“Theory” is often a dirty word for many practitioners and entrepreneurs.  Theory is nothing but axioms weaved out of an unrealistic world defined by academics. One could argue that these invented realms do not serve any useful purpose other than making academics look good and survive.

To practitioners and entrepreneurs, the real learning ground is not the world’s best university; it is in the “society” university.  Roughing it out in the real world is where learning takes place.  Classrooms, as far as they are concerned are for wimps.

As lecturer and business adventurer, I must beg to defer. 

The Mind or the Gut?

Theories of the business and finance world have come a long way and methods to test the validity of these theories are also now more advanced.  Furthermore, with the help of information technology, reliable data used in these test is now easier to acquire.

If that is true, why then are our Singapore graduates still learning the real world through the hard way of failure?  Shouldn’t they be more vigilant since they have survived the tough Singapore education system?  Is there a fault in the system?

A recent Business Times article written by a business consultant suggested that we need to expose our students to more practical exposure during their education process, as focusing mainly on “training the mind” will not help our students in their path towards entrepreneurship. Instead he believes more “training of the gut” is required for entrepreneurship and “to analyze is to paralyze”. 

But analysis with the gut or mind is analysis itself.  Using the “mind” basically means creating a structure such that the conscious mind can be put to work for analysis.  This method allows proper reasoning to be formed and communicated. Using the “gut” on the other hand targets analysis work to happen in the subconscious mind.  Analysis using this method is relatively faster due to the many heuristic processes at work but the analysis cannot be easily communicated and can often be biased.

Classroom Example of Explaining the Real World Through Theories

As it is coming to the end of the term, I decided to spend the week sharing with my students some behavioral traits of the real world, or at least the feel of it, and explain them using theories.  In doing so, I decided to play the “X or Y” game with them.

The Game

The game is simple. The class is split into 4 groups representing 4 departments. Each group is to appoint a manager of the department.  The objective of the game is to have each department make a decision between “X” and “Y” such that the decisions maximize the value of the department and the firm.

There are 20 rounds to this game.  In each round, each department is to decide between 2 decisions “X” or “Y”.  Each department is then supposed to submit a secret bid to the CEO after which the CEO will announce the final outcome – total number of “Xs” and “Ys”.  The teams must keep track of the amount of value they add to their departments.  The payoffs to the decisions are such:

Therefore, if 3 departments bid for “Y” while 1 bids “X”, the 3 departments who chose “Y” would have lost value of 3 points while the 1 that bids for “Y” will gain 3 points.  As the bids are secret, each department will not know what the other department’s bid was.

Three conference rounds are also selected within the 20 rounds namely, “6”, “11”, and “16”.  These 3 rounds allow the manager of each department to come together to exchange information and agree on a strategy but the final decision of the departments can be different from what was agreed.

The outcome

The first two to three rounds are always the more interesting rounds.  Since each team is to play the game based on what they have been briefed on only, choices are made based on their level of understanding.  This facilitated me to assess their learning curve.

Students get better at the game thereafter from round 3 to 5.  At conference round, the manager of each department would often try to explain the payoffs to each other until everyone has a common understanding.  They will then agree on the best strategy to implement before returning to their departments to make the final decision.   

Though the students understand that if they all put “Y”, they will all be profitable, the final outcome almost always ends up with at least one “X”.  So far, no class has actually achieved positive results as a whole and within its individual departments.

On the surface, this game seems to suggest that companies fail due to of lack of cooperation and therefore the participants of the game are encouraged to cling on to the notion that we must ideally work as a team.

But the game is more than that, it is really about life – always expect others to maximize their own utility.  The message was really not about teamwork; it’s about not expecting teamwork and finding ways manage a team, or a few teams, such that their interest is aligned to the ultimate goal.

My explanation of the behaviors observed in the game:

Utility Theory, REMM, and Agency Theory

Coined by the great Daniel Bernoulli, utility was developed as a counter argument to the then popular “expected valued” analysis. An English philosopher, Jeremy Bentham, later defined utility in hedonic terms of pleasure and pain.

Under the REMM (Resourceful, Evaluative, Maximizing, Model) defined by Jensen and Meckling, we are all maximizers of utility.  Being evaluators, we will assess the utility (and disutility) expected from all choices, the final choice – the one that produces the highest utility.  As such, we will only cooperate or collaborate with one another when the benefits are more then the costs. 

Even in a collaborative mode, we will continue to maximize our utility through profiting from the group while sharing or transferring the cost to other members.  This is Agency Theory.

Combining these theories, we can explain why the individual department was not cooperative.  Maximizing the department’s value can either be achieved by collaborative efforts to bid for “Y” or be the odd one out by putting “X” while everyone else puts “Y”.  Though the first choice is ideal, no performance differential is actually created (since everyone gets one value point).  To earn 3 value points is therefore the best departmental decision, which explains why most students choose “X” in the initial phase.

Game Theory – Non Sequential Game

The final payoffs received by the departments are not only the function of their choice but the choice of other departments as well.  As rational economic beings, we will choose the alternative that provides the highest rewards or the lowest loss.  A good analogy to this is the prisoners’ dilemma.

Even though the ideal strategy is to choose “Y”, the choice may not be ideal to the departments – only one “X” is needed to spoil the ideal strategy.  The best, or dominant, strategy is “X”.  By choosing “X”, the departments are certain that the maximum loss they suffer is minus 1 value point.

Though during conference round - where the managers of the department meet to exchange information and strategy - there was a general understanding that they should all choose “Y” for the good of the whole, it will almost always end up with a renegade.

Even the few who tried to maintain righteousness subsequently realigned their choices toward the dominant strategy after suffering the high cost.

Commitment Problem

Some students wondered if the outcome would be different if conference round was at the beginning.  Their argument is that understanding would have been formed amongst them and the ideal choice would have been known and set.

But really, though the ideal choice produces overall good, it does not give anyone or team an edge.  There is really nothing to stop anyone of them from being a renegade – Commitment Problem.

To prevent this from happening, a “commitment device” could have been structured during one of the three conference rounds (such as making the renegade treat lunch).  Alignment of interest therefore calls for the use of both punishment and reward in order to strengthen that commitment to cooperate.
 
Information Asymmetry and Signaling Theory

In the first few rounds, teams were generally unaware of each other’s strategy.  Most teams would realize that the most lucrative payoff was to take “X” in hope that everyone else takes “Y”.  Furthermore, “X” produces the lowest loss in the event the other teams take “Y” too.

But near the first conference round, many would have figured out the ideal strategy – everyone should bid for “Y”.  The idea of conference round was for everyone to share their analysis on the situation at hand and agree on the best strategy; and it works.  During the first conference round, the many strategy combinations were shared and their final decision is almost always “choose “Y” for the good of the whole” but a renegade will always appear.

With the lack of a commitment device, the teams are likely to notice that the renegade of conference round will reap the most benefits at the expense of others.  Though a common understanding was established during conference, that verbal commitment bears no information in regards to each team sticking to their words.  Teams are still ignorant of each other’s intention and plans due to lack of the sharing of true information – Information Asymmetry.

There are actually two reasons why a team will renegade during conference round – offensive and defensive reasons.  While the offensive reason has a “tunneling” objective, the defensive reason was to observe a renegade.  Unfortunately, though the intentions are different, the signal sent to other teams is the same – no one can be trusted.

A few honest or righteous teams tried to convince other teams that they should continue to bid for the good of the whole.  Their signaling strategy – continue to put “Y” regardless of what others do and show that they are doing that by displaying their losses at conference round.

Signals are strong when two properties exist: (1) when the signal is costly to fake and (2) when it forces others to reveal information about themselves.

The cost of sending the “I am a believer of the good of the whole” information was costly to fake since it comes at a maximum cost of 3 value points and during conference round, by revealing the losses forces all to confess their actions.

Conclusion

After explaining all these behaviors and theories to my students, my conclusion was that even those who still strongly feel that we should put the interest of the firm before self would sooner or later resign their believe to the dominant strategy; which is to protect oneself from incurring more signaling cost.

The business world is therefore not only about discovering an ideal strategy and advocating it to the world in hope that everyone can benefit from it.  It’s also about understanding that we are all maximisers of our own utility. Whether you are an employee or an entrepreneur, whether you are in a profit or not-for-profit organization, it is the management of these conflicting interests that will determine the probability of success.
 
Also, contrary to popular belief, I have shown that it is possible to learn much about business strategies in the classroom. 

Any opinions or comments ?