Liars and Outliers (25 page)

On the other hand, sometimes this is innocent and nothing more than the organization's failed societal pressure systems resulting in a too-high scope of defection. In either case, in corporations where this sort of thing is prone to happen, the individuals who do it are the ones who will most likely be rewarded. So if there are five fishers, and one of them breaks the rules and secretly overfishes, she will bring in the most revenue to the company and get promoted to manager. The fishers that cooperated and didn't overfish will be passed over. Investment managers who sold the toxic securities were the ones who got the big bonuses.

Sometimes this is incremental. If your colleagues are all overfishing 2%, then overfishing 3% isn't a big deal. But then it becomes 5%, 7%, 10%, and so on. As long as the incentive structure rewards doing slightly better than your colleagues, the incentive to defect remains. You get what you reward.

Larger organizations are naturally nested: departments within corporations, agencies within the government, units within a larger military structure, states within a country, and so on. This nested structure regularly leads to societal dilemmas. They're much like the employee societal dilemmas—should he work hard for the group interest of the company, or slack off for his own self-interest—but a subgroup inside the organization is the actor, rather than an individual. Should an airport screener act in the best interest of the TSA or in the best interest of the federal government? Should an employee act in the best interest of his department, his office, or his company as a whole?

I once worked for a company that had rigid rules about controlling costs. Those rules were implemented by department, not company-wide. The idea, of course, was that cost minimization at the smaller level would translate to cost minimization across the entire company. But sometimes it didn't work that way. I remember several instances where I had a choice between an action that would cost my department more, and an action that would cost my department less but would—because of costs to other departments—cost the company more. For example, I could fly a multi-city itinerary on several more expensive tickets, each allocated to the department that was responsible for that particular city. Or I could fly on a single cheaper ticket. Of course, my boss told me to choose the option that cost our department less, because that's how he was rewarded.

There are other competing interests within organizations: profits, perks (use of the corporate jet, for example), the corporate brand, an alternate idea of what the corporate brand should be, and so on. There are lots of these sorts of conflicts of interest in the investment banking world, such as the
conflict between the
group that takes companies public and the group that recommends stocks to investors.
8
A full discussion
of that would take an entire book.

Chapter 13

Corporations

Everything we discussed in the previous chapter applies to corporations, and some of the examples we used in the previous chapter were corporations. But because they are actors in so many societal dilemmas—they're legal persons in some countries—they warrant separate discussion. But before examining how societal dilemmas affect corporations, we need first to understand the basic supply-and-demand mechanics of a market economy as a pair of societal dilemmas.

Suppose a local market has a group of sandwich merchants, each of whom needs to set a sale price for its sandwiches. A sandwich costs $4 to make, and the minimum price a merchant can sell them at and stay in business is $5. At a price of $6 per sandwich, consumers will buy 100 of them—sales equally divided amongst the merchants. At a sale price of $5 per sandwich, consumers will buy 150—again, equally divided. If one merchant's prices are lower than the others', the undercutter will get all the business.

The merchants face a societal dilemma, an Arms Race akin to the advertise-or-not example in Chapter 5. It's in their collective group interest for prices to remain high; they collectively make a greater profit if they all charge $6 for a sandwich. But by keeping their prices high, each of them runs the risk of their competitors acting in their self-interest and undercutting them. And since they can't trust the others not to do that, they all preemptively lower their prices and all end up selling sandwiches at $5 each. In economics this is known as the “race to the bottom.”

This societal dilemma is in continuous force. Day after day, month after month, the merchants are under constant temptation to defect and lower their prices, not just down to $5, but even lower, if possible. The end result is that all of them end up selling sandwiches as cheaply as they possibly can, to the benefit of all the customers.

It's obvious how to solve this: the merchants need to trust each other. Like the mall stores at the beginning of Chapter 9, they can collectively agree to sell sandwiches at a minimum price of $6 because they know it benefits them as a group. This practice was common throughout history. The medieval guild system was a way for sellers to coerce each other into keeping prices high; it was illegal to engage in trade except through the guild, and the system was enforced by the king. Cartels are a more modern form of this; oligopolies are another. Another way is to convince the government to pass a law outlawing cheaper sandwiches. Whatever name you use, the
result is price-fixing
.

Merchants like doing this, because keeping prices high is profitable. As
Adam Smith
said, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Price-fixing has had varying degrees of success throughout history.
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Sometimes it lasts for a long time. De Beers has successfully controlled the diamond market and kept prices artificially high since the 1880s. And sometimes it collapses quickly—the
global citric acid cartel
lasted only four years and the DRAM
computer-memory cartel
just three. Sometimes buyers, such as Gateway and Dell in the DRAM price-fixing case, have a hand in breaking cartels, but it's usually government. Similarly, it's usually government that helps support them. Smuggling and other commerce often take place outside the cartel, but the cartel still works as long as they're kept to a minimum.

That's not good enough for a modern market economy. It is a basic tenet of capitalism that competition—sellers competing for buyers—rather than cartels are what should set prices. Capitalist society wants universal defection amongst sellers, because we recognize that a constant downward pressure on prices benefits the economy as a whole.

What we realize is that there's another societal dilemma functioning simultaneously and competing with the first.

Each merchant is in a societal dilemma with all of the other sandwich sellers; they're also in a larger societal dilemma with all the rest of society, including all the other sandwich sellers. Cooperating in one means defecting in the other, and in a modern market economy, the latter dilemma takes precedence.
2

This works to the buyer's advantage, although more in theory than in practice. The previous societal dilemma pushes prices down only when there are more salable goods than there are buyers, and sellers are competing for buyers.

In some cases, the buyers can get stuck in a societal dilemma as well, pushing prices up. This is the other half of a market economy: buyers competing with each other. Imagine that a sandwich seller has twenty sandwiches left, and there are forty people who want to buy one—including customer Bob. The normal price for the sandwich is $5, but the seller has raised his price to $6.

Here's the new societal dilemma. Bob is actually willing to pay $6 for the sandwich, but he'd rather get it for $5. So would everyone else. If everyone cooperated and refused to pay $6 for a sandwich, the seller would eventually be forced to lower his prices. But there's always the incentive to defect—and be sure of getting a sandwich—rather than cooperate so that everyone who gets a sandwich pays only $5.

Of course, this kind of thing never happens at sandwich shops. But it regularly happens in real estate markets, when buyers bid amounts higher than the asking price in order to out-compete other buyers for properties. It also happens with popular concerts and sporting events, where scalpers create a secondary market with higher prices as more buyers compete for a limited number of seats.

Auctions are fueled by this societal dilemma. As long as there are more bidders who want an item than there are items, they'll compete with each other to push prices as high as possible. And auctions implement societal pressures to prevent buyer collusion. For example, eBay makes it difficult for buyers to contact each other and collude.

A similar mechanism occurs with clothing in department stores. All department stores eventually mark down their seasonal inventory to get rid of it. Selling it cheap, or even at a loss, is better than keeping it on the shelves or in a storeroom somewhere. If Alice finds something she wants to buy early in the season, she is faced with a societal dilemma. If she cooperates with everyone else and refuses to buy the clothing at full price, eventually the entire inventory will be discounted—drastically. But she risks others defecting and buying the garments at full price, and there not being any left of what she wants at the end of the season for the store to discount. Some discount retailers such as
Outnet.com
explicitly make use of this societal dilemma in their sales techniques. A garment starts out at full price, and is discounted more each week, until it reaches a final—very large—discount. Shoppers are truly faced with a societal dilemma: buy now at the higher price, or wait for a lower price and potentially lose the garment to someone else.
3
Many antique shops and consignment stores use this strategy, too. As long as multiple buyers want the same item, it works.
4

On the other hand, traditional buying clubs allow buyers to cooperate and push prices down. In addition to minimizing distribution and presentation costs, Costco and Sam's Club negotiate lower prices on behalf of their members.

Both of these pairs of societal dilemmas assume that, within each subgroup, buyers, sellers, and sandwiches are interchangeable. But of course that's not the case. Humans are a species of innovators, and we're always looking for ways to sell more profitable sandwiches and buy cheaper ones. The seller has two basic options:

• Merchant Alice can sell a cheaper sandwich. If Merchant Alice can substitute cheaper ingredients or use a cheaper sandwich-making process, she can either sell her sandwiches more cheaply than the competition or sell them at the same price with a greater profit margin—both options making her more money. It might not work. If the customers notice that Alice's sandwiches are of poorer quality than Bob's, they'll value them less. But if the customers don't notice that the sandwiches are any worse, then Alice deserves the increased business. She's figured out a way to make sandwiches cheaper in a way that makes no difference to the customer.
  5
  
• Merchant Alice can sell a better sandwich. Maybe she finds more expensive but tastier ingredients, or uses a more complicated sandwich-making process. Or she could make the sandwich-buying experience better by serving it with a smile and remembering her regular customers' names. She can either sell that better sandwich at the same price, bringing her more customers and more profit, or she can sell the better sandwiches at a more expensive price—whatever price the customers think those new sandwiches and the premium experience are worth. Of course, this requires that the customers value this better sandwich more. If they do, then Alice also deserves the increased business.
  

Both of these things happen all the time. Innovation is one of the important things a market economy fuels. On the buyer's side, the ways for customers to innovate are more limited.

Yes, this is all basic supply-and-demand economics; but it's economics from the perspective of societal pressures. You can look at a market economy as two different pairs of competing societal dilemmas: one preventing sellers from colluding, and the other preventing buyers from colluding. On a local scale, moral and reputational pressure largely enforces all of this. As long as buyers know the prices sellers are selling at and the sellers know what buyers are willing to pay—and this is generally true in local public markets—competition works as a price-setting mechanism. And if there are enough sellers, it's hard for them to collude and fix prices; someone is bound to defect and undercut the group. Sellers can try to differentiate their products from each other—either by selling less-desirable variants at a cheaper price or more-desirable variants at a higher price—and buyers will compete against each other to set new prices. The best way to succeed in this marketplace is to offer the best products at the lowest prices: that is, to have the best reputation for quality and price. There need to be enough buyers and sellers to make the market fluid, and enough transparency that the buyers know what they're buying; but if those things are true, then it all works.

It's only when you scale things up that these systems start failing. Societal pressures don't work the same when the sellers are large corporations as they do when they're sole proprietors in a public market. They don't work the same when the products are complicated—like cell phone plans—as they do when the products are simple. They don't work the same when commerce becomes global. They don't work the same when technology allows those corporations to defect at a scope larger than their own net worth.