Thursday, April 1, 2021

The Value of Business Experiments Part 3: Innovation, Strategy, and Alignment

In previous posts I have discussed the value proposition of business experiments from both a classical and behavioral economic perspective. This series of posts has been greatly influenced by Jim Manzi's book 'Uncontrolled: The Surprising Payoff of Trial-and-Error for Business, Politics, and Society.' Midway through the book Manzi highlights three important things that experiments in business can do:

1) They provide precision around the tactical implementation of strategy
2) They provide feedback on the performance of a strategy which allows for refinements to be driven by evidence
3) They help achieve organizational and strategic alignment

Manzi explains that within any corporation there are always silos and subcultures advocating competing strategies with perverse incentives and agendas in pursuit of power and control. How do we know who is right and which programs or ideas are successful considering the many factors that could be influencing any outcome of interest? Manzi describes any environment where the number of causes of variation are enormous as an environment that has 'high causal density.' We can claim to address this with a data driven culture, but what does that mean? Modern companies in a digital age with AI and big data are drowning in data. This makes it easy to adorn rhetoric in advanced analytical frameworks. Because data seldom speaks, anyone can speak for the data through wily data story telling.

As Jim Manzi and Stefan Thomke discuss in Harvard Business Review:

"business experiments can allow companies to look beyond correlation and investigate causality....Without it, executives have only a fragmentary understanding of their businesses, and the decisions they make can easily backfire."

In complex environments with high causal density, we don't know enough about the nature and causes of human behavior, decisions, and causal paths from actions to outcomes to list them all and measure and account for them even if we could agree how to measure them. This is the nature of decision making under uncertainty. But, as R.A. Fisher taught us with his agricultural experiments, randomized tests allow us to account for all of these hidden factors (Manzi calls them hidden conditionals). Only then does our data stand a chance to speak truth.

In Dual Transformation: How to Reposition Today's Business While Creating the Future authors discuss the importance of experimentation as a way to navigate uncertainty in causally dense environments in what they refer to as transformation B:

“Whenever you innovate, you can never be sure about the assumptions on which your business rests. So, like a good scientist, you start with a hypothesis, then design and experiment. Make sure the experiment has clear objectives (why are you running it and what do you hope to learn). Even if you have no idea what the right answer is, make a prediction. Finally, execute in such a way that you can measure the prediction, such as running a so-called A/B test in which you vary a single factor."

Experiments aren't just tinkering and trying new things. While these are helpful to innovation, just tinkering and measuring and observing still leaves you speculating about what really works and is subject to all the same behavioral biases and pitfalls of big data previously discussed.

List and Gneezy address this in The Why Axis:

"Many businesses experiment and often...businesses always tinker...and try new things...the problem is that businesses rarely conduct experiments that allow a comparison between a treatment and control group...Business experiments are research investigations that give companies the opportunity to get fast and accurate data regarding important decisions."

Three things distinguish a successful business experiment from just tinkering:

1) Separation of signal from noise through well designed and sufficiently powered tests
2) Connecting cause and effect through randomization 
3) Clear signals on business value that follows from 1 & 2 above

Having causal knowledge helps identify more informed and calculated risks vs. risks taken on the basis of gut instinct, political motivation, or overly optimistic data-driven correlational pattern finding analytics. 

Experiments add incremental knowledge and value to business. No single experiment is going to be a 'killer app' that by itself will generate millions in profits. But in aggregate the knowledge created by experiments probably offers the greatest strategic value across an enterprise compared to any other analytic method.

As discussed earlier, business experiments create value by helping manage the knowledge problem within firms, it's worth repeating again from List and Gneezy:

"We think that businesses that don't experiment and fail to show, through hard data, that their ideas can actually work before the company takes action - are wasting their money....every day they set suboptimal prices, place adds that do not work, or use ineffective incentive schemes for their work force, they effectively leave millions of dollars on the table."

As Luke Froeb writes in Managerial Economics, A Problem Solving Approach (3rd Edition):

"With the benefit of hindsight, it is easy to identify successful strategies (and the reasons for their success) or failed strategies (and the reason for their failures). It's much more difficult to identify successful or failed strategies before they succeed or fail."

Again from Dual Transformation:

"Explorers recognize they can't know the right answer, so they want to invest as little as possible in learning which of their hypotheses are right and which ones are wrong"

Business experiments offer the opportunity to test strategies early on a smaller scale to get causal feedback about potential success or failure before fully committing large amounts of irrecoverable resources. This takes the concept of failing fast to a whole new level. As discussed in The Why Axis and Uncontrolled, business experiments play a central role in product development and innovation across a range of industries and companies from Harrah's casinos, Capital One, and Humana who have been leading in this area for decades to new ventures like Amazon and Uber. 

"At Uber Labs, we apply behavioral science insights and methodologies to help product teams improve the Uber customer experience. One of the most exciting areas we’ve been working on is causal inference, a category of statistical methods that is commonly used in behavioral science research to understand the causes behind the results we see from experiments or observations...Teams across Uber apply causal inference methods that enable us to bring richer insights to operations analysis, product development, and other areas critical to improving the user experience on our platform." - From: Using Causal Inference to Improve the Uber User Experience (link)

Achieving the greatest value from business experiments requires leadership commitment.  It also demands a culture that is genuinely open to learning through a blend of trial and error, data driven decision making informed by theory, and the infrastructure necessary for implementing enough tests and iterations to generate the knowledge necessary for rapid learning and innovation. The result is a corporate culture that allows an organization to formulate, implement, and modify strategy faster and more tactfully than others.

See also:
The Value of Business Experiments: The Knowledge Problem
The Value of Business Experiments Part 2: A Behavioral Economics Perspective
Statistics is a Way of Thinking, Not a Box of Tools

 

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