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.