Termites under your bed!

Why organizations fail? Why organizations do not achieve its full potential? Why do they degrow? When they start falling apart?

Are there termites under your bed?

Rest of the post is all about that. It is also about – How growth and prosperity of organizations could be restored based on certain stories from economics and economic principles.

There are three stories. You can read each story independently. Each is powerful on its own right.

First Story: Nation’s failure vis-à-vis Organizational failure

Let us take a view from the top by posing the trillion-dollar question as raised by Darron Acemoglu and James A. Robinson (henceforth Acemoglu) in their famous book – Why Nations Fail. It is important to understand the philosophical underpinnings of the book to appreciate it in the micro context of an organization.

Before Acemoglu, there are several theories put forward to showcase a nation’s failure – geography hypothesis, the culture hypothesis, the ignorance hypothesis. However, all these theories fell short of explaining the counterfactual scenarios. In chapter 2, Acemoglu refer these as ‘Theories that don’t work’. So, what works?

It is Institutions.

Secure private property rights, legal mechanism to enforce contract, freedom to exchange, good public services etc are some of the elements of good institutions. While economic institutions provide incentives to perform, they rest on political laws and rules. Therefore, inclusive economic institutions and inclusive political institutions are the two imperatives for prosperity.

Acemoglu differentiates between extractive and inclusive economic institutions.

Acemoglu says –

Inclusive economic institutions…..are those that allow and encourage participation by the great mass of people in economic activities that make best use of their talents and skills and that enable individuals to make the choices they wish. To be inclusive, economic institutions must feature secure private property, an unbiased system of law, and a provision of public services that provides a level playing field in which people can exchange and contract; it also must permit the entry of new busi-nesses and allow people to choose their careers.

Therefore, absence of these elements results in a form of extractive economic institution.

While inclusive economic institutions are necessary, these are not sufficient to ensure prosperity. We need inclusive political institutions as well. Acemoglu says -

...political institutions that are sufficiently centralized and pluralistic as inclusive political institutions. When either of these conditions fails, we will refer to the institutions as extractive political institutions.

He cites example of South Korea and United States where there are not only pluralistic political institutions but also “sufficiently centralized and powerful states”. He contrasts that with Somalia where there is no real authority and one clan fights against the other. He argues -

There is strong synergy between economic and political institu-tions. Extractive political institutions concentrate power in the hands of a narrow elite and place few constraints on the exercise of this power. Economic institutions are then often structured by this elite to extract resources from the rest of the society. Extractive economic institutions thus naturally accompany extractive political institutions. In fact, they must inherently depend on extractive political institutions for their survival. Inclusive political institutions, vesting power broadly, would tend to uproot economic institutions that expropriate the re-sources of the many, erect entry barriers, and suppress the function-ing of markets so that only a few benefits.

Therefore, inclusive political institutions are foundational for inclusive economic institutions. It is exceedingly difficult to usurp power and set up extractive economic institutions when power is broadly distributed across society and poses constraint on arbitrary use. It is important to note that centralization of political institutions and pluralism must go hand in hand to have inclusive political institution.

Isn’t there enough evidence of countries with extractive institutions performing better? Yes, there are.

A centralized planning system could direct resources from agriculture to industry within no time or produce something that world desires and make a good fortune. It can achieve miracle in a short span of time. However, inevitably it would hit the dead-end. They would fail sooner or later.

Why? Acemoglu argues -

Even though extractive institutions can generate some growth, they will usually not generate sustained economic growth, and cer-tainly not the type of growth that is accompanied by creative destruc-tion. When both political and economic institutions are extractive, the incentives will not be there for creative destruction and technological change. For a while, the state may be able to create rapid economic growth by allocating resources and people by fiat, but this process is intrinsically limited. When the limits are hit, growth stops….

Why creative destruction (i.e., innovation and adoption) is not possible under extractive institutions?

Acemoglu says – “Because elites dominating extractive institutions fear creative destruction, they will resist it, and any growth that germinates under extractive institutions will be ultimately short lived. Second, the ability of those who dominate extractive institutions to benefit greatly at the expense of the rest of society implies that political power under ex-tractive institutions is highly coveted, making many groups and indi-viduals fight to obtain it. As a consequence, there will be powerful forces pushing societies under extractive institutions toward political instability…. The synergies between extractive economic and political institu-tions create a vicious circle, where extractive institutions, once in place, tend to persist.”

How one can apply these to individual organization?

You will notice a few being at the top for too long, a strong resistance to innovation/change, insufficient incentive mechanism to promote creativity, appropriation of credit and good work, encouragement of group fights, lack of credibility in commitment and delivery etc. You may notice the iron hand of oligarchy all over. There may be an economic incentive structure by way of setting up rules/protocols/norms etc for transactions. However, the political institutions or the governance mechanism is extractive.

Think about it deeply and you will be able to see and differentiate between good organizations and bad organizations as well as between good leadership and bad leadership. Organisational culture is built over a long period of time. Therefore, changing it also would require a good enough time. Once there is an intent, it would be possible. The key is a deep commitment in letter and spirit.

Let us now go to the second part of the Story – the Nokia Story.

Second Story: The Nokia Story

I would suggest everyone to read this book –Transforming Nokia – The power of paranoid Optimism to lead through colossal change (2019, McGraw-Hill Education) by Risto siilasmaa. He is the current Chairman of Nokia – joined the board in 2008 and became its chairman in 2012. This book is all about Nokia’s transformation from abyss as well as what had happened in the first place. Nokia at its peak was as good as a small country in terms of its revenue. As per Wiki, in the year 2000, “Nokia alone accounted for 4% of the country's GDP, 21% of total exports, and 70% of the Helsinki Stock Exchange market capital.” The Economist made a story in August 2012 with a title ‘The Nokia Effect: Finland’s fortunes are affected by one firm. What about other countries?”. The picture is taken from The Economist’s story. 

As you can see, in 2011, Nokia’s revenue was 20% of GDP!!!

Siilasmaa in his book writes –

“Nokia in 2008 was on top of the world. …By 2000, Nokia accounted for an astonishing 4 percent of the Finnish GDP, and it generated nearly a fifth of Finland’s exports. Nokia made as much money as all the other companies in Finland combined”.

Siilasmaa continues –

“In the four years that I had been on the board, I had seen the company lose over 90 percent of its value. That spring of 2012, we issued two profit warnings over two quarters. Our operating loss was over €2 billion during the first half of 2012. Our mobile phone revenues were almost in free fall. Only a year after laying off 10,000 workers, we were planning another round of painful layoffs, the biggest in the company’s history. Our share price was an agony to watch; it was barely €3, down from about €28 when I joined the board.”

There are many reasons cited by Siilasmaa for this colossal failure of Nokia. However, what drew my attention is the following conversation of Siilasmaa with the then Board Chairman of Nokia. Here is a conversation:

Siilasmaa (Board Member) to Jorma (Board Chairman) – “But it seems to me that we may be missing the big picture of what is happening. We’re not having the deep discussions with management and among ourselves that would give us a clear understanding not just of what’s happening but of how we might be able to fix it. We have failed to invest sufficient time analyzing technology and competitors.”

Jorma to Siilasmaa –

“Risto, you need to remember that you come from a small software company. You just don’t understand how a global company the size of Nokia works. The board cannot become operational.”

Siilasmaa continues –

“The higher you ascend in the hierarchy, the more removed you are from the action. The farther you are from the front lines, the more filters the information will go through before it reaches you, and the more likely it is that you will be the last to know what’s really happening…..

In today’s fast-moving business world, you may not have the time to do the in-depth research to answer these questions. You may not have the authority to demand it. However, if the culture allows, you can propose that your colleagues think through the following questions:”

What are these questions:

1.   Are we discussing the right things?

2.   Are we discussing the right questions the right way?

3.   Are we comfortable challenging the leader’s opinions?

As per Siilasmaa’s own admission, certainly those were missing in Nokia which led to this gigantic failure.

Think through these questions in your own organizational set up. Do we discuss the right questions? Are you reminded too often about your designation and level within the organisation? Can you ask counter questions to your leadership? Does the answer come from a written script given by the Media or Corporate Communication department? Do they appear genuine in their response? Have they ever changed any of their strategic decision in the presence of incredible facts and figures based on your argument? How big is their individual ego? It may be hard to find a positive answer to all the questions. However, there are organisations who exhibit these qualities and value their employee. They understand that the most important asset they have is their people. They exhibit tremendous courage in taking hard questions and providing a genuine response. They earn employees trust and that takes them to higher orbit of growth.

Now lets move to our third story which is about – Trusts in transactions.

Third Story: Trust in Transactions

The branch of social science that deals with strategy is known as ‘Game Theory’. In business school, they teach a lot on strategy to make you a better strategist. I wish they could have taught a little bit about moral philosophy from these game theoretic models. I have not done an MBA, but I have not come across a paper from various MBA program on ethics and philosophy. There may be at some places and I apologize for my ignorance. However, in economics, a good dose of political economy/economic thoughts and its evolution were taught when I was a student. It might have been shunned as well since it cannot compete with R/Python/AI/ML/Big data.

So, what does game theory has to do with organizational success or failure and more on trust in transaction?

Let us pick one of the favorite games of Game Theorist. It is known as prisoner’s dilemma.

Albert Tucker’s prisoner’s dilemma is a paradox applicable in wide variety of context including trusts in transaction. It is plain, simple and at the same time extremely powerful.

Assume there is a crime committed by two person – Alice and Alia. They are caught in a crime and kept in separate cell of a jail. The jail authorities have interrogated them in two separate rooms as well. Alice and Alia have two choices – either they will remain silent or they will confess.

The interrogators told Alice that they have enough circumstantial evidence to put both in jail, however, if she confesses and let the prosecutors prosecute Alia, she will be given lesser punishment while Alia will undergo a 10-year imprisonment. Prosecutor also informed Alice that the same offer is being extended to Alia as well. Alice immediately asked – what if both of us confess? The interrogator gave a sharp reply – Both of you then would go to jail for 2 years.

Since both could not communicate, then what should be their strategy?

Let us now put up the payoff matrix for such a game. A payoff matrix is nothing but a visual presentation of the possible strategic outcomes.

Payoff Matrix-I

Both the prisoner’s are in a dilemma. Should they confess or should not? The payoff matrix shows the outcome. The first cell should be read as follows: If Alia and Alice remain silent and does not co-operate, then the interrogator would levy a charge against both and send them to 1 year of imprisonment.

What would be the dominant strategy in this game?

Think about it!

Alia would always think – it is better for me to confess no matter what Alice does because if Alice confesses then I would be worse off. Alia further talks to herself – Even if Alice confesses and I confess too, then the jail term is only 2 years which is far better than going to jail for 10 years.

This thought process would result in a dominant strategy where both would confess, and both would go to jail for 2 years. However, had they remained silent and defiant; both would have served a jail term of 1 year each?

This is a classic case of collective action failure. This thought process acts as deterrent in joint work. What if I support but the other person defects! The other person would get promoted, shall have better career prospect but I will be a loser or at best would lose in relative terms. You can read this nice wiki introduction on collective action problem or social dilemma.

All of us would gain immensely out of cooperation but seldom do out of selfish interest. Our conflicting interest inhibits joint action.

No matter how bold face you may put in public, when you do a self-reflection, you would realize that – this is not a mere game, it has some elements of truth. This is because we have a trust deficit in joint action. This unfortunate truth has been discussed in various context in economics. It has helped in designing policy dealing with common resources.

Now let us take this game one step ahead.

Payoff Matrix-II

We will discuss about iterative game (same game but repeated over a multiple period/transactions) and shall see what the outcome would be.

Assume there are two countries who are the trading partners. There is a free trade agreement between both. There is zero tariff and no hidden non-tariff barriers. It is a good world where both the nations trade and maximize the welfare for the citizens.

Now let us play this game. Assume there is a 5-year trade deal so for 60 months they can do free transactions amongst themselves without any tariff or other barriers. If both countries respect the trade deal and co-operate, their payoff is USD $10 billion each. Free trade enhances welfare. Isn’t it? If one country defects and impose trade restrictions, then it would be able to exports more while import restrictions may promote its own domestic industry (which is untrue empirically, remember import substitution policy and all its perils). So, the payoff matrix for the defecting country is $20 billion while the co-operating country’s payoff now has reduced to $-5 billion. 

Now the trillion-dollar question is: when should the country first defect over this 60-month trade deal? Country A might think that – I would defect on 59th month so that I have no further deal with Country B on the basis of this trade deal and country B in any case would bring back the tariff post the expiry of this deal.

Country B would now think that – Country A might impose restrictions on 59th month so better I should outsmart Country A and better impose restrictions on 58th month. This simultaneous thinking process would take both the countries to such a point that – they will even fail in their first transactions.

Does it happen in reality? Well, it does not happen in the very first month as they have a little bit of humanity left in themselves but over a period, it is not unusual for countries in going back from a trade deal as they think their defection would yield better result for themselves.

You apply this iterative game theory logic to real life situation. You would realize that – this is an ugly manifestation of trust deficit. We are unable to enter into long-term deal or strategic partnership as we do not trust in many cases. What the heck? Isn’t there enough international, national and company level agreement and co-operation? There are. In fact, there are infinite number of agreements because of which the world trades, individuals do transaction and we prosper.

So, what makes such transactions successful?

Avinash Dixit and Barry J Nalebuff in their famous book – The Art of Strategy has given certain tips on that. I will not delve into the details. I am just listing out some of those points with my own commentary.

1.   Detection of cheating – Detect early so that gain from cheating would be minimized while cheating cost could be increased.

2.   Clarity – Boundaries of good ethical and commercial behavior must be laid out in open in a transparent manner so that each party understands it fully. Leaders must show consistent behavior and there should not be any difference in what they say and how they act. Their public posturing and private communication should be consistent.

3.   Certainty – Everyone should be aware that the defection would be caught and punished while co-operation would be rewarded. Does it mean making the WTO more effective with teeth? Leaders must ensure on the certainty of outcome. They must show their seriousness about their commitment.

4.   Size – The size of the punishment should be set at sufficiently high level to have a deterrence power. Defectors must be seriously penalized and the penalty should restrict the temptation on defection;

5.   Repeating – Look at the nature of transaction. Is it one-time or multiple times? Is it on a single product or over multiple product and services? Devise your strategy accordingly.

Finally, I would like to leave you with this picture from the book ‘Trusts in Transactions’ edited by Prasanta Ray and Rukmini Sen. Setting up a monetary reward is not all about incentives. It is much more than that. 

In my future post, I will delve into the details of incentive – what it is and what it is not.