Wednesday, March 30, 2011

The Problem(s) with Fairness, part 1

We often make appeals to fairness.  It's a universal concept, something virtually every person understands and respects.  Unfortunately it's also quite dangerous to invoke.

The first problem with fairness is that it's not nearly as objective as we think it is.  Take a simple question like, "If someone sues someone else and loses, should they have to pay the defendant's legal costs?"  This is an appeal to fairness and not everyone will agree.  But what's really amazing is that many people hold both answers to be true!  How can this be?

In 2005 U.S. News and World Report asked people one of the following questions:

"If someone sues you and you win the case, should he pay your legal costs?"  85% of people answered yes.

"If you sue someone and lose the case, should you pay his legal costs?"  44% of people answered yes.

These questions are virtually identical.  Each corresponds with, "If someone sues someone else and loses, should they have to pay the defendant's legal costs?"  But simply because we're placed in one role in one version and another role in the other, we're likely to see things differently.  If I'm sued, then certainly it's fair that he pays my costs if I win.  After all, it was probably frivolous.  But if I sue someone else and lose I shouldn't have to bear their costs.  That would make it too dangerous for someone with a legitimate but uncertain case to go to court!  Four out of ten people change their minds on what seems like such a fundamental principle of fairness, and I bet most of the rest were less sure of their answer depending on which role they were in.

This question of bias came up for me today.  We were negotiating an interesting case in which one firm had developed a valuable technology but could only get full value out of it by partnering with a sister firm (owned by the same parent company).  Their corporate rules were decentralized which meant that the two firms would have to negotiate any deal.

There were all sorts of ways the deal could be structured and it was clear that choosing the right structure would make a big difference in how much money there was to divide amongst us.  My group came up with an interesting idea.  Since we high a high level of trust with our counterparts, we would propose full disclosure of all information in order to achieve the largest amount of value.  Then we would split the value created by the deal equally.

But how much value was that?  It seemed to me that there was an obvious answer.  As the owners of the technology, we had a value on our own of $50 million.  The value created by the deal was therefore the total value after the deal less the $50 million we had at the start.  (Their BATNA was worth $0.)  My team agreed.  When we met with our counterparts it turned out that they had had the same basic idea -- full disclosure and an even division -- although they hadn't clarified in their own thoughts what was being divided.

I explained our view of what should be considered the value created by the deal and after going over it they agreed.  We quickly identified the best possible deal, which led to a total value of $150 million.  They got $50 million ($50 million more than they had at the start) and we got $100 million (also $50 million more than at the start).  We were all happy.

When we got back to class, however, we noticed that most of the other groups had split the value of their deals more evenly.  In fact, if anything the balance of division seemed to favor the other company.  Each group had looked at the situation very differently and come to quite different conclusions about what was fair.

One of my HBS professors from my MBA days said that fairness meant nothing more than, "I like it."  I disagree.  I think fairness is something we all value and that when you say to me, "That's not fair," we both understand what you mean by that.  But one thing we should always remember is that what you think is fair and what I think is fair will often be quite different.  We know what fairness is but we don't necessarily know what is fair.

Monday, March 28, 2011

Know thy enemy

In my experience the most common mistake people make in a negotiation (besides not doing any homework at all) is not trying to figure out how the other party or parties sees things.  What are their priorities?  How badly do they need a deal?

Today we did a brief negotiation that illustrated this quite well.  It was a very simple negotiation with only one variable to discuss: price.  Students were broken off into pairs with one person given the role of buyer and one of seller.  (The actual deal had much more context, but I don't want to reveal details that could ruin the negotiation for other HBS students.)  Each had a private set of instructions that gave information relevant to their role.

The ZOPA on this deal was from $50,000 to $350,000.  Any price lower than $50,000 and the seller walks away.  Anything higher than $350,000 is higher than the value to the buyer.

This was a straight price negotiation with no other terms at play.  Unsurprisingly, with such a large ZOPA almost every pair made a deal.  What might surprise you is that the people in the buyer role got much less than half of the pie.  The mid-point of the ZOPA was $200,000 and at least 80% of the deals were for more than $200,000, with many in the $300,000 range.  Only four were for less than $100,000.

What happened?  I can't be sure, but I think most of the buyers made a fundamental mistake -- they looked at the deal only from their own perspective.

Part of the background of the case is that the item for sale looked hot and the agent had arranged an auction with "multiple" buyers since interest was high.  You tried for one-on-one negotiations and were told "no".  In preparation for the auction it was decided in your company that you'd make an aggressive initial offer of $100,000 but that the bidding was likely to reach $300,000.  Your maximum bid would be $350,000.

Then, one week before the auction, the seller contacted you and said that since the he liked your team and firm so much (and thus there would be value to partering with you) she'd like to meet with you to see if a good enough deal could be reached that no auction would be necessary.  You were glad for the opportunity to avoid an auction and your boss reiterated that you could go as high as $350,000.

If you look at the situation from the buyer's perspective you have an initial number of $100,000 in mind and you were expecting to pay $300,000 and possibly a bit more.  Anything better than $300,000 is an improvement on the auction and you're probably still thinking in terms of an initial offer of $100,000.  That's what happened with most of my fellow students.

I was also given the buyer role; we made a deal at $75,000.  (Two other buyers beat me with deals at $70K and $60K.)

The main difference is that I focused my preparation on figuring out what the deal looked like to the seller.  No one voluntarily moves from a bidding war to one-on-one negotiations.  I could think of only two explanations.  Most likely the other bidders had dropped out.  Another slight possibility was that the "real" seller (the person in the seller role was acting as an agent) had decided for non-financial reasons that we were the best partner and had instructed the agent to make a deal with us.  Either way, the seller wasn't in a good position.

My initial offer was $37,000 which led to an counter-offer of $100,000.  As a result, I was working the seller down from a price that in most other negotiations the buyer had put out as an initial offer for the seller to work up from.

This wasn't any brilliance on my part -- just an awareness of the importance of understanding the deal not just from your perspective but from the perspectives of the other parties involved.  When we look at other deals we'll see how this effort is important not just for value capture but also for value creation -- being able to find win-win opportunities that increase the pile of money on the table.

And as the week goes on we'll see if I end up on the worse side of the scoreboard on the exercises yet to come!

BATNA and ZOPA -- a quick introduction

I'm not a huge fan of jargon or acronyms but there are two that are so handy and so important that anyone doing negotiations should know them.  I also want to be able to use them freely here, so I'm going to explain them up front.  The terms are BATNA and ZOPA.

BATNA stands for Best Alternative To Negotiated Agreement.  Your BATNA is what you'll do if you don't reach a deal.  It could be "go to court" if you're trying to settle a legal dispute, it could be "invest the money organically" or "buy a different company" if you're negotiating an acquisition or it could be, "stay home and watch TV" if you're negotiating with your parents for permission to go with your friends to a party.

Your BATNA is very important because it defines what deals are worth considering and what deals aren't.  Any offer that isn't better for you than your BATNA is worse than "no deal" and should be refused.

ZOPA stands for Zone of Possible Agreement.  The people you're negotiating with have a BATNA too.  The ZOPA is the set of all deals that are at least as good for each party in a negotiation as their respective BATNAs.

To put it in simple terms, let's assume you're negotiating to buy a used car.  You've thought about what you'll do if you can't reach a deal and there's another car you could buy for $8,000 but the car you're negotiating for now is worth $1,000 more to you.  Your BATNA is "buy the other car for $8,000" and in terms of this deal that's equivalent in value to "buy this car for $9,000".

Unknown to you, the seller is moving overseas and has to sell.  She has an offer for $6,000 and if she can't get a higher price from you, she'll take it.

The ZOPA for this negotiation is $6,000 to $9,000.  Any deal within that range is possible.  The ZOPA reflects how much value is being created in the deal -- you and the seller are better off by a combined $3,000 if you buy the car from her.  Where you end up in the ZOPA (assuming you don't negotiate yourself out of a deal altogether) reflects how much of the value you capture for yourself.

You Are Not So Smart

If you ever get a chance to see or speak with Mahzarin Banaji don't miss it.  She gave a lecture on what she calls "Mind Bugs".  These are a host of mental blocks due to the way our brains are wired as well as biases we develop from a very early age.

Here's an example.  The video below was constructed by overlaying two different movies, each of a team of three people passing a basketball back and forth.  All the people from the first filming wear black shirts and all those from the second wear white.  Your task is to watch carefully and count the number of passes made by the players watching the black shirts.  See if you can manage it!

Don't read further until you've watched the's only 18 seconds long.

No, I mean it!  Go watch the video.

Did you manage to track the passes?  Did you see the woman with an umbrella walk across the screen?  Our class of highly-motivated executives got the count right, but only one person (out of about eighty) saw the woman with the umbrella.  So the next time your spouse says, "I already told you that!" don't be so sure they didn't.

There was a lot more to it and the discussion of cognitive bias was really interesting.  I'll probably come back to it in a couple of weeks but since I can't cover everything in the course in real time I'm going to move on to things more directly tied to negotiations.  You can learn some examples of cognitive bias at a blog that shares the name of this post, but again, if you ever get the chance to see Mahzarin...take it.

Sunday, March 27, 2011

Back at Harvard, day 1

This blog is going to have an unusual start.  This week I'm lucky enough to be participating in an advanced negotiations course for business executives at Harvard Business School.  I decided to start off by sharing the key thoughts or experiences of each day.  It's quite likely I won't be able to keep up with blogging a full day's work each evening but I'll fill in the blanks where necessary.

Tonight began with one of my favorite illustrations of poor human decision-making: an auction of a $100 with the following rules:

1. No speaking by anyone other than the auctioneer.  All you're allowed to do is bid or sit quietly and wait.
2. The first bid must be exactly $5.  All subsequent bids must be exactly $5 higher than the prior bid.
3. You can't bid twice in a row.
4. The highest bidder gets the $100 in exchange for his bid.
5. The second-highest bidder gets nothing but must still pay his bid.

There are about eighty people in the room.  Would you bid?  If so, where would you stop?

Most of us sat it out (myself included!) but quite a few people bid and new people jumped in at various times.  Finally the inevitable happened...all but two people dropped out and they were trapped.  If you've bid $90 and someone else bids $95 you have a very strong incentive to bid $100 because your net loss is currently $90 and if your $100 bid holds up you break even.  The problem, of course, is that the person who bid $95 has the same incentive to bid $105 so you'll keep going until finally someone decides to cut their losses.  In our class that happened at $130, but auctions of this kind can run into the thousands of dollars once people decide that they may be losing money but they're not going to lose the auction!

After dinner we were presented with the following exercise:

In an industry with two co-leaders (i.e. two leading companies of roughly equal size), a medium-sized company (we'll call it "Prize") announces that it's for sale.  The following assumptions are given:

1.  The value of Prize as an independent company is $1 billion, but due to synergy it's worth $1.2 billion to either of the co-leaders.
2.  It's bad for either of the co-leaders if the other one acquires Prize because then they fall to #2.  This would reduce their value by $0.5 billion.

You're the CEO of one of the co-leaders.  What do you do?

Let's start with the math.  Prize is worth $1.2 billion to you, but just like in the dollar auction the CEO of the other firm has an incentive to bid more than it's worth because there's a cost to losing the auction.  If you have a bidding war the winner is likely to pay close to $1.7 billion, at which point each of the co-leaders has lost $500 million in value.

I'm embarassed to admit that although I saw the correct goal (don't bid but also convince the other co-leader not to bid) but wasn't able to think of a way to achieve the goal that wasn't illegal.  Once either company bids the other one is forced in, so their best result is for neither to bid.

As it turns out, this hypothetical was based on a real situation -- the U.S. airline industry when USAir announced that it was for sale.  American and United, the market leaders, were quickly identified as the likely buyers and Bob Crandall (who was in charge of American Airlines) recognized the danger of a bidding war.  His solution?  He sent a memo (a physical memo, not an email) to every single employee of his airline, down to the baggage handlers, explaining that American Airlines did not intend to bid for USAir but that if United did decide to bid for it, American would be forced to defend its position in the market.

As you can imagine, with that many memos printed one of them found its way to United Airlines.  Neither airline bid for USAir.

Why Negotiation?

When I was five years old, my brother realized something very important.

At that time our parents would hide jelly beans (my favorite) and chocolate eggs (his favorite) around the house at Easter.  Once we'd gathered them up we would trade something like two beans for one egg (since the eggs were bigger).  Then Harold realized that I didn't like chocolate eggs at all.  He declared that he would only trade if for every jelly bean he gave me he got five eggs.  I grumbled, but since the eggs were worthless to me I gave in.

The next year Harold took it a step further.  Instead of grabbing any candy he saw he would only go for the jelly beans.  Since he could trade a few beans for all the chocolate eggs later, they weren't worth slowing down for.

Unfortunately for him, I refused to go along as I had the year before.  I said I was willing to throw my eggs in the trash rather than trade them to him at five eggs to one bean.  We eventually settled on something like one to one, which was still better for him than where we'd been two years ago but much better for me than one year ago.

Today I understand that childhood conflict much more clearly...and talk about it in jargon.  I had a bad BATNA and he used his knowledge to capture all the value in our ZOPA.  I recognized that our negotiation was iterative so I refused to accept a deal even though it was ahead of my theoretical reservation price.

Jargon aside, the point is that negotiation is part of life.  We do it all the time and if we do it well we get better results.  Best of all, so do many other people we care about.  As we'll see, a lot of good negotiation is about making everyone involved better off.

Negotiations are also very important.  Clearly we care a lot about reaching mutually positive agreements with our husbands, wives and children.  We also risk leaving a lot of money on the table if we don't negotiate effectively (or, as so many do, don't negotiate at all).

One brief example.  A couple of years ago a friend of mine called me for negotiation advice.  She'd been offered a promotion at work with a salary bump.  She really wanted the new job and the salary was quite competitive with what she might get elsewhere, so she had good reason to be happy but she also suspected that she might be able to ask for more.  She was leaning towards just accepting the offer and had just about talked herself into that position.  We spent about an hour on the phone, going over her interests, the key players where she worked and what could happen depending on her choice and came up with a number we were confident she could ask for that had no downside but which I was sure would either be accepted or met with an improved offer.

That conversation, and her decision to negotiate rather than accept the first offer, was worth several thousand dollars to her -- every year.  I'm sure she was nervous or uncomfortable coming back with a counter-offer rather than grateful acceptance, but I'm even more sure it was worth it.

This blog is going to be a mix of theory and practice.  We'll discuss important articles and concepts in negotiation theory and we'll touch a bit on the lighter side of game theory but we'll also look at a lot of real life examples.  My hope is that we learn some things together and have fun doing it.  I hope you'll join in and share your own insights and experience or ask questions if anything isn't well explained.