Chapter 9

Corporate Games II

Games Against Your Employees

I don’t want to belong to any club that will accept people like me as a member.1

—Groucho Marx

Correctly using information about potential and current employees is one of the most important keys to success for a firm. When it comes to adverse selection, we are mostly concerned with figuring out which potential employees we want to hire or assign to a particular task. When it comes to moral hazard, we are thinking about what problems can occur with employees after they join the firm. As always, in game theory we are keeping an eye on how choices and reactions are interrelated.

9.1 Adverse Selection: Signaling and Screening

In general, the solution to adverse selection problems is to learn more information about who or what you are dealing with. Of course, doing standard background checks and interviews are helpful. Another standard practice is requiring letters of reference from previous and current employers. One must be wary of glowing letters of reference from a current employer, however. What kind of boss would write their employee a great letter of reference? Possibly, one who wants that employee to leave!

Employers should carefully evaluate the strategic and informational implications that the choices of an applicant may reveal. For example, if someone from a high paying, well-known firm applies for a position at your lower paying, mediocre firm, one should rightly be suspicious. Using a similar logic, applicants who are looking to make an unusual career move should go out of their way to explain their motivation in a cover letter, and should be wary of an employer’s offer of overly lavish salaries in a hospitable working environment. When someone’s actions do not make sense given the available information, then there is some hidden information that needs to be uncovered!

Game theory can help us to devise logical ways of learning hidden information from people. Suppose that we need to determine which potential or new employees are talented, and which ones are “screw-ups.” We could ask them, “Would you prefer an office in the basement, or one beside the CEO of the company?” If you choose the basement, you are communicating that you are a screw-up and don’t want people to watch you. Of course, you might just be shy, but that is also useful information to know about employees.

Filtering people by learning information about them is called screening, and in this case we are using the choice of an employee to “separate themselves” into two groups. This would only work in the above case when the costs of a bad employee surviving in the office next to the CEO are too high for the person to bear. In other words, it has to be too hard for the screw-up to fake being competent in full view of the CEO.

Some businesses refuse to hire people who are not currently employed. While controversial, there is some logic to this. In a world where information about potential employees is far from perfect, being unemployed does convey some information. In a firm where there are two more or less identical employees on paper, when times get tough employers should get rid of the one that is less productive, at least in theory. Or, there may be other reasons why someone who looks good on paper (degrees, GPA, experience) may be the first one let go. Perhaps they have a bad temper, are awkward around the customers, or have trouble remembering to take a bath.2 Also, someone who is unemployed may have been fired from their last job. Research has found that ever being fired in one’s lifetime conveys significant information about a ­person’s lifetime earnings capacity.

Sometimes employees want to help firms discover that they are ­talented go-getters. Business Week reports that the average return on investment to a four-year degree in the United States is around $350,000.3,4 There are two prevailing theories about why companies might want to pay people more who have a four-year degree. The first theory suggests that people learn job skills in college. For some types of degrees this makes sense, such as accounting or engineering. However, this does not explain why some top consulting firms hire Ivy League graduates with degrees in ­English or anthropology, paying them handsome salaries. The second theory says that someone to has the ability to enter into college, stick with it for four to five years, and graduate have separated themselves into a category that is different from people who are unable or unwilling to complete this task. So this explanation says that students who are smart, hard ­working, or both, can communicate this information by “signaling” their talent by obtaining a college degree. Sending a signal that sets you apart from the crowd is a way to help employers identify you as a hard worker. ­However, this signal must be difficult to send, and must really represent a ­meaningful separation.

There are often discussions by well-intentioned policy makers about making it easier for people to get high-school diplomas and college degrees. There is a movement in the United States to open “early college programs.” From one of the proponent websites:

Since 2002, the partner organizations of the Early College High School Initiative have started or redesigned 240 + schools serving more than 75,000 students in 28 states and the District of Columbia. The schools are designed so that low-income youth, first-generation college goers, English language learners, students of color, and other young people underrepresented in higher education can simultaneously earn a high school diploma and an Associate’s degree or up to two years of credit toward a Bachelor’s degree—tuition free.5

In short, the program is taking students from groups that often struggle to obtain a high-school diploma by age 18 and are often underprepared for a college curriculum, and are awarding them both a high-school diploma and a two-year college degree by age 18.

While it is clear that there is an unacceptable education gap, and that preparing everyone in the world with more rigorous, thoughtful, and demanding education should perhaps be our highest priority, these ­programs appear to do the opposite. Attempting to “cram” two years of college into the existing high-school curriculum of even the brightest ­students seems to be a destructive exercise. These students would benefit from more years of serious study, not two fewer years and a piece of paper asserting a falsehood. To attempt to do such “cramming” to the least prepared high-school students is utterly misguided. Because a two-year degree by definition is supposed to demonstrate two years of ­additional preparation after high school, these programs are likely to make two-year degrees worthless for all, and put these at-risk students in jeopardy of being unable to complete a four-year degree at a university. The well-meaning government officials might then decide that these students should be awarded a master’s degree at age 18.

Signaling and screening can work to communicate information, but only if one is careful to make sure that the signals and choices represent real information. In the end, the reward for a degree will be proportionate to either how much valuable learning took place, or how difficult it was to obtain. So, if an online university tells you that they will award you a degree in only a year, or that you can get a PhD by working only a few hours per week for a year or two, you should not expect people to place a large value on something that takes a small effort (even if the online college charges you a lot of money). In fact, it sends the opposite signal to savvy employers.

In the United States, fake degrees have been around for a long time, so long that it is fairly easy to figure out if a degree is fake (or ­semifake), if an employer wants to. Now, China is having a problem with fake ­universities—both the American ones and over 100 Chinese ones. As reported in The Economist, some people have the attitude that “A diploma is worth actual money, whereas an education is not.”6 Smart businessmen should have the opposite opinion: Reward your employees for skills and productivity, not for pieces of paper.

9.2 Moral Hazard

Suppose that you have hired people who are of good quality, how do you ensure that their interests will match your interests afterward? Someone who is a talented, hard-working employee, will not necessarily stay that way forever. People may steal from the company either because they “need it” or because they feel that they are underpaid, especially if they feel that there is no chance that they will be caught. More subtly, all employees have a choice between working hard and slacking off. Working hard takes effort, and if that effort is not rewarded, it is rational for employees to slack off.

At the simplest level, the prevention of moral hazard involves ­implementing systems under which you can monitor the actions and productivity of your workers—basic necessities if you are going to be able to reward performance and deter theft or embezzlement. However, even under the best circumstances it is impossible to watch every employee at every moment. It is best if you can put the correct people in the correct environment with the correct kind of contract.

One of the best means of avoiding moral hazard is to try to create an environment in which your employees will truly enjoy working hard. There are many ways in which you can reward hard work, using financial and nonfinancial means. Ideally, paying more to more productive employees is the best solution. Therefore, basing pay directly on productivity in some way, either by using a piece-rate system, commissions, or merit-based pay raises is not only fair, but also creates the right incentive structure. However, employers need to focus on the fact that these ­financial rewards should be more closely tied to the employee’s contribution to profits, rather than simply revenue. For example, a car salesman may be able to bring in a large volume of sales by selling the cars below cost. Your compensation structure should not reward this kind of behavior.

Another interesting idea that might prevent moral hazard is to pay people a lot more than you have to. This idea is called paying “efficiency wages.” The idea is that if you pay your employees the minimum you have to (the same that everybody else is paying), employees may feel that they don’t really have much to lose if they get fired for slacking off. They will go get a job somewhere else making exactly the same thing. However, if you pay people more than everybody else does, people really have something to lose if they don’t do their best and get fired. Henry Ford is credited with using this idea on his automotive production lines when he offered employees $5 per day in 1914—around double the amount paid for similar jobs at the time. However, in order for this to work there does have to be a real chance that they will lose their job if they underperform.

In addition to traditional ways of motivating employees, behavioral economics has been discovering some better, more inexpensive ways that keep employees motivated. Giving your employees a sense that what they do is important and valued often works better than high pay. Behavioral economists have been exploring this for the last decade or so. In Dan Pink’s book Drive, he describes the difference between extrinsic motivators (carrots and sticks such as salary or strict work schedules or punishments for underperformance) and intrinsic motivators that come from within the employee (freedom to do the job in a creative manner, a sense of purpose or importance of the job). He suggests that intrinsic motivators work much better and for longer periods of time.

Dan Ariely describes the difference in a slightly different way in his book Predictably Irrational. He describes the two different kinds of motivators as “market motivators” and “social motivators.” Employees only motivated by market forces will provide effort only in exchange for money. However, when they feel that they are a part of an important organization, they will provide effort because they want to. Creating such an environment can be difficult, and can rarely be faked, but managers can do a better job of communicating these ideas. In the classroom, I tell students who complain about the amount of homework,

If I truly hated you, I would give you no homework, you would learn nothing, and be less successful in your life. It is only because I love you and this University that I take so much time and energy to give and grade homework.

Some students groan, but most come to believe it, because it fits in with my overall actions and personality. Trying to build social motivators in a false way is likely to backfire, so don’t ask your employees to “buy in” to an idea that you don’t believe in yourself!

9.3 Negotiations and Bargaining

Another important contribution of game theory with regard to employer–employee relationships is with regard to negotiations and bargaining, whether between unions and management, or between a single employee and his boss. Of course, the principles of effective bargaining also apply to many other situations, including international ones. Some of John Nash’s early work on game theory was on bargaining, where he analyzed strategies in a simple game. The Nash Bargaining Game is where two players have to negotiate how to split a pie—perhaps the profits from a potential business venture or splitting the profits generated from a professional sports team between owners and players. Suppose that these profits amount to $100.

The rules of this simple game are that each player must submit a request for a share of the money, and if the total demanded is greater than $100, both get nothing as this represents a disagreement, and the two will not enter into the venture. Nash’s work was largely theoretical but showed that a “Nash equilibrium” was any split such that the two amounts requested add to precisely $100. Why?

Recall that in order to be a Nash equilibrium, each player must not want to change their mind. Suppose that Player A requested $20 and Player B requested $80. This is a Nash equilibrium because:

i. If Player A asks for more (say, $25), he will get zero as the total requested will be over $100.

ii. If Player A asks for less (say, $19), he will needlessly get less.

iii. Therefore, Player A does to want to change his mind.

And, similarly for Player B: So neither player wants to change their minds.

Another Nobel Prize winner, Thomas Schelling was famous for his work on bargaining. He had a lot of advice to give on how to be a strong bargainer. I will briefly discuss some of this advice below.

Tie Your Hands, Burn Your Bridges: The everyday advice you hear, “Don’t burn your bridges, because you never know when you might have to cross back over them” is not necessarily true. If you absolutely have to win at negotiations, then one way to do so is to purposefully back yourself into a corner with no other means of escape. This takes a lot of bravery but can be effective if you know what you’re doing. When Cortez was battling the native people in Mexico, his own soldiers were not excited about the prospect of fighting “the barbarians,” and many just wanted to go home. In order to win these negotiations with the soldiers, to convince them that they really wanted to fight, Cortez destroyed his own ships. Now Cortez and his men had no choice but to fight and to win together.

Go a Little Crazy—Brinkmanship: In Chapter 5, we briefly mentioned how adding the possibility of going insane can improve your chances of winning a game. This is also a possibility when negotiating, using a strategy called “brinkmanship.” Brinkmanship gets its name from threatening a small chance to go “over the brink” and do something catastrophic, or bringing two nations to the “brink” of nuclear warfare. However, as with all things in game theory, if is it not true and believable, it will not work.

For example, in 1979 the United States passed a law called the Taiwan Relations Act as a signal to China that they should not invade Taiwan. In part, it says that the purpose of the law is:

c. to make clear that the United States rests upon the expectation that the future of Taiwan will be determined by peaceful means;

d. to consider that any effort to determine the future of Taiwan by other than peaceful means, including by boycotts, or embargoes, to be a threat to the peace and security of the Western Pacific area and of grave concern to the United States;

e. to provide Taiwan with defensive arms; and

f. to assert the right to resist any resort to force or other forms of coercion that would jeopardize the security or social and economic systems of the people of Taiwan.

While this act falls a little short of declaring “China, if you attack Taiwan the United States will declare war on you,” it does seem to ­indicate that there is a possibility that this might be the consequence. There is a huge benefit in threatening this type of probable ­catastrophe: while it does serve as an effective deterrent, the threatening person does not lose credibility if they don’t actually carry out the threat every ­single time.

Another movie-type analogy would be the following conversation between two cowboys in an “Old West” film:

A: “Tell me where you hid the gold, or I’ll kill you!”

B: “You can’t kill me, only I know where the gold is!”

A: “OK, then, let’s play one-man Russian Roulette.”

By the certain threat of killing B, A would lose everything. However, by taking a gun with a bullet in one of the six chambers (a one-sixth chance of killing him), he has a good chance of learning where the gold is, because A shows his willingness to go over the brink.

Salami Tactics: While often seeming childish and having been invented by children, salami tactics are also often very effective negotiating tools. Salami is a product that is often sliced very thinly, and people can keep adding these thin slices to a sandwich one at a time. Each time you add a slice you aren’t really changing the amount of meat by much, but the constant addition does lead to large changes over time!

By analogy, when negotiating a new salary, for example one could say, “is a $10 raise too much?” Since a $10 raise is okay, then, “is a $20 raise too much?” and since your boss doesn’t think that is too much either, “is a $30 raise too much?” Each $10 increment is so insignificant, who could say no? However, after a thousand such requests, you’re talking real money and the boss has to say “No” to further raises at some point.

Cut Off Communication: In the movies, one of the tactics of the hostage negotiators is to always keep the bank robbers talking. One of the tactics of the bank robbers might be to cut off communication until they get the first concession from the police. It works just as well the other way around: sometimes police negotiators will refuse to even listen to the demands of hostage takers until they release all of the women and children, for example. Making a credible commitment that all negotiations will stop until the other side gives up at least one concession can often strengthen your bargaining position.

Making Threats: When it comes to making threats, there are five important factors to keep in mind. First, if you make a threat, you must be willing to carry it out. I’ll let Dr. Schelling speak his own words for the other four, because he said it best:7

• “We have observed that the rationality of the adversary is ­pertinent to the efficacy of a threat, and that madmen, like small children, can often not be controlled by threats.”

• “We have recognized that the efficacy of the threat may depend on what alternatives are available to the potential enemy, who, if he is not to react like a trapped lion, must be left some tolerable recourse.”

• “We have come to realize that a threat of all-out retaliation gives the enemy every incentive, should he choose not to heed the threat, to initiate his transgression with an all-out strike at us; it eliminates lesser courses of action and forces him to choose between two extremes.”

• “We have learned that the threat of massive destruction may deter an enemy only if there is a corresponding implicit promise of nondestruction in the event he complies, so that we must consider whether too great a capacity to strike him by surprise may induce him to strike first to avoid being ­disarmed by a first strike from us.”

So, to summarize, we know that only rational people will respond in a rational manner to a threat. And, when you make a threat, you have to make sure that your opponent has an attractive option. For example, you can’t tell your employees “Shut up and keep working yourselves to death. If any of you quit, I will kill you.” Both working and quitting are horrible options in this case. Also, making the ultimate threat of destruction against someone automatically gives them a pretty good choice in comparison: destroy you first. And last, if the threat is going to get people to cooperate, people must be comfortable that you will not carry out the same threat if they cooperate. Time after time in movies we see the bad guy tell people that he will kill them if they don’t give him the information he needs, and then kill them anyway after they give him the information. If people suspect this, then threats are not likely to work.

Why We Should Cooperate: Schelling takes some lessons from Chapter 6 on repeated games in his discussions about how to cooperate in negotiations. Rather than negotiating the entire contract or treaty at one time, take it piece by piece. Additionally, negotiators need to keep in mind that driving the hardest bargain possible is not always the best option. When people agree to a settlement, each side needs to realize some kind of gain. Otherwise, why settle?

Additionally, Schelling points out that after any agreement is made, something must exist to make the parties stick to the agreement. One last quote from Schelling:

What makes many agreements enforceable is only the recognition of future opportunities for agreement that will be eliminated if mutual trust is not created and maintained, and whose value outweighs the momentary gain from cheating in the present instance.