Liars and Outliers (27 page)

Reputation relies on transparency to work, but for many modern products, the seller knows a lot more than the buyer. There's a general economic theory about this, called
a lemons market
. Both experiment and observation demonstrate that in a lemons market, bad products drive out good products. That is, if one company is selling cheap toxic water—or cheap unhealthy sandwiches—and the buyer doesn't know the difference between the good products and the cheap ones, he'll buy the cheap ones, and competitors will be pressured to make their products equally cheap and equally bad.

What we know about reputational pressures is that they work best in small groups where there are strong social ties among the individuals. A sandwich seller in a local public market probably doesn't need a whole lot of institutional pressure. He's part of a community, and if his sandwiches start making people sick fast enough that they notice the connection, no one will buy them anymore. But just as this sort of security system doesn't scale for individuals as the community gets larger, social ties weaken, and the value of the items being bought and sold increases, it doesn't scale for corporations, either.
Globalization is making
the effects of reputational pressure weaker. As a result, the effects of defection are greater. Three examples:

• In 2011, the pharmaceutical giant
  Glaxo Smith-Kline
  was fined $750 million for marketing drugs manufactured in a Puerto Rican plant whose managers ignored numerous FDA letters warning that products were likely contaminated.
  
• Hundreds of people in Haiti, Panama, and Nigeria
  died of kidney failure
  in the 1990s and 2000s after consuming medicinal syrups manufactured with toxic diethylene glycol—an industrial chemical used to make plastics. Economically minded manufacturers had secretly substituted the toxic chemical for the more expensive, but nontoxic, glycerin.
  
• Starting in the mid-1990s, the Ford Motor Company knew that its Explorer model was
  prone to rollover
  , but didn't do anything to fix the problem until 2002. Until they did, there were 185 deaths and 700 injuries resulting from the problem.
  

Just as moral and reputational pressures can fail against corporations, so can institutional pressures. We've discussed some of the ways they fail against individuals in Chapter 9: interpretation, loopholes, lack of enforcement. These failures can be more severe in corporations, because corporations can afford more and better lawyers to figure out how to evade laws. And law enforcement is much more consumer-friendly when it comes to dealing with individual defectors. If someone steals your wallet, you know how to call the police. If a corporation breaks the law, whom do you call?

Fines can be an effective institutional penalty, but can fail if they're too small. The DeCoster family egg farms, responsible for the huge
salmonella outbreak
in 2010, had been repeatedly fined for health violations for over ten years. In 2011, the large pharmaceutical company Merck Serono agreed to pay a $44.5 million fine for illegally marketing
the drug Rebif
. That sounds like a lot, until you realize that the annual sales of the drug were $2.5 billion and the misconduct occurred over an eight-year period. It's no wonder the firm was a repeat offender; the fines were just a cost of doing business. Another example: the penalties for
using child labor
are so small in some countries—$59 to $147 in Egypt, $470 in India, $70 in Kenya, $47 to $470 in Nicaragua, $25 to $253 in the Philippines—that it makes financial sense for Western companies to defect. In Chapter 11, I mentioned the fake anti-virus industry. One company largely ignored the Federal Trade Commission prosecution because it was making more money than the fine was likely to be.
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We discussed other societal pressure failures inside corporations in the previous chapter: employees of a corporation defecting from that corporation, employee loyalty that encourages cooperation with the corporation and defection from society as a whole, and employees defecting from a corporation to benefit that corporation. Additionally, two of the differences between corporations and people listed above—that millions of people depend on them for their livelihood and that punishing them can have ripple effects through society—mean that sometimes it's in society's best interest to not punish defecting corporations: a fact a smart corporation can use to its advantage.

There is one more societal pressure failure that is unique to large and powerful corporations: the co-option of institutional pressure to further their own self-interest.

Imagine a societal dilemma, one that affects a rich and powerful interest: probably a corporation or an industry, but maybe a person or group of people. It could be the
oil industry wanting
government subsidies (in 2011, the U.S. effectively provided $4.4 billion in tax breaks to this industry alone, not even counting the military costs to protect their supply chains); or the Walt Disney Corporation wanting the government to extend the period of copyright so Mickey Mouse doesn't fall into the public domain. The group interest is to resolve the dilemma fairly. The self-interest for the corporation is to resolve the dilemma in its favor.

If a company can convince the government to resolve the dilemma in its favor, then its self-interest becomes the group interest. In this way, companies can defect in spirit by deliberately changing the laws so they are not defecting in practice—thereby circumventing or subverting societal pressures. So, for example, companies that make car seats, airbags, full-body scanners, compact fluorescent bulbs, car insurance, surveillance cameras, vaccines, radon detectors, and Internet filters for schools have had laws passed mandating—or at least encouraging—their use. And the healthcare industry got a
law passed limiting
its liability for care improperly delayed or denied.

In a sense, what corporations are doing here is reversing the principal–agent relationship. They're deliberately manipulating institutional pressures so they can directly benefit from them. In economics, changing laws to suit your desires without adding any value is known as rent-seeking.

One way to manipulate laws is through licensing requirements. Over the past several years, there have been debates in several states about
licensing interior designers
. It's either a necessary measure to keep charlatans out of the busi-ness, or an onerous, pro-cartel, anti-competitive system. Another way is through public opinion. The political decision not to regulate the derivatives markets is a good example: not only did it involve lobbyists and campaign contributions to get laws changed, but also public relations to convince journalists and the public that keeping the markets unregulated was a good idea.

Here's another example. Hydraulic fracturing, or fracking, is a means of extracting oil and gas from subterranean reservoirs by forcing pressurized fluid into underground rock formations. The process was originally commercialized in 1949 and in its first few decades of use was primarily used to boost production of old wells. Recent advances in
horizontal drilling technology
, combined with hydraulic fracturing, have enabled the tapping of heretofore inaccessible reserves, and the recent rise in oil prices has made it economically viable. However, the procedure also poses environmental risks, most notably the risk that chemicals used in the process—including methanol, benzene, and diesel fuel—might contaminate ground water, degrade air quality, and migrate to the earth's surface; and that the resultant toxic wastewater might be impossible to decontaminate.
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This societal dilemma sounds a lot like the monk parakeet example from Chapter 9, and you'd expect society to figure out whether this procedure is worth it. But the companies that use the procedure—Halliburton is a big player here—lobbied successfully for a provision in the 2005 Bush administration energy bill exempting fracking from regulation by the U.S. Environmental Protection Agency under the Safe Drinking Water Act.
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That's the effect of reversing the principal–agent relationship: the government becomes the agent of the corporation.

One common way to do this is regulatory capture, which we'll talk about in the next chapter. Another way is to simply be unregulatable for political or economic reasons. Homebuilders have been sued repeatedly over the past decade for
shoddy building practices
, many of them illegal. “Too big to regulate” is how one source put it, making it impossible for homeowners to know they're getting a substandard house until it's too late. The banking industry is similarly trying very hard to be unregulatable, claiming that any regulations would damage the economy more than it would help it.

When it comes to organizations, size is proportional to power. Legislative bodies used to rule fewer people and smaller geographic areas. In the United States, many laws that were passed by states in the 1800s became federal matters in the 1900s. There's nothing sinister about it; it's just that it now makes more sense to deal with these laws on that scale. Today, international legislative bodies have increasingly more power—simply because more things make sense to deal with on a multinational level.

This is especially true in corporations. Broadly speaking, there's a natural size of an organization based on the technology of its time. The average organization size
used to be smaller
, became larger, and now is even larger. Historically, there have only been a few very large organizations: the Roman Empire, the Catholic Church, and so on. These worked because they were organizations of organizations. That's how countries work; the U.S. has federal, state, and municipal governments. That's also how feudalism, militaries, franchise stores, and large multinational corporations work.

It still works this way, but we're better at it now. Organizational size is restricted by the limits of moving information around. Different people within, and different parts of, an organization need to communicate with each other; and the larger an organization, the harder that is to do. Most organizations are hierarchical, making communications easier. And militaries have generally been examples of the largest-sized organization a particular technological level can produce. But there's a limit where the costs of communications outweigh the value of being part of one organization. Economist
Ronald Coase first
pointed this out in 1937. Called “Coase's limit” or “Coase's ceiling,” it's the point of diminishing returns for a company: where adding another person to an organization doesn't actually add any value to the organization. You can think of an employee inside of an organization having two parts to his job: coordinating with people inside the organization and doing actual work that makes the company money. Some people are wholly focused inside the organization: the HR department, for example. Others do the actual work, but still have internal coordination roles. There's a point where adding an additional person to the organization increases the internal coordination for everyone else to a point that's greater than the additional actual work he does. So, the company actually loses money overall by hiring him.
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The ease of collecting, moving, compiling, analyzing, and disseminating information affects Coase's ceiling, and one of the effects of information technology is that it raises Coase's ceiling because the resultant efficiency increases.
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Larger size has several effects on societal dilemmas:

• Large corporations can do more damage by defecting. A single company, Enron, did $11 billion worth of financial damage to the U.S. economy. That much damage might previously have required ten smaller companies to defect. This means that as large corporations grow, fewer defectors can do even more damage. So society needs more security, to further reduce the amount of defection, in order to keep the potential damage constant.
  
• Individuals within a large corporation can defect from the corporation to a greater degree, for greater personal gain and to the greater detriment of the corporation.
  Nick Leeson's
  unauthorized trading while he worked for Barings Bank destroyed the entire company in 1995. Kenneth Lay, Jeffrey Skilling, and other senior Enron executives destroyed that company.
  Kweku Adoboli
  lost $2.3 billion for the investment bank UBS in 2011.
  
• Large corporations have more power to deliberately manipulate societal pressures. This includes getting laws passed specifically to benefit them, and engaging in jurisdictional arbitrage by deliberately moving certain operations to certain countries in order to take advantage of local laws.
  Different countries
  have different, often conflicting, laws about price-fixing, and international companies have an easier time forming cartels. This sort of thing can be more local, too. Until recently,
  Amazon.com used its
  large national footprint and lack of physical stores to avoid having to charge sales tax in most states.
  
• Punishing a large corporation might result in so much cost or damage to society that it makes sense to let them get away with their wrongdoing. The ultimate expression of this is when a company is “too big to fail”: when the government is so afraid of the secondary effects of a company going under that they will bail the company out in order to prevent it.
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• Individuals within large corporations can be emotionally further away from the individuals they're affecting when they make decisions about whether to cooperate or defect. Remember that moral pressure decreases in effectiveness with emotional distance. The larger the corporation, the larger the tendency towards emotional distance.
  
• Larger corporations have more to lose by defecting. Their reputation is more valuable, and damage to it will have greater effects on the corporation. This serves to restrict what they're willing to do.