MBA Oath

Get ready to be provoked.

Sometimes when you're an educator, you get to say provocative things just to try to stir up discussion. And that's what I'm about to do.

So here goes...

And remember, I'm just trying to provoke you.

A group of Harvard MBA students is circulating the MBA Oath. In part, the idea is to remedy the black eye that the recent financial crisis has given to schools of management, by having MBAs promise to work to enhance social value.

I'm not sure what I think of this idea. (Actually, I am sure, but I'll save that for later.)

At the suggestion of a friend who is a professor at another b-school, I wrote up a competing Oath. Here it is:

I, the undersigned graduate of so-and-so business school, recognize the inherent tension between value creation and value capture. Private enterprise has little incentive to create value unless it is allowed to capture at least some of it. Our capitalist system recognizes this tension, and allows firms to pursue profits self-interestedly, subject to many limitations imposed by the legal and regulatory system. As a manager, I realize that it is not my role to determine what is an "appropriate" or "inappropriate" profit-making opportunity; in our society, the political, legal, and regulatory processes make that determination. I therefore pledge to maximize shareholder value (subject to all applicable laws and regulations), and recognize that I serve a great social purpose in so doing.

Now that I've provoked you, tell me what you think. Which Oath is better? Which one would you sign? Should managers work for social value or shareholder value? What the heck is social value, anyway?

iPhone Pricing

An EMBA student points out that Apple announced yesterday some incredibly cheap iPhones --- $99 for the 3G second generation with 8 GB.

What is going on?

Well, a lot. But part of what's going on is that Apple's trying to manipulate a coordination game that's happening between customers and software developers.

I'll explain in a minute, but first let's talk about what a coordination game is.

It's a game where the players' best choices depend on what other players are doing. If you're a former student of mine, you've probably seen me talk through the "Battle of the Sexes" game, where two people want to spend the day together, but they have different preferences about where to spend it. In this game box, Rachel has to choose whether she wants to go to Wrigley Field or the Field Museum. Scott has the same set of choices. If Rachel chooses Wrigley and Scott chooses Museum, the outcome is in the upper-right cell, where Rachel's payoff (represented in lower-left of the cell) is five, and Scott's payoff (upper-right) is also five.

The notable thing about this game is that there are two Nash Equilibria. One is where Rachel and Scott both go the Museum. Another is where both go to Wrigley. At any of the other cells, a player could unilaterally change his or her strategy and achieve a higher payoff --- so those cells aren't equilibria.

Coordination games aren't just classroom trivia --- they're real and they're real important.

Here's another game box. The players here are software developers and end users of smartphones. The choices for the developers are "develop for iPhone" and "develop for Palm Pre". The choices for end-users are "buy an iPhone" and "buy a Palm Pre". With the payoffs I've drawn, the developers don't really care whether they develop for iPhone or Pre --- they just want to be where the customers are. Further, customers don't care about which platform they're on, they just want to be where the apps are.

This is a coordination game, and it has two Nash Equilibria, just like the Battle of the Sexes.

If the developers don't care which platform they're on and the end users don't care which platform they're on, then who does care? Apple (and Palm) care a lot.

My guess is that Apple's super aggressive iPhone pricing is driven (in part) by the recent introduction of the Palm Pre, which has been getting some good reviews. Apple knows that it can't win (indefinitely) by having a better device than other smartphone makers --- device features are just too easy to copy. But it can win (indefinitely) if it can get developers and end-users to coordinate on the iPhone platform. The reason is that no developer will develop for the Pre if developers don't expect end-users to buy it. And no user will buy one if users don't expect developers to develop. By pricing aggressively and pulling as many end-users over to its platform as possible, Apple is trying manipulate the equilibrium of this coordination game, and reduce developer incentives to develop for Pre.

Malcolm Gladwell

A DESB MBA alumnus sends a link to this article from ESPN.com:

Gladwell-Simmons II: Ultimate rematch

In it, Malcolm Gladwell (of Blink fame) criticizes pro sports leagues for rewarding teams that perform badly by giving them high draft picks. Here's a snippet:

I think, for example, that the idea of ranking draft picks in reverse order of finish -- as much as it sounds "fair" -- does untold damage to the game. You simply cannot have a system that rewards anyone, ever, for losing. Economists worry about this all the time, when they talk about "moral hazard." Moral hazard is the idea that if you insure someone against risk, you will make risky behavior more likely. So if you always bail out the banks when they take absurd risks and do stupid things, they are going to keep on taking absurd risks and doing stupid things. Bailouts create moral hazard. Moral hazard is also why your health insurance has a co-pay. If your insurer paid for everything, the theory goes, it would encourage you to go to the doctor when you really don't need to. No economist in his right mind would ever endorse the football and basketball drafts the way they are structured now.

I'm going to argue with Gladwell by re-telling a story. The story belongs to a colleague from my Kellogg days who is an expert on innovation. This story is his, and it didn't happen at Kellogg.

He was teaching one day (at another school) about how to provide incentives for innovation. During the class, he'd argue that innovation is inherently risky. Even if your employees take all the right actions all the time, sometimes they will fail to innovate.

Now, suppose you punish employees who fail to innovate, by withholding raises or promotions or something. What will employees do? They'll pursue the path that seems most likely to lead to some sort of innovation, which may or may not be the path that maximizes the firm's expected profits. To get employees to innovate appropriately, you sometimes have to insulate the employees from the full consequences when things go badly. It's a counter-intuitive and subtle message.

The big finish to my friend's lecture was this message: To encourage innovation, sometimes you have to reward failure.

A student raises his hand. My professor friend calls on him. Student says: "At my company, we tried to reward success."

Now why's that related to anything that Malcolm Gladwell said? Gladwell wrote this: "You simply cannot have a system that rewards anyone, ever, for losing."

A response from this economist: Sure you can. And that's exactly the right thing to do when the costs of "rewarding success only" --- as Gladwell advocates --- exceed the benefits.

Examples:

• Rewarding scientists who take all the right actions but fail to innovate is exactly the right thing to do if you want to encourage scientists to do something other than take the sure-thing path to a simple innovation.
• Rewarding teachers who fail to make students happy is exactly the thing to do if you want to encourage teachers to develop lesson plans that push students.
• Offering a government bailout to banks certainly rewards losing, but it's exactly the thing to do if the consequences of not doing the bailout are worse.
• Offering a good draft pick to a bad team is exactly the thing to do if... fans value competitive balance.

A couple of comments on the financial rescue and the NFL/NBA drafts: It's for sure the case that government bailouts reward failure and can lead to moral hazard, as Gladwell points out. But does this mean we shouldn't have done it? Well, the financial system, it turns out, is really important to the economy at large. And a domino effect of failures through the financial system could have led to a much larger disruption in the flow of credit to the real economy. And that would have been bad. Worse than the moral hazard as future bankers expect big bailouts? Well, maybe, but it's hard to to say. Unfortunately, we (meaning economists) don't get to observe what would have happened if we had let AIG fail.

With regard to the drafts: Would NBA revenues be higher if the "basketball player" labor market worked like every other labor market? Think about what happened when you graduated college --- you were a free agent, free to sign with whatever team, er, firm you wanted. Suppose all rookie basketball players could do the same. Now, players like to win. As a result, they're likely to be willing to accept slightly lower salaries in order to sign with a team that has a chance to win. Now you've got a really pernicious feedback loop going --- teams that have a chance to win would have higher revenues (due to more fans) AND lower costs (due to the players-like-to-win effect). The Clippers would really, really not have a prayer.

As a general rule, I'd say that providing incentives has both costs and benefits, and it's important to think through both. Too often, people make mistakes along the line of saying "X is good. Let's reward X." This is what Gladwell is doing when he says we need to reward winning only. And it's also what my professor friend's student was doing when he said that we should reward success.