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Use self-selection as entrepreneurial tool

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The recent offer by General Motors to its employees of a "buyout" plan raises the classic case of "self-selection bias." This concept is important to entrepreneurs in choosing the features and price of their product or service.

GM offered buyouts often amounting to several thousand dollars for employees who will leave. GM wanted to reduce its work force by more than 30,000 workers. The danger in this approach is made evident by looking at the decision faced by the individual employees.

Which employees would you guess will take the offer, and which will not?

The employees most likely to take the offer are those who can get jobs elsewhere that pay as much as their current GM jobs. By taking the offer, they do not give up salary and pick up the several thousand dollars GM is offering. The employees most likely to refuse the offer are those who cannot get jobs elsewhere at the same level of pay and benefits as their GM jobs.

The problem is that, generally speaking, those who can get good jobs elsewhere are the best employees. The ones who cannot get jobs elsewhere are probably the least skilled workers and/or overpaid at GM.

So the most capable employees leave and the overpaid employees stay. What impact will this have on GM's future? GM claims that it tried to tailor its offer to prevent this self-selection bias from happening, but various laws prevent it from differing too much from worker to worker.

I recently saw an advertisement for long-term care insurance that suffered from the same problem. The offer was that if employees were to sign up by a certain date there would be no health background check. They would pay the same rate regardless of health. Which employees do you think are the most likely to sign up? Clearly, those with health conditions and the highest probability of needing long-term care and/or older workers who will not have to pay as many months before needing care are most likely to take advantage of this offer.

I strongly suspect the insurance company is aware of this bias and has priced the insurance to reflect the high-risk pool of employees. What does that say to the employee who has longer to retirement and does not have the higher health risks? It probably means that the insurance is not a good deal for many of them.

That said, I believe entrepreneurship in the United States has been a beneficiary of self-selection bias. For example, immigrants account for a disproportionate share of entrepreneurs in this country. I believe it is because the immigrants who will benefit most from being here are those who work the hardest to come. They are people who can take advantage of our entrepreneurial culture, our capital markets, our legal structure and our relatively light regulations on starting new businesses. The result is that the United States gets the most entrepreneurial immigrants, and the countries they leave will have fewer entrepreneurs.

Similarly, when entrepreneurs decide what price or features to put on their product they are impacting the type of customers they attract. Cell phones that are also MP3 players, PDAs, calculators, radios, GPS systems, cameras and podcast players will appeal to a select set of individuals. Adding the additional cost to offer these features will turn away many customers who will seldom use them. Customers self-select for their own personal use.

The insightful entrepreneur will target customers whom he/she can serve in a more cost-effective way than other competitors. Thinking through which customers will most likely choose your product given your price and features may not only save you grief but also allow you to offer a unique product at a price that competitors will not match because it will turn away too many of their existing customers.

Hal Heaton is affiliated with the BYU Center for Entrepreneurship. He can be reached via e-mail at cfe@byu.edu.