Applied Reconism. Corporate Governance

Reputation and opportunism

American economist Mancur Olson, in his work “The Logic of Collective Action,” provided a coherent argument that in large groups, the rational behavior of an individual optimizing their costs would be to refrain from participating in the creation of public goods. Indeed, if a public good will be obtained regardless of their participation, then the rational choice is to abstain, as the public good, by definition, will be available to everyone. It is rational to be a “free rider.”

In corporate governance, this means bad news for the manager. It is economically beneficial for the employee not to work, as the company’s profit or even the mere existence of the company is a public good that will be created and maintained even if the employee does not participate in it.

Olson shows that a public good in a large group is likely to be achieved only if the costs of obtaining it are equal to or less than the benefits received by any member of the group.

“…this means that there are three separate but working together factors that prevent a large organization from operating in the common interest.”

• First of all, the larger the group, the smaller the share of the individual in the overall result, and the less adequate the reward for any group action, which moves the group further away from effective functioning.
• Secondly, the larger the group, the less likely it is that any sub-group within that group will receive a sufficient amount of collective good to bear the costs of providing even a small quantity of that good; in other words, the larger the group, the less likely it is that oligopolistic interaction will occur, which could help ensure the collective good.
• Thirdly, the larger the number of participants in a group, the higher the organizational costs, and the greater the obstacle that must be overcome before any collective good can be provided. As a result of all this, the larger the group, the further it will drift away from providing itself with an optimal amount of public good, and usually very large groups, in the absence of coercion or external influence, will not be able to provide it at all, even in minimal amounts…

Olson described the ways in which large groups, which he referred to as latent, can be mobilized to create public goods. He identified two methods of mobilizing groups — coercion and the presence of selective incentives, meaning incentives that do not apply to the group as a whole but rather to specific individuals, encouraging them to participate in such a group.

In human resource management, such incentives can be either sanctions against an employee or bonuses for well-done work. However, it is important to understand that both sanctions and bonuses can only be applied when it is possible to clearly identify and distinguish individuals who deserve a particular type of incentive. A general annual bonus that is distributed among the employees of a company will be paid to everyone, regardless of who actually contributed and who was just a “freeloader” pretending to do something.

Mansur Olson, in addition to large latent groups, examined the work of so-called “privileged” and “intermediate” groups. By privileged groups, he meant those that “are small enough and in which each member, or at least one member, has an incentive to pursue the collective good, even if it means bearing all the costs themselves. For such groups, there is confidence that the collective good will be provided; moreover, it can be provided without any organization or coordination of the group.”

By “intermediate groups,” he meant groups in which “… none of the participants receives such a significant share of the overall benefit that they would have the motivation to provide this good solely on their own. However, the number of participants in this group is not so large that no one would notice if one of them refused to take on some share of the costs. In such a group, the collective good may or may not be provided; however, it will definitely not be achieved without some form of coordination or organization of the group.”

Thus, if we ensure an increase in the visibility of a group member’s participation, we can also expect an increase in the acceptable size of the group that can still act effectively and cohesively. Sociologist, Harvard University professor, and one of the authors of the social exchange theory, George Homans, wrote that small groups exhibit much more consistency than large ones: “At the level… of a small group, that is, at the level of such a social unit (regardless of what we call it), where each member has firsthand information about all the other individuals in the group, human society has demonstrated the ability to act cohesively for many thousands of years…” In modern terms, Homans argued that the key to a group’s effectiveness lies in its complete mutual transparency.

When examining the problem of opportunism (free riders, corrupt individuals) within the framework of new institutional economics, the following means of social control are considered to avoid opportunism:

• Trust as a means of increasing efficiency, reducing control costs, and achieving agreements and mutual understanding in risk assessment more quickly.
• Culture serves as a framework that defines common values, concepts, and goals, acting as a factor influencing coordination problem-solving. It is associated with the processes of establishing contact and reaching agreements: in the case of longer partnerships within a monoculture, there is a likelihood of increased transaction costs due to dependency, trust abuse, and opportunism, which undermine efficiency.
• Reputation serves as a specific form of capital. A good reputation reduces the incentive for opportunism and, as a result, lowers the costs of information gathering and negotiations.

It is not difficult to show that both trust and culture are derivatives of reputation or, in other words, reputational expectations. For example, we trust someone to the extent that we expect value for that partner in maintaining their reputation.

The effectiveness of reputation in countering opportunism is most influenced by three factors:

• the density of the social network in which reputation spreads, that is, the number of social connections among players;
• the speed of information dissemination in this network and its resilience to distortions;
• the engagement of participants in the social network, meaning the duration of relationships over time and the number of these relationships.

The combined influence of these three factors on a social network can be referred to as the degree of transparency of the social network. If we talk about the behavior of a person who is well-known to everyone around, meaning we have a high density of the network, and information spreads instantly within this network, and the person in question frequently interacts with other members of the network, then news that, for example, he took a candy from a child will spread instantly.

At the same time, real social networks are not transparent for a number of reasons. The Dunbar number also plays a role here, limiting the number of connections for each employee. [96]. and the speed of information transfer between people. People themselves are not perfect
storage and transmitters of information and can forget or distort certain
data about other individuals, and their involvement in their own social network is
far from 100%.

In such conditions, the reputational mechanism serves as an excellent “antidote” to opportunism in small, mutually transparent groups, where one can expect that the first player will engage in a transaction with the second only after learning about the results of their previous transactions with other participants.

Human ethology.

The most intelligent and perceptive creatures—primates, lions, elephants, dolphins, wolves—exhibit pronounced individual differences and therefore usually live in small groups of individuals capable of recognizing one another. [2]. The relationships within the groups formed by these animals are built on a reputation-based system. For example, other males will not challenge the dominant male precisely because he has the appropriate reputation, and they will respond more actively to a call of “there’s food here” if it comes from an individual known for being a good provider.

In a large human society, individual reputational connections cease to function effectively due to the large number of individuals within the group and, consequently, the vast number of strangers who constantly surround people.

Society is becoming anonymous. After all, in addition to communities of animals that possess individuality, are capable of recognizing one another, and building hierarchically structured groups regulated by aggression, there also exist anonymous, depersonalized communities where individuals do not recognize each other and can only distinguish members of their own group from outsiders—like ant colonies, flocks of birds, or herds of antelopes. Such communities do not require hierarchy or aggression. They can consist of a large number of individuals, as members of the group do not need to remember individual differences. Each member of such a community must be completely predictable to the others. This means that the other members of the anonymous community must trust him as they would trust themselves, and he must behave accordingly. The “norms of behavior” in such communities are strictly defined by instincts and reflexes.

Communities of this type form a decentralized “network” of fairly simple and unintelligent beings that, by working together, can effectively and quickly make quite complex decisions. An anonymous, albeit with some caveats, colony of rats exhibits behavior that some biologists refer to as “collective intelligence.” A herd of antelopes instantly reacts to a lion spotted by one of them. Ants and bees possess technologies that no elephant or dolphin could even dream of. And this is despite the fact that each individual ant or bee has virtually no brain.

Since the emergence of the first large human communities, there has been a process of anonymization. Reputation assessments replaced individual recognition with group recognition, based on cultural stereotypes—such as language, religion, traditions—or through the conditional inclusion of unfamiliar individuals into the familiar biological hierarchy. This way, people could interact within very large groups, simply fitting each specific stranger into a limited number of templates or roles and assigning them a standard reputation score associated with those roles.

Naturally, as such role templates, people began to use an established hierarchical scheme of relationships in tribal communities. Thus, chiefs and kings became the “fathers” of their nations, while, for example, fellow soldiers became “brothers in arms.” In this way, people seemingly followed the path of ants, but in reality, they simply learned to scale the hierarchy to very large sizes without confirming its effectiveness, merely following their instincts.

People and organization

Based on the above, some very interesting conclusions can be drawn:

The larger the company, the more room there is for “free riders,” and the more space there is for idlers, the less efficient it becomes, requiring more people to accomplish the same tasks, which in turn creates even more room for free riders. This phenomenon is known as the spontaneous growth of bureaucracy.

Effective use of human resources in organizations is only possible with the establishment of internal transparency and mutual accountability. Stimulating employees is ineffective, and in the absence of transparency, it can even lead to the opposite results.

“Freeloaders” find it beneficial to cast shadows on the fence, reducing transparency, depersonalize the decisions made, create and maintain unjustified confidentiality, reduce information exchange between departments, and demand unilateral reporting instead of supporting mutual accountability.

Potentially, everyone can be a “freeloader.” After all, even the creation of such a simple public good as exposing a slacker requires significant personal costs from an individual. This means that even an honest person who does not inform their superiors about slackers is also a “freeloader.”

Leaders of organizations often, under the pretext of not wanting to engage in micromanagement, distance themselves from communication with their teams, thereby creating an opaque environment for themselves in which they are unable to form their own assessments of their employees. Additionally, in their quest to be impartial and objective, leaders anonymize and strip their employees of individuality in their own eyes. Both of these phenomena create favorable conditions for opportunists. It is worth recalling that, according to legends, great commanders of antiquity remembered all their soldiers by face. Apparently, this talent of theirs, their higher Dunbar number, allowed them to assess both the abilities and contributions of each individual and to effectively lead their armies.

What to do?

First, we need to imagine what would happen if everyone in the organization were a personality focused on their reputation, rather than an unnoticed lemming or “plankton.” It would turn out that there are no people who are perfectly matched to their functional responsibilities based on their competencies. In some areas, they can help their neighbor. In others, they may be weak, but in a transparent environment, they are not ashamed of this and gladly accept help.

The organizational structure based on functions is becoming outdated, and it is more appropriate to focus on business processes and the coordination of people’s participation in them. In a functional structure, the work will be done by the person whose job description includes it, regardless of their actual competence. Additionally, individuals may be inclined to hide their true skills, and attempts at genuine or directive assistance from a more competent (or cheaper) employee may be met with jealousy. After all, their role is associated with their position, and by accepting help from someone more skilled, they risk losing their job. In a business process-oriented approach, tasks are performed by people who are more knowledgeable about the issue, depending on the situation and the project. The ability to assess a person’s skills, set expectations, and build a reputation can only be achieved in a transparent organization where strong connections are established among employees, regardless of their position in the company.

Driven by reputational factors, employees will shift the communication paradigm from “who is in charge” or “who do you think you are, goodbye!” to a primary motif of “how can I help you.” After all, a good reputation will allow them to seek help later on.

Building reputational relationships is completely incompatible with high employee turnover. This means we need to nurture talent, monitor employee motivation, and strive to be the best employer in the industry. And even, oh my, offer workers lifetime employment.

Impersonal phrases like “the company decided” or “the management believes” will disappear. Every decision, every idea, every thought will have a specific author, as this is how reputation is built. A leader will no longer be able to simply give orders. They will need to learn how to “sell” their initiatives and, under no circumstances, pressure their subordinates. Moreover, they are no longer subordinates; they are simply colleagues with their own roles in the business processes.

To maintain a high density of information exchange, all divisions that are “a thing unto themselves” and do not actively communicate with the rest of the company will eventually die out on their own, and their tasks will be carried out by outsourcing companies. The company itself will focus on its core business.

So, when we envision what the company is becoming, which is a tightly-knit team that has shed the unnecessary and is focused on the essentials, we can start thinking about how to achieve this state.

The path is indeed thorny. All the “hangers-on,” who seemed indispensable, will either leave on their own or be forced out, but the company will certainly not collapse without them. Such people are usually just functionaries, focused on some intermediary role. They are most interested in depersonalizing or anonymizing decisions, establishing levels of secrecy, and engaging in intrigues to create a smokescreen. However, a mass exodus of employees can demoralize the rest.

Managers will need to engage in mentorship and communication with people rather than impersonal administration. They will have to see their employees as clients to whom they need to “sell” the added value they provide. This will lead to the development of something that modern managers fear—favoritism. However, in the new conditions, these won’t be favorites who have outperformed others in backroom struggles, but rather genuinely more authoritative individuals recognized by both the manager and the entire team.

And if there is a willingness to move forward, it should start with the basics. With the indication of authorship under each document. With the establishment of mutual accountability, without any smoke and mirrors. By tracking the activities of “anonymizers” and understanding that they are the “freeloaders.” By ensuring clarity and transparency in the daily work of each employee. By answering questions like: what did each person accomplish today, where is this document located, how much time did each person spend online and where. And let these answers be accessible not just to the manager, but to everyone. The manager should also be held accountable daily. We should move away from the philosophy of “function – person” and replace it with the philosophy of “business process – roles.” We can even start by replacing meetings, where people can participate silently, avoiding collective work, or worse, inserting their “important” thoughts just to feel significant, with cooperative creation of documents in collaborative systems. So that everyone’s participation is visible and documented, rather than forgotten as a mere emotional memory.

Start small.