Understanding Managers' Trade-offs between Exploration and Exploitation

82 Pages Posted: 30 Apr 2021

See all articles by Alina Ferecatu

Alina Ferecatu

Rotterdam School of Management, Erasmus University; Rotterdam School of Management, Erasmus University

Arnaud De Bruyn

ESSEC Business School

Date Written: April 23, 2021

Abstract

Managers frequently explore new strategies, and exploit familiar ones, when making decisions on new product development, pricing, or advertising. Exploring for too long, or exploiting too soon, will generate inferior financial returns. Our research describes decision-makers' exploration/exploitation trade-offs and their link to psychometric traits. We conduct an incentive-aligned study in which subjects play a multi-armed bandit experiment and evaluate how subjects balance exploration and exploitation, linked to psychometric traits. To formally describe exploration/exploitation trade-offs, we develop a behavioral model that captures latent dynamics in learning behavior. Subjects transition between three unobserved states: exploration, exploitation, and inertia, updating their beliefs about expected payoffs. Our analysis suggests that decision-makers over-explore low-performing options, forgoing over 30% of potential revenue. They heavily rely on recent experiences. Risk-averse decision-makers spend more time exploring. Maximizers are more sensitive to payoffs than satisficers. Our research builds the groundwork needed to devise remedial actions aimed at assisting managers find an optimal balance between exploration and exploitation. One way to achieve this goal is by carefully designing the learning environment. In two additional studies, we analyse the evolution of exploration/exploitation trade-offs across different learning environments. Offering decision-makers repeated opportunities to learn and increasing the planning horizon appears beneficial.

Keywords: Managerial decision-making, Behavioral economics, Exploration/exploitation trade-offs, Multi-armed bandits, Belief-updating, Satisficing

Suggested Citation

Ferecatu, Alina and De Bruyn, Arnaud, Understanding Managers' Trade-offs between Exploration and Exploitation (April 23, 2021). Available at SSRN: https://ssrn.com/abstract=3832662 or http://dx.doi.org/10.2139/ssrn.3832662

Alina Ferecatu (Contact Author)

Rotterdam School of Management, Erasmus University ( email )

RSM Erasmus University
PO Box 1738
Rotterdam, 3062 PA
Netherlands

Rotterdam School of Management, Erasmus University ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Arnaud De Bruyn

ESSEC Business School ( email )

France

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
114
Abstract Views
533
Rank
435,891
PlumX Metrics