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The Limits of Rational Trust: Part 2

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Last week we talked about how rational trust, which is to say, being trustworthy because it can be shown that being trustworthy leads to more money or other benefits, can break down, either because a the person involved knew they wouldn’t be around for the long term, or because the reward for betraying a trust was so great that they could cash out.

Other failures of rational trust are:

  • When you’re not at the table, but on the table;
  • when the social mechanisms of reputation and deterrance break down;
  • when someone has a dominant strategy, something they can force on other people.

This post we’ll discuss not being at the table, and the breakdown of social mechanisms of trust.

Are you the roast beef being carved up?

It is rational to be trustworthy to people who are your customers because you want repeat business. But often even if you’re buying something, you aren’t the customer. So, for example, who are the customers for credit cards?

Here’s the odd thing about credit cards. Credit cards which charge merchants more, and that therefore also cost consumers more, since merchants have to pass those costs on, are the ones that are chosen by banks to be offered. Chosen by banks is the key phrase. Almost everyone gets their credit card through their bank. The banks control the pipeline, therefore the banks are the actual consumers. They, and the credit card companies are at the table, retailers and consumers are on the table. The real customer for credit cards isn’t consumers, and it isn’t businesses, who feel they must accept them or give up huge amounts of business, instead it is the banks. Since this is the case, it is rational to charge consumers and businesses more, not less, because the more you charge them, the more you can give to the real customer, the banks, who can deliver what amount to captive audiences.

Just because you’re buying something doesn’t mean you’re the customer, it just means you are paying.

Heads I win, tails you lose!

The next failure point of rational trust is when the social mechanisms for enforcement break down. If CEOs can materially misrepresent their company’s positions, and still be paid millions, if outright systemic fraud can occur throughout an industry, for example, mortgage origination and packaging during the housing bubble, and virtually no one is charged with a crime, and many of the companies which engaged in the fraud are bailed out at taxpayer expense, then why shouldn’t they engage in fraud?

Call it “heads I win, tails you lose”. If I know that I’ve done so much damage that the entire world’s economy is at risk, well, what’s to fear? On Wall Street they used to call this the “eat babies” scenario, which is to say, if the government didn’t step in, things would be so dire that everyone would be eating babies. Apocalytpically bad. Now, one can argue over whether failing to bail out Wall Street would have been so bad (I don’t think so), but it certainly seems the prime actors thought it would be, and unquestionably many actors at the Federal Reserve, Treasury and in power in DC thought it would be.

In capitalism, the joke runs, bankrupt companies go out of business. On Wall Street, they get bailed out. The political mechanism, which is ultimately a social mechanism, for enforcing law and basic capitalist principles broke down.

This has far less grandiose forms than the late financial crisis. It occurs any time when breaches of trust will not materially affect someone’s ability to continue to operate in business and to make money. If the social circle one moves in doesn’t care about breaches of trust or ethics, then it is rational not to care about either. Rational trust is about consequences, if the consequences are less than the benefits, why be trustworthy?

Next post: Dominant strategies, or “you’ll take this deal because you have no choice.”

Serving To Win

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Which of these statements resonates more with you?

1. I try to win, because losing sucks.

2. I try to serve my clients, because then I win too.

3. I try to serve my clients, which generally works out best for me as well.

If you chose #1, OK, I get it, I like competing as much as the next guy, but come back another time, we’re not talking to you today.

Today we’re talking about service, winning, and the link between them.

Do you serve to win? Does serving cause winning? Or is winning an occasional byproduct of serving?

What it comes down to is: Why are you serving?

Does Doing Good Cause Doing Well?

There’s a myth being perpetuated by well-intended, wishful-thinking, creative, holistic people out there: the myth that if you do right, you absolutely will do well.

In its more extreme forms, this belief would suggest that all highly ethical and socially responsible companies always make more money, every quarter.

Of course, there’s no shortage of cynical, embittered, hard-bitten “realists” who just can’t wait to whump the idealists upside the head with a good “oh-yeah-take-Bernie-Madoff” or two.

Who’s right?

Prisoner’s Dilemma

Social scientists and game theorists are enamored of The Prisoner’s Dilemma, a two-person game about cooperation and competition. In each game, each player can choose to cooperate or compete.

  • If one chooses to cooperate and the other to compete, the cooperator gets 10 years in prison, while the competitor goes free.
  • If they each choose to compete, they each get 5 years in prison.
  • If they each choose to cooperate, they each get 6 months in prison.

The person economists assume we all are—rational maximizer of self-interest—will rationally choose to compete. So will his competitor. Boom.

That approach sums up approach number 1—play to win. Turns out that businesspeople in controlled tests of prisoner’s dilemma strongly favor approach number one; it fits with what they learned in business school, be number 1 or 2 in your market, competitive advantage, etc.

In a connected world: boom. So much for statement number 1 at the outset of this post. Because in the real world, prisoner’s dilemma doesn’t just get played once.

Playing the Game More than Once

Part of the “trick” of prisoner’s dilemma is to play it more than once. Over time, the optimal strategy turns out to be “tit for tat,” i.e. assume the other party will cooperate, and do likewise. This generally ends up in iterative decisions to cooperate, with only occasional breakdowns of order.

But why do people continue to choose “cooperate?” Is it because the economists are right, and we’re all rational maximizers of self-interest who look at the long run? Do we calculate the odds and figure that the net present value of cooperating is greater than that of competing? Turns out it’s a little murkier than that.

Playing the Game With More Than One Player

In addition to frequency, the game is affected by participation. If there are high levels of information, visibility and interaction about how other players are engaging in the same game, then the cooperation strategy becomes even more dominant. There are fewer defectors from the cooperative strategy trying to squeeze in that last little bit of competitive edge.

Fewer Madoffs.

But: if you have more people choosing to tweak those odds, looking for just the right moment to sucker-punch the other guy after having lulled them into somnolence by a series of apparently cooperative gestures, looking to gain that final advantage—then the system starts to fall apart.

Why We Play the Game Matters

Prisoner’s dilemma is a pretty good metaphor for life. The economists’ fiction of individual actors is just that—a fiction. Francis Fukuyama puts it this way in The Origins of Political Order:

It is in fact individualism and not sociability that developed over the course of human history. That individualism seems today like a solid core of our economic and political behavior is only because we have developed institutions that override our more naturally communal instincts. Aristotle was more correct…when he said that human beings were political by nature.

The only serious debate is between statements two and three. Do you cooperate to win? Or do you cooperate because—that’s what you do? It’s the latter attitude, held by enough people over a long enough time period, that drives economic wealth.

  • A business strategist who advises any given company to be socially responsible because they’ll make more money that way is detracting, not contributing, to social responsibility;
  • An investor looking for socially responsible companies solely in order to make more money on their investment is a risk-seeking investor;
  • A society of people who cooperate “in order to win” is in trouble.

The Paradox of Trust

Belief number two—serving your clients because that way you win—is ultimately self-defeating. Because if “to win” is your ultimate goal, you’ll sooner or later end up facing a situation where you have to choose between serving and winning. And you’ll choose winning.

And then people will stop trusting you. And that disease is communicable.

Two variables make it all work: time, and numbers. Play the game enough times, with enough players, and it works. Where it goes wrong is when we:

  • Start managing to quarterly earnings
  • Start analyzing performance metrics in the short term
  • Analyze individual psychology outside of group psychology
  • Use the language of self-interest instead of group interest.

The paradox is: economics work if we justify it ethically. But if we try to justify ethics economically, it all falls apart. Beware of those who justify ethical behavior by the bottom lines.

Answer three—serve your clients because things generally work out better that way—is the “right” answer for all of us. If we remember to keep it long-term, and keep it social, then it works.

Negotiation and the Short Term Performance Trap

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Economists and psychologists love intellectual puzzles like The Prisoner’s Dilemma, a game that posits a 2-person bargaining or competition situation.

In The Prisoner’s Dilemma, one person goes free if he “rats out” the other prisoner and the other prisoner stays mum. Unfortunately, if both rat out each other, they each get life in prison.  If both stay mum, they each get off with just a year.

When the game is played with strangers—one time only—the most common result is the double-rat-out.  Oops.

The challenge to economists is to explain why people so frequently do not act “rationally.”

The answer shows up when you play it ten times in a row. With a friend. With eye contact.

But—especially—from playing it ten times in a row.

Then the players quickly learn to cooperate.  (Though sometimes they’ll turn vicious again the last round.  Or maybe not. Think reality TV shows.)

The point is: it’s smart to think collaboration, cooperation, medium to long term focus.  Not a one-time, zero-sum, confrontational me-vs.-you outcome.

The learning for managers, sales managers, brokers, etc. is clear: if you think you’ll never see this customer again, nor have to deal with this customer’s spouse, friend, or cousin, and you think no one will ever hear what you’re about to do, and you’ll gladly trade a good reputation for money—then go ahead, squeeze the customer, try to win the negotiation—treat it like a transaction.

All others: operate on the assumption of multiple transactions—which, for lack of a better term, let’s call relationships.

Assume you will have repeat customers; that your reputation matters, even in terms of simple self-interest; that what goes around comes around; that six degrees of separation in today’s world is a vast overstatement, and it’ll bite you if you don’t believe it.

It’s a simple enough answer. People in social situations routinely act as if they’re a member of an ongoing social group, even if they’re not. (See for example similar results regarding The Ultimatum Game).

That, however, is in social situations.  At the business level, particularly with customers, another belief system often gets in the way.  I hear it frequently.  It sounds like this:

You don’t understand, Charlie; around here, you get measured on short-term results. So there’s a lot of pressure. You have to be a lot tougher on customers—terms, pricing. Trust is nice and all that; but I’ve got a job and a bonus structure and I’ve got to make a living. Go tell it to my boss.

OK, let’s tell it to”your boss.”

Every time you treat a customer from a transactional point of view, you are hurting your long-term profitability. And the short term has a way of turning long-term very quickly. You run out of new customers to squeeze to get all you can in one deal.  And if you rat-out your customer, and your customer rats you out in return, you just bought yourself long-term low profit prison terms.

Put another way:

The best short-term performance does not come from short-term management—it comes from medium- and long-term management done well.

Management, that is, based on the presumption of a relationship, not a series of oppositional transactions. Management based on principles, not self-interest.  If you want to be in charge of your own long-term career, don’t let “your boss” ruin it with short-term management.  Your customers will remember your behavior, not your boss’s words.

Trust makes money.  Prisoners who rat each other out lose money.

Please tell “your boss.”