden
e-mail: [email protected]
phone: +46 86654500, fax: +46 86654599
1
1. Introduction
A conventional belief is that people become more alert, efficient and dynamic when experiencing
setbacks and tougher external environments. A related economic argument is that firm
productivity and renewal is enhanced by negative shocks. There is some evidence that total-factor
and labor productivity growth move counter-cyclically at least after adjustment for laborhoarding effects (Aghion and Howitt 1998, 239-243; Malley and Muscatelli 1999; Estrella 2004).
A possible explanation is that firm productivity is stimulated by worse external circumstances.
Negative driving forces may also explain why firms exposed to foreign competition have a more
favorable productivity development and product composition than other firms (Baily and
Gersbach 1995; Bloom and Van Reenen 2007). Moreover, the revitalizing effect of harder
external circumstances is a possible explanation for the survival of established firms for many
decades. Four-fifth of the companies on the Fortune Magazine list over the 500 largest US
companies 2009 were formed before 1970, thus well before the IT revolution (Stangler and
Kedrosky 2010, 14). The central hypothesis in the theory of transformation pressure (henceforth
TTP) is that tougher external circumstances, manifested by a reduction in actual profits, will
enhance the productivity and innovative performance of established firms (Erixon 1991, 2007).
The idea that firm performance is improved by worse external conditions is not obvious. By
visualizing the salience of scale advantages, self-financing and learning evolutionary economists
and macroeconomists alike generally shed light on positive driving forces. And when considering
the stimulus of ‘pressure’ on aggregate productivity (growth) they primarily envisage the
consequences of innovation captured by Schumpeter’s notion of creative destruction – static
firms and industries will perish because of the expansion of innovative firms and industries.
Neither Schumpeter nor the neo-Schumpeterians outside the neoclassical tradition stress the
pivotal role of negative driving forces for the renewal and productivity development of
established firms (Erixon 2013, 5-12). The focus in the TTP on the productivity performance of
established firms is legitimized by the fact that ‘within-firm effects’ are usually a more important
component of national productivity growth than entries, exits and changes in the industrial
composition (Bartelsman et al. 2004; Brown and Earle 2008; Giannangeli and Gómez-Salvador
2008). These empirical results do not deny that surviving new firms often display high
2
productivity growth, probably reflecting a selection and learning process, or that entry and other
challenges may stimulate the productivity of established firms.
The aim of this article is to disentangle the psychological mechanisms underlying the positive
relationship between external pressure and firm productivity in the TTP. Accordingly, we ignore
the ‘structural’ hypothesis in the theory that hard external conditions may boost aggregate
productivity growth by speeding up the phasing out and elimination of firms with low
productivity levels or low productivity growth (see creative destruction). In the TTP, the
productivity of established firms is enhanced by fierce competition, lower (or more qualified)
product demand and negative supply shocks. More precisely, established firms are supposed to
first upgrade their growth strategy after an actual fall in profits. The TTP stresses the psychology
of a negative relationship between actual profit on the one hand and productivity and innovation
on the other. The theory suggests, by references to the psychological literature, that decision
makers in established firms are governed in periods of increasing profits by current outcomes,
overconfidence and a fundamental status-quo bias. By a similar reference to psychology (and
neuroscience) the TTP maintains that actors become more creative, rational and alert, including
the possibility of overreaction, in recessions. In a special version of the TTP, firms experiencing
an actual decline in profits are particularly eager to abandon a status-quo alternative if they
previously have experienced a profit boom.
Another aim of this article is to present the results from an experiment testing the central
hypotheses in the TTP. The participants were 218 students attending an undergraduate course in
macroeconomics at Stockholm University during four autumn semesters, 2009, 2010, 2012 and
2013. By acting as chief executive officers (CEOs) of an established company the students were
asked to make decisions on investment and growth strategies under varying profit conditions.
They were further asked to describe their view ex post of the motives and psychological biases
that had governed their choices. The experiment was based on the idea that the reaction by
established firms to changes in profits is influenced by some fundamental biological traits and
social conventions in a developed country shared or easily imagined by university students in
economics. However, the experiment was also tailored to provide room for rational
considerations.
3
The sequential design of the experiment made it possible to follow each student’s investment and
strategy choices when profits varied over time. For example, we could assess whether any
difference in the students’ strategy during a ‘normal’ increase in profits and a profit boom was
decisive for their inducement to transform after a profit decline (see the specific TTP). By the
sequential approach we could also check whether any declaration by the students that a particular
choice reflected that they were consistently rational or at least behaved (more) rationally after a
profit fall (see the TTP) was contradicted by their answers to earlier questions.
We will first relate the TTP, although briefly, to the economic literature suggesting a positive
relationship between external pressure and productivity or innovation (Section 2). The following
section addresses the central ideas in the TTP about the psychology of firm actors (Section 3).
The subsequent section (Section 4) presents the design of the experiment and also the statistical
results with a particular eye on the TTP hypotheses. The next section (Section 5) introduces two
qualified theories of transformation pressure. The final section (Section 6) overviews and make
some comments on the main conclusions in the article.
2. The salience of transformation pressure in the economic literature – a brief overview
The idea that the productivity and innovative performance of established firms is enhanced by
falling profits and accordingly moves counter-cyclically is not new. Pertinent ideas can be found
in Robertson (1915) and also in an ‘orthodox’ Schumpeterian tradition (Mensch 1979; Van Duijn
1983; Kleinknecht 1987). The latter tradition emphasizes that the saturation of demand for
established products will be obvious in depressions having a positive effect on R&D investment
and innovation in existing firms. Neoclassical Schumpeterian economists have recognized the
possibility of counter-cyclical productivity growth and the positive effect of stronger competition
on the productivity and innovativeness of incumbent firms (Aghion and Howitt 1998, 2009;
Aghion et al. 2009). Moreover, case studies have pinpointed the importance of factor
disadvantages, qualified product demand and rivalry among domestic producers for the
competitive advantage of nations (Porter 1990, Ch. 3). For example, national innovation may be
stimulated by higher input prices caused by stricter environmental standards (Porter and Van den
Linde 1995).
4
Notwithstanding differences in theoretical perspective, neither the orthodox, nor the neoclassical,
Schumpeterians (or the case studies under review), are concerned with the vitalizing and sobering
effects of hard external conditions. First, when elaborating the nexus between tough external
circumstances and innovation (or productivity changes) in established firms, the neoclassical
Schumpeterians largely focus on the technological opportunities and abundant resources in hard
times. Firms near the technological frontier have the opportunity to make profitable innovations
as a response to the introduction of superior technologies by new competitors. Like some of the
orthodox Schumpeterians, neoclassical economists also shed light on the freeing of resources for
R&D investment in recession or depression (Mensch 1979, 138-139, 150, 178-179; Aghion and
Howitt 1998, 239-243; Malley and Muscatelli 1999, 339-340; Barlevy 2004). Second, when
arguing that established firms have incentives to innovate under stronger external pressure, the
neoclassical and orthodox Schumpeterians implicitly assume that actual (or nearby) entries (or
harder foreign competition) and depressions respectively are unambiguous signals of the need for
renewal. Thus, the Schumpeterian economists under review ignore the case of genuine
uncertainty, and also the opposite case of reliable information about (the probabilities of)
intensified competition and product maturity in the future, providing arguments for firm renewal
already in prosperity. For example, a depression may not be a new, or even strong, signal of a
threat to the long-run profitability and survival of the firm (cf. the orthodox Schumpeterian
theory).
The lack of references to psychology restricts the possibilities in the orthodox and neoclassical
Schumpeterian literature to explain why companies will only introduce new products,
technologies and organizations when facing an actual competitive pressure or decline in product
demand. Furthermore, a reference to the emergent properties of established firm would have
reinforced the argument for a positive relation between external pressure and productivity (or
innovation). The priority to firm survival increases the incentive for rationalization and renewal
in periods of declining profits.
Through the focus on the adaptation to changing external circumstances, the struggle for
existence, the emergent properties of companies and by providing room for genetic factors,
5
universal Darwinism seems well fitted to incorporate the idea that the transformation of
established firms is stimulated by negative events. But this idea has no special status in works by
Darwinian economists (cf. Hodgson and Knudsen 2010). They focus on selection processes and
social replicators (habits, customs, etc.), not on changes in human behavior in the phenotype
dimension (Erixon 2013, 18-24). Not being deterred by the risk of ‘biological reductionism’, the
TTP highlights the emotional and cognitive adaption to various external circumstances by
established firms. However, the numerous references to basic psychological and neural processes
in the TTP are not intended to deny that the reaction by firm actors to variation in profits is also
explained by social conventions. Nor does the focus on the productive behavior of existing firms
exclude the basic Darwinian presumption that the existing industrial structure, technologies and
actor characteristics are the result of a selection process.
The TTP has many similarities with Harvey Leibenstein’s theory of X-inefficiency.1 For
example, when defining a state of low productivity growth, Leibenstein, though not his
neoclassical followers, referred to habits and psychological distortions (Leibenstein 1979, 484485, 1985, 6-7). But there is some dissimilarity between the TTP and the theory of Xinefficiency. The TTP suggests that severe external condition may boost not only the efforts but
also the cognitive skills of firm actors. Moreover, by emphasizing that managers and owners
share the same psychological biases and interests in the survival of the firm, the TTP downplays
the principal-agent dichotomy in works by Leibenstein and his followers. For example, in the
TTP, the owners’ supervision, evaluation and selection of managers is assumed to be enhanced
by external pressure. Accordingly, the TTP downplays the goal conflict between owners and
CEOs and the hypothesis in the X-inefficiency literature that ‘utility-maximizing’ managers may
depart from profit maximization if the firm is facing (or expecting) favorable profit condition (De
Alessi 1983; Hermalin 1992). Agent laziness in good times could be a threat to the firm’s longrun profit and existence and therefore to the managers’ comfort and incomes even in their current
employment. Arrangements must often be made in good times to sustain profitability and
increase the chance of firm survival (Erixon 2007, 332-333). The TTP emphasizes in contrast to
1
Both the TTP and the Leibenstein theory of selective rationality assert that actors will be (more) rational if the firms
are put under external pressure. And both theories suggest that harder external circumstances (stronger competition
in the Leibenstein case) will induce agents not only to become more efficient but also to use and even develop new
technologies (Leibenstein 1980, 39, 46, 234-236).
6
Leibenstein’s theory of selective rationality that actors will only take action to increase
productivity if the firm is experiencing an actual decline in profits.
The present-value approach in economics provides no space for a negative relationship between
(expected) profit and investment. But the option theory of investment under risk offers a rational
motive for investment on the basis of actual outcomes – by waiting until a change in profit
actually happens, firms can attain more information about the extent and character of possible
threats and opportunities (cf. Dixit and Pindyck 1994, 85, 173). However, in this theory, and also
in Robert Lucas’s rational expectation theory of adaptive learning, profit expectations are based
on profit observations during a long period, thus making it possible to differentiate between
temporary and long-run changes (Lucas 1986, S414-416). In contrast, the TTP suggests that
recent profit development has strong weight when firms make up their investment and strategy
plans. An actual reduction in profits works as an alarm clock inducing decision makers to become
more rational, or at least more anxious to apply near-rational heuristic rules, although there is risk
of overreaction because of a lingering propensity to respond to current outcomes. The idea that
decisions on investment and growth strategies are determined by current outcomes is well-known
in macroeconomics (see the notion of static expectations). But the macroeconomic literature
seldom develops the underlying psychological mechanism.
The hypothesis that the cognitive capacity of firm actors is enlarged by external pressure is
central in the TTP. In neoclassical equilibrium models higher factor prices will alter the
combination of inputs and the character of new technologies. But the model does not say (without
some ad hoc assumptions) that higher input prices can create a competitive advantage by
stimulating the effort or capacity of managers and owners. Neo-Schumpeterian economists
maintain that cost pressure may intensify the firms’ search for new technologies, products and
organization (cf. Zollo and Winter 2002, 341). The neo-Schumpeterians have also incorporated
the idea that higher (relative) factor prices, growing resource scarcity and regulations will
stimulate the development of new technologies and innovations (Nelson and Winter 1982, 185186; Dosi 1988, 1140-1148). The TTP takes this a step further by maintaining that higher factor
prices and growing input scarcity may enhance technological progress and innovation by the
7
associated decline in actual profits. And the TTP further assumes that the cognitive skill of firm
actors will be enhanced by all kinds of external pressure, thus not only by higher input prices.
3. The theory of transformation pressure
3.1 Central assumptions and hypotheses
The TTP is basically a theory of economic growth. Negative shocks are supposed to stimulate
productivity growth by fostering innovation and irreversible changes in industrial composition.
By focusing on changes in current profits the TTP also sheds light on a relationship between
economic policy and economic growth. The theory maintains that productivity, and also
innovation, is stimulated by restrictive fiscal and monetary policy and by revaluation of the
currency.2 This article focuses, however, on the productivity and innovative performance by
established firms over the business cycle. In the TTP, the pace of productivity increases is low in
recovery and high in recession. A specific version of the TTP assumes that productivity growth is
particularly low when profits approaches peak levels and particularly high immediately after the
peak and in the depression.3 The TTP does not exclude that established firms facing a profit
decline will increase productivity by defensive actions such as rationalization rather than by
radical measures to improve technology and product composition. However, in the specific TTP,
innovation dominates over rationalization in depression.
In the TTP firms may increase investment in periods of tougher external circumstances in order
to enhance their productivity performance. A conjecture that investment is promoted by negative
shocks is controversial in economics. Reductions in actual and expected profits have a negative
effect on the net present value of investment. The TTP takes it for granted that aggregate physical
investments will be restricted by negative shocks and accordingly move pro-cyclically. But the
theory maintains that negative events may stimulate investment aimed at transforming the firm
2
In fact, the theory was developed in a period when some economists and politicians accused the devaluations in
Sweden in the early 1980s of having delayed structural change and the renewal of firms and industries in the exposed
sector (Erixon 1991, 353-356).
3
The specific TTP assumes that the psychology of established firms is of minor importance for productivity growth
and innovation immediately after a trough that is, in the recovery phase with Schumpeter’s terminology in the
Business Cycles (Schumpeter 1939). Accordingly the theory does not assume a consistent convex-concave relation
between profit and productivity growth (or innovation).
8
(for example R&D investment). Enforced investments to promote productivity growth and renew
the company can neutralize the negative effects of negative external events on the profitability of
investment. However, the TTP does not exclude the possibility that firm actors are willing to
meet an external threat by investment aimed at transforming the firm even if net present values
are negative.
In the TTP firm survival is the prime goal for CEOs and strategic owners of established firms.
The goals of firm survival and profit maximization will generally coincide. But investment to
extend the life of an established firm may be unprofitable both ex ante and ex post. Firm-specific
competences, but also emotions, may explain why established managers and major owners give
priority to firm survival. And new managers and owners are supposed to be attracted by, and
willing to adjust to, the culture and goals of an established firm. At the same time, the interests of
the firm must coincide, or at least not conflict, with the interests of individual actors. The
prestige, career and expected incomes of the managers in particular are closely related to the
survival of the established firm where they are currently employed.
3.2 The priority to current profits
The TTP posits that current outcomes have a decisive impact on the investment and strategy
decisions by established firms. Actors are assumed to overreact to the profit increase in a
recovery. They make no conscious endeavors here to maximize profits or to satisfy the ultimate
goal of firm survival. In the subsequent recession current outcomes will still be decisive for
investment and strategy choices either by forcing the actors to make (more) rational decisions,
use near-rational heuristic rules or by causing them to overreact.4 The (more) rational actors are
supposed to respond to an actual fall in profit by starting to collect and process information to
find out whether the reduction is temporary or permanent and, further, whether it reflects firmspecific or external circumstances. The TTP does not preclude that the profit fall may be
temporary and modest and therefore no threat to the long-run profitability and survival of the
4
The notion of rationality has two meanings in the article. Firm actors are rational if their strategy and investments
decisions are based on the principle of (expected) profit maximization (given the information costs) and satisfy the
underlying axioms or Bayes’s rule. Actors are also rational if they deliberately spend time on activities aimed at
increasing their knowledge about existing technologies and markets (see learning-by-doing), available investment
alternatives, past profits and about the probability of possible outcomes in the future. Both definitions of rationality
exclude that firm actors are governed by heuristic rules and strong emotions.
9
firm. But the TTP emphasizes that (more) rational actors, thus not only actors who are
overreacting or using near-rational heuristic rules, will alter their investment plans and growth
strategies when a profit recovery turns into a recession.
The hypothesis that firm actors will not react to an external threat until they face an actual decline
in profits does not depend on any specific assumption about risk and uncertainty. When (the
probabilities of) future outcomes are relatively easy to predict, firms are supposed to ignore
available information about possible threats and/or postpone the necessary adjustment until the
day of an actual decline in profits. The profit fall may come as a shock to firm actors who under
the spell of misleading psychological forces have ignored relevant information. In the case of
genuine (Keynesian-Knightian) uncertainty firms cannot gain any reliable information by waiting
until a threat has showed up. Yet, in the TTP, decision makers will first react to threats when
observing an actual decline in profits. And they will not make any preparations in advance to
meet genuinely unexpected negative events, for example, by extending the pool of investment
alternatives or by taking precautions to increase flexibility.
In the TTP, the overreaction by firm actors to actual changes in profits reflects that they are
governed by heuristic decision rules and by emotions (instincts) obstructing rather than
facilitating the decision process.5 People following the peak-end rule consider recent and
exceptional events only (Kahneman 2003; Do et al. 2008). Moreover, the impact of current
profits on firm decisions can reflect the impact of historical relativism. A conviction that history
is irrelevant can be seen as a heuristic rule but also, as also the peak-end rule, as an expression of
an emotional state characterized by a propensity to live in the present (cf. Shiller 2001, 13251328).
5
Some psychologists consider the use of heuristic rules as a strategy (often unconscious) to free people from the
time-consuming task of maximizing (expected) utility (Shah and Oppenheimer 2008). People have a limited
capability to identify, store and process all information and to make calculations. Effort-reducing rules of thumb may
result in satisfactory, near-rational, outcomes (see also Hodgson 2007 and Pagano 2007). But the TTP emphasizes in
line with Tversky and Kahneman (1974, 1986) that heuristic decisions are basically irrational. Actors’ focus on
current outcomes and their preference for status-quo options in periods of increasing profits (see next section) is a
serious threat to the long-run profitability and survival of the firm. However, the TTP includes the possibility that
external pressure may induce actors to switch to near-rational heuristic rules increasing the chance of firm survival
(see Section 3.5).
10
In the TTP, firm actors are not only governed in a profit recovery (or recession) by the peak-end
rule and historical relativism per se. Actors can also extend the use of these heuristic guidelines
during a prolonged recovery (or recession). Furthermore, the prominence of current outcomes is
conditional for the emergence or strengthening of an overconfident (underconfident) attitude
among firm actors in periods of increasing (decreasing) profits. Overconfidence is common and
will not be corrected by learning or by experts when predictability is low (thus when signals are
ambiguous) as in financial markets and also in the non-financial business sector.6 We will make a
distinction between overestimation of expected profits (judgmental overconfidence) and
overestimation of competence. In the judgment case, in periods of increasing profits, firm actors
are supposed to neglect the risk of unfavorable outcomes in the future; they will either be
overwhelmed by strong positive feelings when evaluating the profit prospects of a certain growth
strategy and of the firm itself (unrealistic optimism) or prone to put negative information in a
subconscious mental compartment (Tucket 2009). In the competence case, in times of increasing
profits, CEOs and owners will lose their sense of proportion when assessing their own skill and
capability, for example, to avert possible threats to the firm in the future (illusion of control). In
behavior economics the degree of overconfidence (and underconfidence) is usually measured by
knowledge and mathematical tests or by Bayesian statistics. But the difficulties in obtaining
(more) accurate information about probabilities when the future is genuinely uncertain force us to
hand over the task of measuring the extent of overconfidence to psychotherapists and
neuroscientists. In our study, inferences about the degree and character of overconfidence are
drawn on the basis of a self-diagnosis ex post.7
3.3 The preference for the status quo
The TTP assumes that a previous increase in profits has a decisive impact on investment by
established firms. Central actors governed by myopic heuristic rules and emotions and suffering
from overconfidence will spontaneously increase investment as a response to a recent increase in
6
In the case of CEO overconfidence, see Goel and Thakor (2008, 2737-2741), DellaVigna (2009, 342-343) and
Galasso and Simcoe (2010, 3-4).
7
Our view on overconfidence is not based on the distinction between the overestimation of the precision of signals
(information) and the overestimation of the precision of knowledge and predictability, see Jaimorich and Rebelo
(2007) and Fellner and Krügel (2012). In the TTP some observations (signals) of increasing profits are assumed to
lead to the neglect of the possibility of bad outcomes in the future.
11
profits. But more importantly, the TTP suggests that firms in a profit recovery will stick to their
old technologies, products and organizations and particularly resist a radical transformation.
Actors are supposed to ignore or misread information about potential threats and historical profit
trends challenging the status quo. And a recent increase in profit is assumed to deter the search
for and exploitation of possible investment projects and other opportunities to transform the
company. The theory does not exclude the possibility that investment aimed at transforming the
firm (for example R&D investment) will decrease in a profit recovery (see Section 3.1).
The proposition in the TTP that the psychology of good times is detrimental to transformation is
not evident. It could be argued that overconfident and myopic actors blinded by the light of high
current profits prefer a more radical and perhaps also riskier strategy. And overconfident CEOs
may be more innovative (cf. Galasso and Simcoe 2010). In the TTP, old firms will expand along
established lines in a profit recovery because of a fundamental status-quo bias. This hypothesis is
supported by the psychological literature about a confirmatory (myside) bias. Suffering from a
confirmatory bias both laymen and experts will underreact to (or even ignore) information
rejecting an already chosen alternative and overreact to information verifying the chosen option.
Some encouraging observations of higher profits may create or strengthen overconfidence in the
current strategy given a confirmatory bias. Actors in established firms may also become
overconfident in their ability to ward off external threats when they appear (Rabin and Schrag
1999, Suen 2004; Stanovich and West 2006). The TTP adds that a confirmatory bias may be
strengthened, or even created, in periods of increasing profits.
A status-quo bias can also reflect hyperbolic discounting (O’Donoghue and Rabin 1999;
Angeletos et al. 2001). Actors will postpone rationalization and the introduction of new
technologies, products and organizations if they are overwhelmed by short-term sacrifices and
displeasures when approaching the day of action (Erixon 2007, 337-338). Neuroscience confirms
that different brain activation processes are involved in the evaluation of immediate and delayed
rewards.8 Moreover, a preference for the status quo can emanate from habitual behavior.
Investment along a well-known path may reflect the development of learning-by-doing processes
8
Immediate rewards activate the limbic and paralimbic cortial regions. Delayed rewards trigger the fronto-parietal
regions (Loewenstein et al. 2008, 658-6619; Wittmann et al. 2010).
12
and organizational routines improving the productivity performance of firms. But habits can
simply reflect the obstinate use of heuristic rules and strong conservative emotions. Finally, a
status-quo bias can be explained by indecisiveness. Firm actors’ inability to make a choice may
reflect a major affective deficit in rational calculation (Camerer et al. 2005, 29) or a stalemate
between parallel decision processes (Spiegler 2008, 518). A sensible hypothesis is that the
present-biased preferences, habitual behavior and indecisiveness working against a
transformation of an established firm will be strengthened in periods of increasing profits.
3.4 Waken up by the alarm clock
The TTP suggests that firm actors become (more) rational when experiencing a sudden decline in
profits. Fearing a substantial reduction in profits, and even that the survival of the firm is at stake,
managers and owners will intensify their search for and compilation of relevant information, for
example about alternative investment strategies, production slacks, historical profit developments
and possible threats to the firm in the future. An actual decline in profit, whatever its origin, can
force the firm actors to e.g., reduce or give up their obsessive concern with current outcomes.
Thus, shrinking profits may induce actors to reduce the use of rules of thumb based on the peakend rule and historical relativism. In neuroscientific terms unexpected explicit challenges will
interrupt an automatic brain process favoring a more controlled process (see Camerer et al. 2005,
18). The TTP stresses that CEOs and owners who no longer (or to a lesser degree) are driven by
heuristic rules will undertake measures to increase productivity. Furthermore, in the TTP, a profit
fall will disfavor a status-quo position by mitigating or even eliminating actors’ overconfidence
in their own capacity to conquer external threats when they actually show up and also in the
profit prospects of the current growth strategy. A decline in profits is also supposed to alleviate a
status-quo bias among firm actors by curing indecisiveness, weakening hyperbolic discounting
and reducing conservative thinking.
The TTP allows for that rational firms may give priority in periods of falling profits to
rationalization, mergers and acquisitions and to minor changes in technology, product
composition and organization at the expense of radical transformation. For instance, firms facing
a threat to their existence in a recession can be impelled to take action generating immediate
13
profits because of imperfect capital markets.9 The TTP comprises the possibility that firm actors
will underreact to an actual decline in profits. The profit fall may not be sufficiently strong to
eliminate overconfidence in the status quo in the eyes of a Bayesian observer or a neurologist.
Furthermore, firms may have to face a substantial or long lasting external challenge to combat the
destructive influence of bad habits, indecisiveness and hyperbolic discounting. Psychological
experiments showing that people under time pressure will heuristically limit their search for
information and time spent on each information source suggest that firms will underreact to
external challenges. Experiments have demonstrated that people under stress make stereotypical
choices, reduce their openness to alternative strategies and focus on one problem-solving
strategy.10
However, the TTP emphasizes that firm actors will overreact rather than underreact to a profit
decline strengthening the argument for a negative relationship between actual profit and
productivity growth (cf. Massey and Wu 2005). By overreacting to a few discouraging
observations of profits (the strength of evidence), firm actors may make too drastic strategy
changes. Neuroscience confirms that people’s response to new information can be abrupt and
dramatic (Camerer et al. 2005, 25). Completely rational firms would perhaps have stuck to a
growth strategy without any transformation at all (a possibility downplayed in the TTP) or
switched to a status-quo oriented growth strategy without any radical change in product
composition, technology or organization. The readiness of actors to quit a status-quo strategy
after a profit fall may reflect the persistent impact of current outcomes, thus the firms are still
governed by the peak-end rule and historical relativism. A profit decline may also change
attitudes to status-quo from overconfidence to underconfidence. Actors who earlier had been selfdeceptive about their own judgments and capabilities will not become more sober and selfknowing but instead be seized with panic and feelings of inferiority leading to too little
confidence in business as usual and in their own ability.
9
The hypothesis that firms take minor rather than radical steps to increase productivity in a profit recession is also
supported by psychological experiments indicating that time pressure makes people more risk averse (Erixon 2007,
337; Huber and Kuntz 2007, 423). As usual there are exceptions to the rule, see Davis et al. (1992, 189-191), Mann
(1992, 201-202), Edland and Svenson (1993, 30-33) and Maule et al. (2000, 291-293, 297-298).
10
See the literature survey in Erixon (2007, 341) and also in Byron et al. (2010, 202) and Huntsinger (2012, 1-2).
However, there are psychological studies showing that the change in decision rules under time pressure will result in
more radical strategy changes (Maule et al. 2000, 285).
14
3.5 The use of near-rational heuristic rules under external pressure
When analyzing the reaction by people to external pressure psychologists primarily focus on the
effects of time pressure. Psychologists often make a distinction between the effects on alertness,
decision quality and risk taking (see Payne et al. 1993). Experiments generally demonstrate that
people are more alert (anxious) under time pressure. But at the same time they will make poorer
decisions and extend their use of heuristic rules (see the literature survey in Erixon 2007, 336338, 340 and Boussemart et al. 2009). As aforementioned, the need for quick decisions will
generally increase encoding, that is reduce the number of information sources and exclude a
systematic evaluation of each source.11
Psychological evidence that people make worse decisions and will enlarge their use of heuristic
rules under external pressure is a challenge to the TTP although there is room here for
overreaction. But the general conclusion about a trade-off between effort and quality is rejected
by many psychological studies showing that the quality of decisions will improve under time
pressure (Maule et al. 2000, 284; Drach-Zahavy and Erez 2002; Goodie and Crooks 2004). For
example, Svenson and Benson III (1993) maintain that framing effects (see the prospect theory)
are weaker under time pressure. Moreover, the use of some heuristic rules under time pressure
will improve the quality of decisions (see the notion of near rationality). Psychological
experiments have demonstrated that time pressure will lead to more exchange of information
within groups and to filtration (selection), a lexicographic heuristic process with a stronger
concentration on informative (valenced) facts (Kelly and Loving 2004, 186, 197). Experiments
have also confirmed that filtration under time pressure leads to a greater concern for potential
threats and to intensified search for information about possible negative outcomes (Huber and
Kuntz 2007, 418). Time pressure may even induce a negative emotional state leading to more
controlled and less heuristic decision processes (Dunegan 1993; Huber and Kuntz 2007).
Thus the psychological literature about behavior under time pressure endorses a hypothesis that
firm actors will be more alert and also more concerned about potential threats and their
consequences when the firm is exposed to harder external condition. In the TTP, actors who are
11
The quality of decisions under time pressure is mainly measured in psychological experiments by the capacity of
people to solve some (often mathematical) problem, follow Bayes’s rule or maximize (expected) utility (or the
underlying axioms) in games with well-defined payoffs.
15
more alert, and therefore more rational or more prone to follow near-rational heuristic rules, will
initiate a transformation of the firm. However, the higher arousal level and the possible
overemphasis on negative events may induce actors to overreact, and thus to transform,
notwithstanding that the profit decline is no signal that the firm’s existence is in danger.12
3.6 Creativity under pressure
In the TTP firm actors are supposed to be less prone to follow static heuristic rules and less
swamped by overwhelming emotions favoring the status quo when facing an actual decline in
profits. But the theory also suggests that actors will be more creative and capable of adjusting to
new ideas under adverse economic condition. The phrase that necessity is the mother of invention
captures the idea that harder external circumstances make people more innovative or at least
more able to discover and combine the insights by others. This idea is akin to, and difficult to
separate in practice from, the hypothesis that actors will be more alert and rational under external
pressure. A higher arousal level may be a necessary condition for a positive relationship between
external pressure and creative thinking (Byron et al. 2010, 202). But harder external
circumstances may boost the skill and creativity of firm actors whether they become more alert or
not. Psychologists have conducted field studies of the relationship between time pressure and
creativity and neuroscientists have used brain imaging methods to distinguish whether an
improved individual performance under external pressure reflects that people have become more
alert and rational or more able to use and extend their memory capacity (see Section 4).
Macroeconomics can be enriched by the TTP hypothesis that firm actors are strengthened by
disrupting events and negative experiences. The catch-up literature emphasizes the possibility of
copying foreign technologies and the high marginal productivity of capital at low development
levels. In the TTP a catch-up process can be explained by the possibility that political unrest,
depressions, social trauma, natural catastrophes and wars make the population more creative and
skilful. The TTP may, for example, offer a possible explanation for why the countries defeated in
World War II displayed a high per capita growth 1950-1973 in comparison with the 1913-1950
12
It can be questioned that the literature on time pressure is relevant in the case of TTP. The reference to this
literature is justified by the fact that decision makers mostly become stressed by the threat of firm closure. But stress
among central firm actors may also be a common ailment in periods of high product demand, thus in periods of easy
external circumstances and high actual profits.
16
period and also in comparison with other countries (cf. Ferguson 2007, 121-122). The TTP is
encompasses the idea by Mancur Olsen that such negative experiences will speed up growth by
challenging established organizations (Olsen 1982). But the TTP also comprises the idea that
traumatic events will improve the performance of existing institutions, e.g., by enhancing the
creativity and mental capability of central actors.
In the TTP, the enlargement of cognitive and creative abilities is a salient explanation for the
survival of established firms over decades and also for their renewal in depression. However, the
design of our experiment did not allow a study of the effects of harder external pressure on
people’s creativity and cognitive capacity.
3.6 The specific theory of transformation pressure
In the special TTP the peak-end rule, emphasizing the salience of exceptional events, can explain
why firms are particularly sensitive to profits approaching peak levels. Moreover, the use of the
peak-end rule and the propensity for historical relativism may be more common if a recovery
results in a profit boom. Overconfidence may also be reinforced if a profit recovery turns into a
profit boom (in terms of Bayes’s rule or a mental diagnosis) regardless of any extended use of
heuristic decision rules. In the special TTP all these psychological phenomena can explain, given
a fundamental status-quo bias, why established firms will be particularly status-quo oriented in a
profit boom.
In the specific version of the TTP the increase in productivity growth in a recession will be
exceptional if profits had previously approached record levels. A lingering influence of
exceptional ahistorical thinking (see the peak-end rule and historical relativism) and a switch
from strong overconfidence to strong underconfidence can explain why firms react more quickly
to a profit decline by abandoning a status-quo alternative if they earlier had experienced a profit
boom. Furthermore, firms that had not chosen a status-quo alternative (with or without
transformation) until a profit boom have probably a weaker status-quo bias. The TTP does not
rule out that firms must experience a strong decline in profits to abandon a status-quo option
(with or without transformation) if they had already made this choice before the profit recovery
turned into a profit boom. However, this tendency towards underreaction is not supposed to be
17
decisive in the specific TTP. Thus, the theory infers that firms will generally react more rapidly
by transformation if a profit decline was preceded by a profit boom.
The specific TTP that productivity growth in established firms is exceptionally high in depression
may reflect that the sobering-up and also overreaction process (see the peak-end rule, historical
relativism and underconfidence) is accentuated when profit becomes extremely low. But the
theory emphasizes that actor skill and creativity are stimulated in depressions. In the specific
TTP, this psychological stimulus is also the main explanation for why (the high) productivity
growth in depressions is the consequence of innovation rather than of rationalization. A
competing explanation is that the potential for rationalization has already been exhausted.
4. Testing the theory of transformation pressure
4.1 The general design of the experiment
The prime aim of the experiment was to examine the validity of the hypotheses about investment,
strategy choices and the underlying psychology of firm actors in the TTP. The participants were
students following the same introductory course in macroeconomics at the Department of
Economics, Stockholm university, during four Semesters, Autumn 2009 (85 students), Autumn
2010 (51 students), Autumn 2012 (32 students) and Autumn 2013 (50 students). The students
were instructed to play the role of a CEO for an established company, i.e., a company older than
20 years. Before the experiment, all students had attended lectures, participated in exercises and
conducted an examination on the basic IS-LM model. In this model, private investment is
determined by the rate of interest and GDP (the accelerator). Before enrolled in the role play in
2009, 2012 and 2013, the students had also attended a lecture on how investment is determined
outside the basic IS-LM model. Private investment is here a function of the gross present value –
primarily determined by expected profits and interest rates – and the investment costs. The
students were also informed at these lectures that investment may be stimulated by high actual
profits leading to ‘overoptimism’. The argument for making an exception to the same-lecture
principle (see the 2010 study) was to check whether less information about investment theories in
macroeconomics had any influence on the students’ investment and strategy decisions.
18
The students were asked to complete an anonymous questionnaire in the 2009, 2010 and 2012
studies with nine questions about their investment and strategy options in a profit recovery (three
to four years), a profit boom (a possible outcome during the last recovery year) and in a profit
recession (one year). The students were also asked to report their own perception about the
motives and psychological mechanisms underlying a specific choice. (The questionnaire is
presented in Appendix A.) The 2013 questionnaire added two questions about the strategies in
depression (a decline in profits lasting for three to four years) and about the underlying motives
and psychologies. The set of possible answers provided room not only for the hypotheses
representing the TTP but also for consistently rational considerations, textbook investment
behavior and possible psychological biases outside the TTP. However, the questionnaire
excluded the possibility in the TTP that firms would switch to near-rational heuristic rules in a
profit recession.
The questionnaire was of a multiple-choice character. The students had the possibility to choose
between two to seven answers. But they could only give one answer to each question. Once
having moved to a new question the students were not allowed to return to earlier questions to
modify their answers. When completing the questionnaire the students were not under any time
pressure. They participated in the role play during a break for twenty minutes in the middle of a
lecture. The students were instructed, both verbally and in the questionnaire, to use their
imagination and make endeavors to identify themselves with the CEO of an established company.
They were asked not to be governed by their guesses about what they were expected to reply
according to the macroeconomic textbook or the experimenter. The students should only try to
imagine which choices they would have made as managers and depict their view of why they
acted in the way they did.
When asked about their strategy decisions, the students could choose among three mutually
exclusive strategies - a status-quo strategy without transformation, a status-quo option with
transformation and a radical transformation. The first strategy is a pure status-quo option without
any improvements in technologies or changes in product composition or organizations
whatsoever. Investment is only made to increase production capacity or substitute labor. There is
not even any room here for rationalization, i.e., for the use of production slacks. Thus, this
19
strategy is not associated with any increase in total factor productivity. The second strategy
represents a status-quo oriented transformation. Firms will increase total factor productivity by
rationalization or by marginal changes in technologies, product composition and organizations.
The third growth strategy is a radical transformation constituted by major changes in
technologies, product structures or organizations. Though possibly riskier a radical
transformation is assumed to have a larger growth potential in terms of total factor productivity
than a status-quo oriented transformation, both for the firm itself and for other firms.
The design of the questionnaire made it possible to reproduce a sequence of strategy choices for
each student formed by his or her reaction to variations in profits. Moreover, our sequential
approach and separate questions about investments and growth strategies and the underlying
incentives and psychological mechanisms made it possible to disentangle whether the choices by
the students fulfilled the criteria of bounded rationality (see the TTP) or consistent rationality.
The ambition behind the inclusion of alternatives for consistently rational behavior and the use of
a sequential approach, facilitating an examination of dynamic consistency, was to increase the
internal validity of the experiment. A similar endeavor motivated the inclusion of options
covering psychological phenomena outside the TTP and investment mechanisms other than those
in the TTP and the rational theories of investment. The three replications of the experiment, and
the engagement of students following the same undergraduate course in macroeconomics and
participating in the experiments during the break in the same lecture (with exception for the 2010
inquiry), was intended to reduce the risk for a selection bias. The influence of confounding
factors was hoped to be further reduced by the information in the questionnaire that there was no
financial restriction on firm investment. Furthermore, in three of the four experiments, the
students were asked about their gender and age (born before 1985 or later). The gender and age
composition was actually the same in the three studies (an almost identical overrepresentation of
men and older students) with exception for the 2013 experiment (where women very slightly
overrepresented), see Appendix B. Finally, the students had minimal information about the
previous experiments. The experiments were made with a one-year interval on an evening course
with mostly non-campus students reducing the risk of communication with earlier participants
(and the experimenters).
20
4.2 The questions
By the first question the students, acting as CEOs for an established company, were asked to
reveal their investment decisions in a situation of increasing actual profits (the rate of return on
equity) during the current year and the previous two-three years. One of the seven alternatives
was based on the TTP hypothesis that an increase in actual profits over a couple of years will
stimulate investment in established firms through the positive effect on expected profits
(Proposition 1). Five other alternatives were compatible with elementary (textbook) investment
theory (two versions of the accelerator theory) or with theories of rational behavior (emphasizing
forward-looking expectations, adaptive learning or the value of waiting). The seventh alternative
was based on the idea that firms will invest if they expect that competitors will expand. The
participants in the experiment were informed that also other firms (including competitors) may be
favored by an increase in profits.13
The second question was only directed to students who had replied that higher profits in the short
run made them inclined to increase investment by the positive effect on expectations. The
students had the chance of replying in accordance with the TTP that the profit boost made them
ahistorical (see historical relativism) or overconfident by inducing unrealistic optimism,
suppression of risk or an illusion of control (three alternatives). The students could also proclaim
that they were influenced by the strong optimism flourishing among firms in an economy with
increasing profits, a social-psychological mechanism falling outside the TTP.
The third question focused on the students’ strategy choice in a period of increasing profits. The
TTP maintains that established firms will then opt for a status-quo oriented strategy (Proposition
2). Thus, the theory was represented by the two status-quo alternatives. The fourth question was
only addressed to students who had declared that they would follow a status-quo strategy in times
of increasing profits. Playing the role of CEOs, the students were asked to describe the motives
and mental states underlying their choice of a status-quo option. The TTP was represented by the
same four psychological options as in the investment case above. An additional option
represented the non-TTP case of enforced rationality in a recovery – the increase in profits will
13
The TTP does not exclude that R&D investment will increase in times of harder competitive pressure. But the
theory requires that the competitive pressure is real.
21
induce firm actors to abandon an underconfident attitude to status quo developed during an
earlier period of falling profits.14
The fifth question to the students concerned their strategy choice in a situation where short-run
profit is approaching record levels. The special case of the TTP states that the number of
established firms choosing radical transformation during a period of increasing profits is
particularly low if the period ends with a profit boom (Proposition 3). Firms that choose a
transformation along a status-quo strategy during a ‘normal’ profit increase are supposed to have
a tendency to follow a strategy without any transformation at all in a profit boom (Proposition 4).
And (the insignificant share of) firms that prefer a radical transformation during a ‘normal’
increase in profits are expected to choose one of the status-quo options when profits become
exceptionally high (Proposition 5). Finally, to confirm the specific TTP, firm actors (students)
who chose a status-quo alternative without any transformation at all when profits were increasing
must hold to this alternative when profit become exceptionally high (Proposition 6).
The sixth question asked for the students’ reaction to news that their firm was facing a risk of a
substantial decline in future profits. In the TTP firm actors make no serious effort to upgrade their
growth strategy until after an actual decline in profit (Proposition 7). Two other options
represented the opposite case of transformation already after an expected decline in profits. The
seventh question should only be answered by students who had declared that they would not
change strategies until the firm experienced an actual decline in profits. The students could
answer that a decline in actual profits was necessary to persuade them to abandon their heuristic
propensity to only consider current outcomes (see historical relativism and the peak end rule).
They had also the chance of replying (by three alternatives) that an actual decline in profit made
them less overconfident about their old strategy (by abandoning overoptimism, suppression of
risk and overestimation of own abilities). Alternatively, the students could declare that they have
a tendency to overreact to an actual decline in profits. The students had also the opportunity to
choose a rational alternative in line with the option theory of investment under risk - they
14
The TTP does not exclude the working of a similar psychological mechanism in periods of increasing profits. But
the theory assumes that this mechanism will be superseded by a tendency to overconfidence over a period ranging
from three to four years.
22
postpone transformation until an actual decline in profit in order to increase the weight of
evidence; new observations of actual outcomes would increase the knowledge about the true
character and scope of external threats.
The eighth question asked the students to reveal their strategy response to a decline in actual
profit in one year after three-four years with an increase in profit. The question did not define
whether the profit fall was unexpected or expected. Hence all students should answer this
question whatever their reply to the previous question about their response to a risk of a
substantial decline in profit in the future. The TTP suggests that established firms tend to
transform after an actual decline in profit (Proposition 8). The theory requires that firms that had
chosen a status-quo strategy without transformation in the previous recovery will meet a profit
decline by transformation along the lines of a status-quo oriented or radical transformation
(Proposition 9). The TTP further asserts that established firms that have opted for a status-quo
based transformation in the period of increasing profits will switch to radical transformation in
the subsequent period of dwindling profits (Proposition 10). The TTP also requires that the firms
that, despite all, made a radical transformation in the profit recovery will be loyal to this strategy
in the subsequent recession (Proposition 11).
The ninth question was only posed to students who chose a transformation option after a fall in
actual profit. The students were asked to specify whether the profit decline must be of equal size
as the previous increase in profit during a period of the same length (here one year) or if it could
be small in relation to the previous increase in profit. The aim was to test the hypothesis in the
special TTP that firms will react faster by transformation if the profit decline was preceded by a
profit boom. The theory suggests that firms that only chose a status-quo oriented transformation
instead of a radical transformation when profits reach record levels are expected to react
immediately to a profit decline by radical transformation (Proposition 12). And the special TTP
further expects that that firms (students) that only preferred a status-quo option without
transformation when the profit levels were extremely high would react rapidly to a profit decline
by transformation (Proposition 13).15
15
A possibility in the special TTP is that firms choosing the same status-quo strategy (with or without
transformation) in periods of a ‘normal’ profit increase and a profit boom will only upgrade their strategy after a
substantial decrease in profits. However, this sequence of strategies is not decisive in the special TTP.
23
In the 2013 study the number of hypotheses about investment falling outside the TTP was
reduced from six to three (see the first question). Furthermore, the 2013 experiment consistently
put the three cases of overconfidence together. But it added an alternative to provide room for the
peak-end rule in the recovery (see the options for ahistorical thinking). And the 2013
questionnaire allowed for that the choice of a status-quo alternative in a recovery reflected the
impact of bad habits and indecisiveness and the reluctance to make immediate sacrifices for later
rewards (see hyperbolic discounting). Accordingly the 2013 experiment included alternatives
representing the abandoning of these psychological biases after a profit decline. But the most
important difference between the experiments was the inclusion in the 2013 study of two
questions about the strategy choices in depression (with declining profits over three to four years)
and about the underlying beliefs and motives. The special TTP posits that established firms will
not only transform but also prefer a radical transformation in depression (Proposition 14). To
satisfy the specific TTP, firms that opted for a status-quo alternative after a one-year fall in
profits must change to radical transformation in the depression (Proposition 15). And the firms
that preferred radical transformation during a one-year fall in profits must remain faithful to this
alternative when the recession is deepened (Proposition 16).
The students who changed to radical transformation during a depression in line with the special
TTP were then asked whether the switch reflected the abandoning of overconfidence (first
alternative), bad habits, hyperbolic discounting and indecisiveness (second alternative) or
overreaction (third alternative). A fourth alternative covered the possibility that depression is a
strong signal to calculating firm actors that the growth potential of existing technologies,
products and organizations has been exhausted. This alternative is compatible with the option
theory of investment under risk but also with the TTP version of enforced rationality. A fifth
(technical) alternative goes definitely beyond the psychological TTP – the depression is a strong
signal that the firm’s potential to increase productivity without radical transformation was already
exhausted during the first recession years.
24
The simple decision three in Figure 1 summarizes the chosen strategies during profit recoveries
and recessions in the general TTP. Figure 2 presents the more complicated decision three in the
special TTP.
Figure 1 and Figure 2 in here
The consistent test was based on the replies by the students on the nine questions in the 2009,
2010 and 2012 experiments. A comparison of the answers by each student made it possible to
shed light on inconsistent behavior at a given time and also over time (dynamic inconsistency).
Some inconsistencies are critical for both the standard theory of constant rationality and the TTP
of bounded rationality. Therefore, our consistency test focuses on the replies by the students that
make it possible to discriminate between the two approaches. Our ambition was to find out
whether we can answer the following four questions in the affirmative:
Case 1: Did the students who made investment on the basis of a small number of observations in
the recovery then declare that their propensity not to transform the firm until after an actual profit
decline in profit reflected that they had become more rational?
Case 2: Did the students who referred to irrational motives for their choice of a status-quo
strategy in a profit recovery then declare that their propensity not to transform the firm until after
an actual profit decline in profit reflected that they had become more rational?
Case 3: Did the students who referred to rational motives for their investment in the recovery
then declare that they had not transformed the firm until after an actual decline in profit on
consistently rational grounds?
Case 4: Did the students who had chosen a status-quo strategy in a profit recovery on rational
grounds then declare that they had not transformed the firm until after an actual decline in profit
on consistently rational grounds?
25
Affirmative answers to the first two questions are favorable to the TTP. Confirming answers to
the following two questions are beneficial for theories of consistent rationality.16
4.3 The results
The answers by the students were processed through a multinomial or a simple binomial test of
the frequency of the TTP answers against a null hypothesis that the observed frequency was a
random draw. The results from the role plays were almost identical. The presentation in this
section focuses on the total result from the 2009, 2010 and 2012 studies (see also Appendix B).
The 2013 questionnaire about psychological mechanisms is not fully comparable with the
previous ones. However, we will present the answers in the 2013 study to the new questions
about the strategy choices and the underlying psychologies in depressions.17 And we have
consistently compared (though not recorded) the choices among the three strategies under
varying profit conditions in the 2013 inquiry with those in the earlier studies. In fact, the there
was a perfect match between the 2013 study and the earlier three studies where the students’
strategy choices are concerned.
The experiments endorsed the TTP hypothesis that established firms will overreact to a short-run
increase in profit (see Proposition 1). The share of replies confirming this hypothesis (27 per
cent) was significant at the 1 percent level.18 Moreover, the proportion of overinvesting students
selecting the psychological alternatives representing the TTP was significant (at the 5 percent
level) but only when put together.19
The students approved the TTP by demonstrating a strong propensity to choose a status-quo
option in periods of rising profits (see Proposition 2). The total share for the status-quo options is
16
Our test of consistent behavior had also the ambition of revealing a possible hindsight bias at the experiment, thus
that the students’ rational motivation for a certain strategy ex post may not reflect their considerations ex ante (see
Koellinger et al. 2007, 503). The test confirms a hindsight bias if the students’ rational argument for a certain
strategy is contradicted by their previous choices and motivations (se Case 3 and 4 above).
17
Full information about the 2013 study can be obtained from the authors upon request.
18
The share for the overinvestment option was 34 percent in the 2013 study in which the students could only choose
between four investment alternatives.
19
In the 2013 study, where the three options of overconfidence were reduced to one, there was no significance at all
for the psychology of overinvestment in the TTP.
26
significant at the 1 per cent level. But more students actually opted for a radical transformation
than for a status-quo position without transformation. And the share of the students who declared
that they had been governed by the psychological mechanisms emphasized in the TTP (among
the students opting for a status-quo alternative) was not even significant when considered
together.20
The students confirmed the specific TTP by being exceptionally status-quo minded in a profit
boom. The proportion of students choosing a status-quo option instead of a radical transformation
was significantly larger (at the 5 per cent level) in the profit boom than in the period of a profit
increase in general (see Proposition 3). The difference primarily reflected a higher propensity for
the pure status-quo alternative in the profit boom (these statistics are not shown in Appendix B).
It is true that a minor share of the students changed from a status-quo option with transformation
to a pure status-quo alternative when the profits approached record levels (see Proposition 4).
However, the share of students who switched from a radical transformation to a status-quo option
in a profit boom was significant at the 1 per cent level (see Proposition 5). Furthermore, the share
of students who were loyal to a status-quo option without transformation when a profit increase
turned into a profit boom was significant at the 1 per cent level (see Proposition 6). We therefore
draw the conclusion that the students were more status-quo oriented in a boom than in a profit
recovery.
The experiment was unable to confirm the TTP hypothesis that firms will first react by
transformation after an actual decline in profit (see Proposition 7). The majority of students
declared that they would react to information about a risk of a substantial decline in profits in the
future by changing to either a status-quo oriented or a radical transformation. The share of the
students (one third) who chose the alternative representing the TTP – firms will not react until the
profit decline manifests itself – was insignificant. What more is, the experiment could not
confirm the TTP explanations for why firms will only react to an actual decline in profits. The
majority of the students (76 per cent) answered in line with the option theory of investment under
20
These psychological mechanisms were also insignificant in the 2013 study. This study considered the impact not
only of ahistorical thinking and overconfidence but also of bad habits, indecisiveness and hyperbolic discounting.
27
risk that they did not react until the profit fall was real to get a clearer picture of the character and
scope of the decline.21
The experiment vindicated that firms would transform after an actual reduction in profits (see
Proposition 8). An overwhelming majority of the students preferred one of the transformation
alternatives. The share for the two transformation options together was significant at the 1 per
percent level. The fact that few students chose a radical transformation (48 out of 159 students)
does not reject the TTP.
The experiment did only partly borne out the hypothesis in the TTP that individual firms will
switch to more advanced strategies when actual profits fall. A significantly large proportion of the
students (at the 1 per cent level) who preferred a pure status-quo strategy in the profit recovery
decided to transform when facing a decrease in profits (see Proposition 9). However, the role
play did not endorse the related hypothesis in the TTP that firms that had chosen a status-quo
oriented transformation during the upswing in profits turned to a radical transformation in the
subsequent period of falling profits (see Proposition 10). And only a minority of the students (19
out of 44(?) students) who chose radical transformation during the profit recovery remained loyal
to this alternative during the following decline in actual profits (see Proposition 11).22
The experiment did not unambiguously support the argument in the specified TTP that firms
would even react to a minor decline in profits by transformation if they had first switched to a
status-quo alternative in a profit boom. Almost all students who had only chosen a status-quo
oriented transformation (instead of a radical transformation) in a profit boom did actually answer
that they would respond to a small reduction in profit by radical transformation (see Proposition
12). But it is difficult to draw any definite conclusions in this case due to the very low number of
students who had changed strategy in the profit recovery (6 out of 7 students). Moreover, an
insignificant proportion of the students who had only opted for a pure status-quo alternative in a
21
This share was even larger (86 per cent) in the 2013 study where other psychological mechanisms than ahistorical
thinking and overconfidence in the TTP were accounted for.
22
But the share of students who switched from radical transformation to a status-quo option was insignificant as
well. Thus, the experiment did not support a hypothesis contradicting the TTP that decision makers became more
status-quo oriented in periods of falling profits.
28
profit boom declared that they would even respond to a small decrease in profits by
transformation (see Proposition 13).23
The experiment supported the specific TTP that firm actors are particular anxious to pursue a
radical transformation in depression (see Proposition 14). The share of students choosing a
radical transformation rather than a status-quo strategy was significantly larger (at the 1 per cent
level) in a profit depression than in a modest profit recession (this statistics are not shown in
Appendix B). A significant proportion (1 per cent level) of the students who chose a status-quo
alternative in a mild recession turned to radical transformation in depression (see Proposition 15).
And the share of students who were loyal in depression to a radical-transformation option already
chosen in a one-year recession was significant (at the 1 per cent level) as well (see Proposition
16). The TTP psychological explanations for the switch to radical transformation in depression
were also confirmed by the experiment but only if the alternative compatible with the option
theory of investment under risk is accounted for (see the precision of signals).
The test of consistency did not confirm the TTP (see Appendix C). Among the students who had
made investment and strategy decisions on irrational grounds and also postponed transformation
until after an actual decline in profit, only a few referred to the fact that they had become more
rational. On the other hand, the test verified the theory of consistent rational behavior. Among the
students who had made investment and strategy decisions on rational grounds, and further not
transformed until after an actual decline in profit, almost all declared that they had consistently
acted on rational grounds.
5. A qualified theory of transformation pressure
By being reasonable, separable from other theories and testable, the TTP satisfies the criteria for
being a fruitful theory about economic growth and the business cycle. At the same time, the
23
Furthermore, the role play was unable to demonstrate that a strong decrease in profit was needed to enforce firms
to transform when they had chosen any of the status-quo strategies during both a profit recovery and a profit boom
(these results are not depicted in Appendix B). However, the special TTP does not assume that this indication of a
strong confidence in status quo in a profit recovery is decisive for the reaction to the following recession. The theory
emphasizes that a profit boom makes firm actors more eager to abandon a status-quo position in the subsequent
recession.
29
results from our test of the TTP are ambiguous. In fact, industrial economics, psychology and
neuroscience provide no general support for the theory. The TTP itself does not take it for
granted that the psychology of external pressure will always maximize productivity growth for
the society at large or even for the firm itself. Harder pressure may lead to short-run, defensive,
action to increase productivity, including rationalization and mergers, rather than to radical
changes in technology, product composition and organization (see the results from our
experiment). The choice of rationalizations and mergers instead of radical transformation may
result in a growth path with lower productivity increases, both in the short and the long run, if the
strategies are mutually exclusive. Industrial, psychological and neurological evidence suggest
that firm productivity may even be impeded by external pressure.
Psychologists claim that exceptionally strong or a long-lasting external pressure is destructive.
Unexpected exceptional threats will paralyze people especially when they feel that events are
uncontrollable (Sweeny 2008, 63). Furthermore, permanent pressure may lead to exhaustion and
blunting effects deteriorating not only the quality of decisions but also the energy levels
(Jaskowski et al. 2000, 91, 102-104; Maule et al. 2000, 297; Dragone 2009, 552-554).
Neuroscientists have actually confirmed the blunting hypothesis. A neural sensitivity to
unexpected changes reflects that people will react more to changes from a reference point than to
outcome levels, see the Kahneman-Tversky prospect theory (Camerer et al. 2005, 27-28;
Loewenstein et al. 2008, 652-653). Furthermore, chronic pressure (stress) will lead to destructive
impulsivity (lower response inhibition) and (at least temporary) to working memory deficits
(Mika et al. 2012).
Psychologists have suggested an inverse U-shaped relation between perceived threats and the
willingness to pay attention to and evaluate possible responses (Sweeny 2008, 70). When arguing
in the 1980s for an inverse U-shaped relation between external pressure and the quality of
decisions Leibenstein referred to the contemporary psychological literature about time pressure
(Leibenstein 1980, 94-96, 1985, 7-9, see also Mann 1992, 210-211 and Payne et al. 1993, 167168). Leibenstein’s hypothesis was later vindicated by psychological field studies e.g. elucidating
that stronger time pressure will stimulate creativity but only up to a certain level (see the
literature surveys and new results in Baer and Oldham 2006 and Byron et al. 2010). Furthermore,
30
recent neuroscientific studies have demonstrated that memory persistence is enhanced by
moderate stress (Hupbach and Fieman 2012; Parfitt et al. 2012). Leibenstein’s nuanced theory
about the optimal external pressure also accords with the findings in industrial economics of an
inverse U-shaped relationship between competition on the one hand and R&D investment,
technical efficiency, innovation and productivity growth on the other (Scherer 1992, 1419-1420;
Nickell et al. 1997, 787; Aghion and Howitt 2009, 7-8). Thus, there are arguments for
formulating a modified version of the TTP emphasizing the growth-enhancing effects of
moderate pressure.
However psychologists maintain that some organizational and personal conditions must be
satisfied to attain an inverse U-relation between external pressure and creativity (Baer and
Oldham 2006). Industrial economists have highlighted the role of technical opportunities,
industry structures and capital-markets conditions for the relationship between the degree of
competition and R&D investment or innovation. Many industrial studies have rejected the
inverted U hypothesis as such (Scherer and Ross 1990, 645-651; Scherer 1992, 1423-1425;
Hopman, Rojas-Romagosa and Veenendaal 2010). The suggested monotonic positive relationship
between competition and R&D investment or innovation actually confirms the unqualified TTP.
Thus there are objections to (and restrictions on) a theory that moderate external pressure in each
period is (always) the most favorable condition for innovation and high productivity growth. A
sensible alternative hypothesis is that the economic development is stimulated by periodic swings
between hard and easy external conditions. Exceptionally strong pressure may be needed to
induce firm actors to abandon a dead-end growth path, for example, by forcing them to get rid of
an overconfident and destructive habitual attitude to their current growth strategy and also to
choose radical instead of status-quo oriented transformation. Furthermore, given the psychology
of firm actors, the pressure on firms must perhaps be extreme in some periods to eliminate the
least productive vintages. In the subsequent period of easy external circumstances there is large
room for innovation through firm heterogeneity. And selected firms have then the opportunity to
enjoy the virtuous circles of scale advantages, learning by doing, organizational routines and
favorable self-financing conditions. Moreover, under easy external condition, innovation and
productivity growth may be enhanced by the low number of exhausted agents. By reference to
31
the psychological literature Tibor Scitovsky advocated an alternation between weak and strong
stimuli over time – an optimal level of arousal will emerge if a period with a tendency to mental
exhaustion is followed by a period of relaxation (Scitovsky 1976, 24-25).
It seems near at hand to qualify the TTP further by highlighting the growth-enhancing role of
both pressures and opportunities during a specific time period. Industrial economists often regard
the combination of large technological opportunities, scale advantages, industrial networks and
intensive competition and the coexistence of large and small firms as favorable to R&D
investment and innovation. The origin of a change in actual profits is probably also paramount
for productivity development. One aspect of overconfidence is that people will credit themselves
for favorable outcomes that are largely the result of chance or beyond their control in general. It
is likely that a profit increase through devaluation has a stronger preservative effect on company
development than a profit boost through previous innovations. Devaluations are likely to generate
an illusion of control and a too strong trust in a status-quo strategy while successful innovators
have a more realistic view of the prospects of ‘old’ innovations and the risk of following a statusquo strategy. Recent psychological experiments have confirmed that people are less
overconfident in both their capability and predictions if they think that successful outcomes
depend on their own efforts (Urbig and Monsen 2012).
6. Conclusions and comments
The idea in the theory of transformation pressure (TTP) that productivity growth within
established firms is higher and innovation more frequent under severe external circumstances has
parallels in the orthodox and neoclassical Schumpeterian tradition and in the theory of Xinefficiency. The TTP makes the precision that the productivity growth of established firms is
inversely related to current profits. Hence, counter-cyclical productivity growth is explained by
the pro-cyclicality of actual profits. And in contrast to similar theories, the TTP highlights the
crucial role of the psychology of firm actors. When profit increases over a couple of years,
owners and CEOs governed by heuristic rules, overconfidence and other psychological biases are
assumed to opt for a status-quo oriented growth strategy. Firm actors are supposed to first
abandon their reluctance to transformation when facing an actual decline in profits, especially if
they expect that the survival of the firm is at stake. Actors will then become more creative and
32
also more calculating weakening the impact of heuristic rules and strong emotions favoring the
status quo. Productivity growth may also increase in bad times through the switch to (nearrational) heuristic rules providing more attention to external threats and their consequences (see
the psychological literature on behavior under time pressure). But the TTP underlines that high
productivity growth in a recession may reflect that firms are overreacting to a decline in actual
profit.
To gauge the validity of the TTP an experimental role play was conducted at Stockholm
University at four occasions 2009-2013. The experiments enrolled in total 218 first-semester
students in macroeconomics. Instructed to act as CEOs for an established company the students
should answer nine to eleven multiple-choice questions about their investment and strategy
choices under varying profit conditions and also about their view ex post of the underlying
motives and psychology. The prime object of the experiment was to test sixteen propositions
associated with the TTP. The questionnaire also provided room for answers in accordance with
standard theories of rational behavior. In fact, the sequential design of the experiment, made it
possible to disentangle whether the students acted consistently in terms of either the theory of
constant rationality or the TTP theory of bounded rationality (cf. DellaVigna 2009, 366). The
results from the four experiments were very similar suggesting that the questionnaire succeeded
in capturing some basic psychological mechanisms.
Our tests of the TTP showed mixed results. The experiment supported the hypotheses about
overinvestment and the choice of status-quo strategies in periods of increasing profits. And a
clear majority of the students preferred a transformation option after a profit decline. But most
students reported in conflict with the TTP that they would transform the firm already after an
expected reduction in profit. And almost all of the remaining students declared that they
postponed transformation until the day of an actual decline in profit in order to get more
information (see the rational option theory of investment under risk). Furthermore, the
experiment could not confirm that the students’ choice of a status-quo option in the previous
recovery reflected the psychology of the TTP. And their preference for status-quo options in the
profit recovery and for transformation in the subsequent profit recession largely reflected the
popularity of a common denominator – a status-quo oriented transformation. Furthermore, the
33
experiment only partially verified the central TTP hypothesis that firm actors will upgrade their
strategy after a negative profit shock. Finally, our test of inconsistent behavior provided a
stronger support to the standard theory of consistently rational behavior than to the TTP theory of
bounded rationality.
In the specific TTP productivity growth is exceptionally low in a profit boom and especially high
in the aftermath of a profit boom and in a depression. The experiment actually showed that the
students’ strategy choices were extremely status-quo oriented in a profit boom. There was also
evidence that the students reacted more rapidly to a profit decline if they had become more
status-quo oriented when the profit recovery turned into a profit boom. And the experiment
supported the specific TTP hypothesis that depression is the phase of radical transformation.
To assure the external validity of the experiment the participants must react in the same way to
changes in actual profits as leading actors in the business sector of a developed economy. The
study was based on the assumption that first-year students in macroeconomics made similar
investment and strategy choices as CEOs of established companies because of basic genetic
factors, social conventions and some common knowledge about investment theories and
calculation methods. Moreover, the external validity of the experiment was expected to be
guaranteed by the gender and age of the students. As relatively old and predominantly male, the
participants were more CEO-like than the average student at the university level and also than the
average student of economics. But the external validity of the experiment can still be questioned.
An obvious objection to the role play is that undergraduate students neither have the ability nor
the incentives to enter into the role of CEOs for an established company. Instead, the students
might have been governed, notwithstanding the instructions, by elementary macroeconomic
theories and by conjectures about the expectations of the experimenters. On the other hand, it is
not certain that real firm actors completing a similar questionnaire would have provided a more
accurate picture of investment and strategy choices than students in economics. Prestigious
managers are probably unwilling, even anonymously, to reveal their true motives and less able to
make a psychological self-diagnosis than students only pretending to be managers.
34
A plausible objection to our experiment is, after all, that it could not reproduce the emotions,
experiences, conventions and social interactions shaping the actual decision-making process in
established firms. Above all, it is likely that the response to negative shocks is industry-, countryand firm-specific. But the main weakness of our study is probably that the participants in the
experiment acted more rationally in their imagination than in reality, especially by the provision
of ‘correct’ textbook and rational alternatives. Thus, it is probable that our experiment had a
rational bias disfavoring the TTP although the bias might actually have been larger if the
questionnaire had been sent out to real CEOs. At the same time, the partial confirmation only of
the TTP conforms to evidence in psychology, neuroscience and also industrial economics that the
theory must be qualified. Productivity growth in the business sector may be maximized under
moderate pressure or through a sequential process where periods of strong pressure are followed
by periods of great opportunity for technical and financial consolidation and the restoration of
cognitive capacity, mental energy and confidence.
Literature list
Aghion P, Howitt P (1998) Endogenous growth. MIT Press, Cambridge, MA
Aghion P, Howitt P (2009) The Economics of Growth. MIT Press, Cambridge, MA
Aghion P, Blundell R, Griffith R, Howitt P, Prantl S (2009) The effects of entry on incumbent
innovation and productivity. The Review of Economics and Statistics 91(1):20-32
Angeletos GM, Laibson D, Repetto A, Tobacman J, Weinberg SA (2001) The hyperbolic
consumption model: calibration, simulation, and empirical evaluation. The Journal of Economic
Perspectives 15(3):47-68
Baer M, Oldham GR (2006) The curvilinear relation between experienced creative time pressure
and creativity: moderating effects of openness to experience and support for creativity. Journal of
Applied Psychology 91(4):963-979
Baily M, Gersbach H (1995) Efficiency in manufacturing and the need for global competition.
Brookings Papers on Economic Activity, Brookings Institution, Washington DC, pp. 307-347
Barlevy G (2004) On the timing of innovation in stochastic Schumpeterian growth models.
NBER Working Paper No. 10741, National Bureau of Economic Research, Cambridge, MA
35
Bartelsman EJ, Haltiwanger JC, Scarpetta S (2004) Microeconomic evidence of creative
destruction in industrial and developing countries. Tinbergen Institute Discussion Paper TI 2004114/3, Tinbergen Institute, Amsterdam
Bloom N, Van Reene J (2007) Measuring and explaining management practices across firms and
industries. Quarterly Journal of Economics 122(4):1351-1408
Boussemart Y, Donmez B, Cummings ML, Las Fargeas J (2009) Effects of time pressure on the
use of an automated decision support system for strike planning. In: Proceedings of the 15th
international symposium on aviation psychology, Dayton, Ohio
Brown DJ, Earle JS (2008) Understanding the contribution of reallocation to productivity growth:
lessons from a comparative firm-level analysis. IZA Discussion Paper No. 3683, The Institute for
the Study of Labor (IZA), Bonn
Byron K, Khazanchi S, Nazarian D (2010) The relationship between stressors and creativity: a
meta-analysis examining competing theoretical models. Journal of Applied Psychology
95(1):201-212
Camerer C, Loewenstein G, Prelec D (2005) Neuroeconomics: how neuroscience can inform
economics. Journal of Economic Literature 43(1):9-64
Davis J, Kameda T, Stasson M (1992) Group risk taking: selected topics. In Yates F (ed) Risk
taking behaviour, ch. 6. John Wiley, New York
De Alessi L (1983) Property rights, transaction costs, and x-efficiency: an essay in economic
theory. American Economic Review 73(1):64-81
DellaVigna S (2009) Psychology and economics: evidence from the field. Journal of Economic
Literature 47(2):315-372
Dixit A, Pindyck R (1994) Investment under Uncertainty. Princeton University Press, Princeton
New Jersey
Do AM, Rupert AV, Wolford G (2008) Evaluations of pleasurable experiences: the peak-and-end
rule. Pscychonomic Bulletin & Review 15(1):96-98
Dosi G (1988) Sources, procedures, and microeconomic effects of innovation. Journal of
Economic Literature 26(3):1120-1171
Drach-Zahavy A, Erez M (2002) Challenge versus threat effects on the goal-performance
relationship. Organizational Behavior and Human Decision Processes 88(2):667-682
Dragone D (2009) I am getting tired: effort and fatigue in intertemporal decision-making. Journal
of Economic Psychology 30(4):552-562
36
Dunegan K (1993) Framing, cognitive modes, and image theory: Toward an understanding of a
glass half full. Journal of Applied Psychology 78(3):491-503
Edland A, Svensson O (1993) Judgement and decision making under time pressure. In Svensson
O, Maule J (eds) Time pressure and stress in human judgement and decision making. Plenum,
New York, pp. 27-40
Erixon L (1991) Transformation pressure and productivity (Omvandlingstryck och produktivitet).
In: Competition, regulation and productivity, Appendix 7 to SOU 1991:92, Swedish Productivity
Commission (Produktivitetsdelegationen), Allmänna Förlaget, Stockholm, pp. 233-399
Erixon L (2007) Even the bad times are good: a behavioural theory of transformation pressure.
Cambridge Journal of Economics 31(3):327-348
Erixon L (2013) A Darwinian theory of transformation pressure. The stimuli of negative shocks
for productivity and renewal in established firms. Research Papers in Economics 2013:4,
Department of Economics, Stockholm University
Estrella A (2004) Decoding productivity: business cycle properties of labor productivity growth.
Federal Reserve Bank of New York, New York
Fellner G, Krügel S (2012) Judgmental overconfidence: Three measures, one bias? Journal of
Economic Psychology 33(1):142-154
Ferguson N (2007) The Second World War as an economic disaster. In: Oliver MJ, Aldcroft DH
(eds) Economic disasters of the twentieth century. Edward Elgar, Cheltenham, UK
Giannangeli S, Gómez-Salvador R (2008) Evolution and sources of manufacturing productivity
growth: Evidence from a panel of European countries. Working Paper Series no. 914/June 2008,
European Central Bank, Frankfurt am Main
Galasso A, Simcoe TS (2010) CEO overconfidence and innovation. NBER Working Paper
16041, National Bureau of Economic Research, Cambridge, MA
Goel AM, Thakor AV (2008) Overconfidence, CEO selection and corporate governance. The
Journal of Finance 63(6):2737-2784
Goodie AS, Crooks CL (2004) Time pressure effects on performance in a base-rate task. The
Journal of General Psychology 131(1):18-28
Hermalin B (1992) The effects of competition on executive behaviour. RAND Journal of
Economics 23(3):350-365
Hodgson GM (2007) Introduction. In: Hodgson GM (ed) The evolution of economic institutions.
A critical reader. Edward Elgar, Aldershot, Cheltenham, UK, pp.1-15
37
Hodgson GM, Knudsen T (2010) Darwin’s conjecture. The search for general principles of social
and economic evolution. The University of Chicago Press, Chicago
Hopman C, Rojas-Romagosa H, Veenendaal P (2010) The relation between competition and
innovation: Empirical results and implementation into WorldScan. CPB Netherlands Bureau for
Economic Policy Analysis, March 2010, Amsterdam
Huber O, Kuntz U (2007) Time pressure in risky decision-making: effect on risk defusing.
Psychology Science 49(4):415-426
Huntsinger JR (2012) Does positive affect broaden and negative affect narrow attentional scope?
Journal of Experimental Psychology: General March 121. doi:10.1037/a0027709
Hupbach A, Fieman R (2012) Moderate stress enhances immediate and delayed retrieval of
educationally relevant material in healthy young men. Behavioral Neuroscience 126(6):819-825.
doi:10.1037/a0030489
Jaimorich N, Rebelo S (2007) Behavioral theories of the business cycle. Journal of the European
Economic Association 5(2-3):361-368
Jaskowski PR, van der Lubbe R, Wauschkuhn B, Wascher E, Verleger R (2000) The influence of
time pressure and cue validity on response force in an S!-S” paradigm. Acta Psychologica
105(1):89-105
Kahneman D (2003) Experienced utility and objective happiness: a moment-based approach. In:
Brocas I , Carrillo JD (eds) The Psychology of economic decisions, volume I: Rationality and
well-being. Oxford University Press, Oxford, pp. 187-208
Kelly J, Loving T (2004) Time pressure and group performance: exploring underlying processes
in the Attentional Focus Model. Journal of Experimental Social Psychology 40(2):185-198
Kleinknecht A (1987) Innovation patterns in crisis and prosperity. Schumpeter’s long cycle
reconsidered. MacMillan Press, London
Koellinger P, Minniti M, Schade C (2007) “I think I can, I think I can”: overconfidence and
entrepreneurial behavior. Journal of Economic Psychology 28(4):502-527
Leibenstein H (1979) A branch of economics is missing: micro-micro theory. Journal of
Economic Literature 17(2):477-502
Leibenstein H (1980) Beyond economic man. A new foundation for microeconomics. Harvard
University Press, Cambridge, MA
Leibenstein H (1985) On relaxing the maximization postulate. Journal of Behavioural Economics
14(1):5-20
38
Loewenstein G, Rick S, Cohen JD (2008) Neuroeconomics. The Annual Review of Psychology
59(1):647-672
Lucas RE Jr (1986) Adaptive behaviour and economic theory. Journal of Business 59(4):S401S426
Malley J, Muscatelli A (1999) Business cycles and productivity growth: are temporary downturns
productive or wasteful? Research in Economics 53(4):337-364
Mann L (1992) Stress, affect, and risk taking. In: Yates F (ed) Risk-taking behavior ch. 7. John
Wiley, New York, pp. 201-230
Massey C, Wu G (2005) Detecting regime shifts: the causes of under- and overreaction.
Management Science 51(6):932-947
Maule J, Hockey R, Bdzola L (2000) Effects of time-pressure on decision-making under
uncertainty: changes in affective state and information processing strategy. Acta Psychologica
104(3):283-301
Mensch G (1979) Stalemate in technology: innovations overcome the depression. Ballinger
Publishing Company, Cambridge, MA
Mika A, Mazur GJ, Hoffman AN, Talboom JS, Bimonte-Nelson HA, Sanabria F, Conrad CD
(2012) Chronic stress impairs prefrontal cortex-dependent response inhibition and spatial
working memory. Behavioral Neuroscience. doi:10.1037/a0029642
Nelson RR, Winter S (1982) An evolutionary theory of economic change. The Belknap Press,
Cambridge MA
Nickell S, Nicolitsas D, Dryden N (1997) What makes firms perform well? European Economic
Review 41(4):783-796
O’Donoghue T, Rabin M (1999). Doing it now or later. American Economic Review 89(1):103124
Olson M (1982) The rise and decline of nations: economic growth, stagflation, and social
rigidities. Yale University Press, New Haven CT
Pagano U (2007) Bounded rationality and institutionalism. In: Hodgson GM (ed) The evolution
of economic institutions. A critical reader. Edward Elgar, Aldershot, Cheltenham, UK
Parfitt GM, Barbosa ĂK, Campos RC, Koth AP, Barros DM (2012) Moderate stress enhances
memory persistence: are adrenergic mechanisms involved? Behavioral Neuroscience 126(5):729734
Payne J, Bettman J, Johnson E (1993) The adaptive decision maker. Cambridge University Press,
Cambridge, UK
39
Porter ME (1990) The competitive advantage of nations. The MacMillan Press, London
Porter ME, Van den Linde C (1995) Green and competitive: ending the stalemate. Harvard
Business Review 73(5):120-133
Rabin M, Schrag J (1999) First impressions matter: a model of confirmatory bias. Quarterly
Journal of Economics 114(1):37-82
Robertson D (1915) A study of industrial fluctuation: an enquiry into the character and causes of
the so-called cyclical movements of trade. PS King, London
Scherer FM (1992) Schumpeter and plausible capitalism. Journal of Economic Literature
30(3):1416-1433
Scherer FM, Ross D (1990) Industrial market structure and economic performance, 3rd edn.
Houghton Mifflin Company, Boston
Schumpeter JA (1939) Business cycles. A theoretical, historical, and statistical analysis of the
capitalist process - Volume I, McGraw-Hill, New York and London
Scitovsky T (1976) The joyless economy. An inquiry into human satisfaction and consumer
dissatisfaction. Oxford University Press, Oxford
Shah AK, Oppenheimer DM (2008) Heuristics made easy: an effort-reduction framework.
Psychological Bulletin 134(2):207-222
Shiller R (2001) Human behaviour and the efficiency of the finacial system. Cowles Foundation
Paper no. 1025, Yale University. www.econ.yale.edu/cowles/P/au/p_shiller.htm
Spiegler R (2008) Comments on the potential significance of neuroeconomics for economic
theory. Economics and Philosophy 24(3):515-521
Stangler D, Kedrosky P (2010) Neutralism and entrepreneurship: the structural dynamics of
startups, young firms, and job creation. Kauffman Foundation Research Series - Firm formation
and economic growth. Kauffman Foundation, Kansas City
Stanovich KE, West RF (2006) Natural myside bias is independent of cognitive ability. Thinking
& Reasoning 13(3):225-247
Suen W (2004) The self-perpetuation of biased beliefs. The Economic Journal, 114(495):377-396
Svenson O, Benson III L (1993) Framing and time pressure in decision making. In: Svenson O,
Maule J (eds) Time pressure and stress in human judgement and decision making. New York,
Plenum, pp. 133-144
40
Sweeny K (2008) Crisis decision theory: decisions in the face of negative events. Psychological
Bulletin 134(1):61-76
Tuckett D (2009) Addressing the psychology of financial markets. Economics: The Open-Access,
Open-Assessment E-Journal 3. doi:10.5018/economics-ejournal.ja.2009-40.
http://dx.doi.org/10.5018/economics-ejournal.ja.2009-40. Accessed 5 October 2011
Tversky A, Kahneman D (1974) Judgement under uncertainty: heuristics and biases. Science
185(4157):1124-1131
Tversky A, Kahneman D (1986) Rational choice and the framing of decisions. Journal of
Business 59(4):251-278
Urbig D, Monsen E (2012) The structure of optimism: “controllability affects the extent to which
efficacy beliefs shape outcome expectancies”, Journal of Economic Psychology 33(4):854-867
Van Duijn JJ (1983) The long wave in economic life. George Allen & Unwin, Boston
Wittmann M, Kathryn LL, Scott DL, Martin PP (2010) Now or later? Stratum and insula
activation to immediate versus delayed rewards. Journal of Neuroscience, Psychology, and
Economics 3(1):15-26
Zollo M, Winter SG (2002) Deliberate learning and the evolution of dynamic capabilities.
Organization Science 13(3):339-351
41
Appendix A The Questionnaire (translation from Swedish)
A role play – acting as a manager for an established (old) company
Starting point:
Assume that you are a manager for a company that has existed for at least 20 years. You shall
now make endeavors to imagine how you would have reacted to changes in the rate of return on
equity (“profits”). Note that you must choose the answer that describes how you believe that you
would have reacted in a real situation. You must only choose the alternative which seems to be
the best for you and the company – the most rational – if you are really convinced that you would
have chosen that alternative in a real situation. Use your ability to enter into the mind of a
manager!
You should not choose the answer that you believe that the experimenter would have expected.
Use your ability to enter into other people’s minds but not with the ambition of identifying the
answers that you think that the experimenter wants!
Answer the questions in turn. You cannot return to earlier questions and correct the answers, once
you have moved on to a new question.
You can only choose one answer to each question. Please encircle your answer.
The role play is anonymous.
Question 1
Your company has experienced increasing profits during this year and the previous two-three
years. (Profits are recorded annually.) It is not excluded that other firms, for example your
competitors, are also favored by a similar increase in profits. Which decision on investments will
you make in this situation and which are your arguments for this decision? The decision is not
about the character of the investments. Investments can be made in machinery, buildings, new
organizations or in R&D.
The following assumption is made in all questions 1-9:
-
The company has the opportunity to borrow cheaply to finance investments, thus the
company has no problem in financing the investment.
a) I will increase the investments since the profit increase in the firm has a positive effect on my
expectations of profits in the future.
b) I will increase the investments since the profit increase in my company is a signal that the
company will suffer from capacity limitations in the future.
c) I will increase the investments fearing that the competitors will react to an actual increase in
profits by investments.
42
d) I will increase the investments since investments by other companies will increase the demand
for the products/services of my company.
e) I will not necessarily increase the investments since my expectations about profits in the future
are based on profits over a longer historical period, thus not only on profits this year and the
previous years.
f) I will not necessarily increase the investments since investments are basically determined by
expected events in the future, not by profits this year or earlier profits.
g) I will postpone investments to get a clearer idea of to what extent the profit increase for the
company is steady (and not temporary). The postponement makes it possible to make more
detailed studies of the historical profit development and/or new observations of the profit
development.
Question 2
You are only to answer this question if you have answered a) on question 1.
Try to describe the psychological mechanism explaining that your investment decision was based
on the company’s profit development during the very last years.
a) Increasing profits for the company this year and the previous years induced me to ignore or
give low weight to the earlier profit development. The actual profit development of the company
made me ahistorical (myopic).
b) Increasing optimism about the future through the firm’s increase in profits made me
injudicious. In other words, the actual profit development of the firm made me intoxicated.
c) Due to the high profits I got an exaggerated belief in mine and the company’s ability to e.g.
meet threats in the future. The actual profit development of the firm made me haughty.
‘
d) Due to the high profits, I repressed the risks of an investment – I acted self-deceptively.
e) I was carried away by the optimistic atmosphere in an economy characterized by a general
increase in profits. My investment propensity expressed a general euphoria in the economy.
Question 3
Assume as above that your firm has experienced an increase in profits this year and the previous
two-three years. Which firm strategy would you use in this situation?
a) I will not take any efficiency-enhancing measures or rationalize and I will maintain the
existing product composition, technology and organization since it appeared to be profitable – a
status-quo strategy without transformation.
43
b) To meet future threats, I take efficiency-enhancing measures or rationalize but I will not
pursue a radical change in product composition, technology or organizations – a status-quo
strategy with transformation.
c) Increasing optimism and longer time perspectives because of the profit boost induced me to
make a radical change in product composition, technology or organizations (for example through
R&D investments) – a radical transformation.
Question 4
You are only to answer this question if you have answered a) or b) on question 3.
Try to describe your motives for or the psychological mechanism behind your decision not to
transform the company at all or only pursue a status-quo oriented transformation when your
company experienced increasing profits during this year and the previous two-three years.
a) The increase in profits made me ignore that the firm must have pursued status-quo oriented
transformation or even radical transformation during earlier periods.
b) The higher optimism about the future through the company’s increase in profits induced me to
make an undiscerning choice of a firm strategy without any transformation at all or a strategy
with a status-quo oriented transformation.
c) Due to the high profits, I got an exaggerated belief in my ability and the company’s ability to
meet threats in the future which made me believe that there were real arguments for a firm
strategy without any radical transformation or without any transformation at all in the current
situation.
d) Due to the high profits, I repressed the risks of a status-quo strategy without transformation or
a status-quo strategy with transformation.
e) The increase in profits made me realize that there are unique competencies in the firm
explaining that a status-quo strategy (with or without transformation) really is profitable in the
future.
Question 5
Which firm strategy would you choose if the increase in profits this year and the previous twothree years was so strong that your company came to experience record-high profits in a
historical perspective?
a) I will choose a status-quo strategy without transformation.
b) I will choose a status-quo strategy with transformation.
c) I will pursue a radical transformation.
44
Question 6
How would you react to new information that your company faced the risk of a substantial
decline in profits in the future? Note that the company has experienced three-four years with
increasing profits.
a) I will switch from a status-quo strategy without transformation to a status-quo strategy with
transformation.
b) I will switch to a radical transformation.
c) I will not change from a status-quo strategy without transformation to a status-quo strategy
with transformation or pursue a radical transformation until the company is facing an actual
decline in profits.
Question 7
You are only to answer this question if you have answered c) on question 6.
Why will you first change to a status-quo strategy with transformation or pursue a radical
transformation when the decline in profits is real?
a) I postpone a reaction to get a clearer picture of the real character and scope of the profit
decline, for example, to what extent the decline reflected external threats or internal firm
conditions.
b) I need an actual decline in profits to abandon my too optimistic view of the firm’s prospect
after the period of increasing profits.
c) I need an actual decline in profits to abandon the false feeling of invulnerability and superiority
during the preceding period of increasing profits.
d) I need an actual profit decline to abandon my myopia during the previous period of increasing
profits and focus on the profit development during a longer historical period.
e) I need an actual decline in profits to abandon my tendency during the period of increasing
profits to repress the risks of a status-quo strategy without transformation or a status-quo strategy
with transformation.
f) I have a tendency to overreact to actual reductions in profits (though not necessarily to
increasing profits), thus to believe that the actual fall in profits is permanent.
Question 8
Which strategy would you choose if your company experienced an actual decline in profits
during a year after three-four years of actual increases in profits?
45
a) A status-quo strategy without transformation.
b) A status-quo strategy with transformation.
c) A radical transformation
Question 9
You are only to answer this question if you answered b) or c) on question 8.
Did your decision to transform the company depend on the size of the actual decline in profits
during the year?
a) Yes – the profit decline must at least be similar to the profit increase in the previous year to
persuade me to transform the company.
b) No – even a small decline in profits compared to the profit increase in the previous year would
persuade me to transform the company.
46
Appendix B Investment and strategy choices by 218 undergraduate students in macroeconomics
at Stockholm University acting as CEOs for an established firm in October 2009, 2010 and 2012
and in October 2013 (strategies and psychologies in depressions only). A test of the validity of
the theory of transformation pressure (TTP) including its description of the underlying
psychological mechanisms
General version of the TTP: Current increase Q1: Decision on investment, N=168
in profits
(a) Overinvestment, n=45
Q2: Psychological mechanism, N=42
Q3: Decision on strategy, N=168
Q5: Decision on strategy, N=167
Q6: Decision on strategy Future decline in profits, N=168
Q8: Decision on strategy Current decline in profits, N=167
p = 0.000***
p = 0.000***
Maintained Status-quo strategy w/o transformation (Q3a to
Q5a), n=10
p =0.004***
Switched from Radical transformation
to a Status-quo option (Q3c to Q5a,b), n=23
p =0.000***
Switched from Status-quo w transformation to Status-quo
w/o transformation (Q3b to Q5a),n=11
p = 0.000***
p = 0.999
(a) Option theory of investment under risk
(rationality), n=40
(b,c,d,e,f,g) TTP Psychology, n=13
(b) Status-quo w transformation, n=111
(c) Radical transformation, n=48
TTP strategy:
*** = 1%, ** = 5%, * = 10%
(a,b,c,d) TTP Psychology, n=48
(e) Higher ra6onality (≠ TTP), n=84
(c) Firms will not react until an actual
decline in profits (TTP), n=55
Q7: Incentives and psychologies N=53
p = 0.02**
p = 0.000***
(a) Status-quo w/o transformation, n=24
(b) Status-quo w transformation, n=123
Change in strategy TTP :
General version of the TTP: Expected and
current decline in profits
(a) Historical relativism, (b) Unrealistic optimism, (c)
Suppression of risk, (d) Illusion of control
(e) General euphoria (≠ TTP), n=11
(a) Status-quo w/o transformation, n=15
(b) Status-quo w transformation, n=118
Q4: Psychological mechanism, n=132
Special version of the TTP: Current increase
in profits to record levels
p = 0.000***
p = 0.000***
p = 0.000***
Maintained Radical transformation (Q3c to Q8c), n=19
Switched to transformation (Q3a to Q8b,c), n=13
p = 0.000***
Q3 option: Status-quo w transformation, N=118
Switched to Radical transformation (Q3b to Q8c), n=27
p = 0.019**
47
Special version of the TTP:
Size of the current decline in profits
Q9: Decision on strategy, N=158
a) Large decline in profits, n=86
b) Small decline in profits, n=72
Change in strategy, TTP:
Q5 but not Q3 option:
Status-quo transformation instead of Radical
Transformation, N = 7
Switched to Radical transformation (Q3c and Q5b to Q8c)
after a small decline in profits (Q9b) , n=6
p = 0.125
Q5 but not Q3 option: Status-quo w/o transformation, N=12
Switched to transformation (Q3b,c and Q5a to Q8b,c)
after a small decline in profits (Q9b), n=4
*** = 1%, ** = 5%, * = 10%
p = 0.388
48
Appendix C The results from the test of consistency - the theory of transformation pressure
(TTP) and the theories of consistently rational behavior (RT), the 2009, 2010 and 2012 studies.
Two-tailed binomial test, expected probability: p=0.5.
Consistency case
First choice
Second choice
p-value
Conclusion
Case 1
Investment on irrational
Transformation after an
0.000
TTP is rejected
grounds
actual decline in profit
N=45
since actors become more
0.013
TTP is rejected
0.002
RT is confirmed
0.001
RT is confirmed
rational
n=0 (N=13)
Case 2
Status-quo strategy on
Transformation after an
irrational grounds
actual decline in profit
N=49
since actors become more
rational
n=3 (N=17)
Case 3
Investment on rational
No transformation until
grounds
after an actual profit decline
N=82
on consistently rational grounds
n=21 (N=26)
Case 4
Status-quo strategy on
No transformation until
rational grounds
after an actual profit decline
N=85
on consistently rational grounds
n=24 (N=30)
49
Figure 1 Strategy choices in the theory of transformation pressure (TTP) – the general case
Recovery/Boom (3-4 years):
Increase in current profits
Recession/Depression (3-4 years):
Decrease in current profits
Status-quo oriented transformation
Status-quo without transformation
Radical transformation
Status-quo with transformation
Radical transformation
Radical transformation (insignificant
Radical transformation
share)
50
Figure 2 Strategy choices in the theory of transformation pressure (TTP) – the special cases
Current profits
Recovery (3-4 years)
Boom (a possibility
during the last year
of a recovery)
Recession (1 year)
Recession (1 year)
Depression (3-4 years
including the recession
year)
Increase
Exceptionally high
Weak decrease
Strong decrease
Strong decrease
Status-quo with
transformation1)
Radical transformation
Radical transformation1)
Radical transformation
Status-quo with
transformation
Status-quo with
transformation
Radical transformation
Radical
transformation
Radical
transformation
Radical transformation
Status-quo with
Status-quo with
transformation
transformation
(insignificant share)
Radical
transformation1)
Radical transformation
Status-quo with
transformation
Status-quo with
transformation
Radical transformation
Radical transformation
Radical transformation
Radical
transformation
Radical
transformation
Radical transformation
Status-quo without
transformation
Status-quo with
transformation
Status-quo without
transformation
Status-quo without
transformation
Status-quo without
transformation
Radical transformation
(insignificant share)
Status-quo with
transformation
Status-quo without
transformation
Radical transformstion
_________________________________________________
1)
Firms that have chosen the same status-quo strategy during a normal increase in profits and in a profit boom need a
substantial decrease in profits to upgrade their strategy. This mechanism is a possible, though not decisive, mechanism
in the specific TTP.