Imagine a hot day, with the sun blazing brightly. A sharecropper is toiling in the field, working hard. He would love to take a breather and relax under the cool shade of a nearby tree, but he will be paid at the end of the day based on how much he harvests. He has a family to feed, and the more he harvests, the more wages he makes. He decides he can rest when he gets home in the evening. Now it is time to work hard and harvest as much as he can before dusk. This is, of course, precisely how the landowner would like the sharecropper to reason—work harder and get paid more; goof off and get paid less.
This story illustrates the workhorse model in economics that describes the relationship between employers and employees. It is called the principal–agent model,16 and multiple Nobel Prizes in economics have been awarded for contributions to the development of it. It offers powerful insights.
When a person is employed by an organization, the organization recognizes that the person is effort averse, that is, they prefer less work to more. All else being equal, the person will shirk when it comes to working for the organization. Because the organization wants the individual to work hard, it must make it in the best interest of that individual to do so. In other words, in the context of the assumptions we discussed in chapter 3, the individual maximizes expected utility (defined over their wealth or consumption) and minimizes the cost in terms of personal effort. Moreover, the organization is a hierarchy—the sharecropper has a boss, the landowner.
To get the individual to work hard, the organization typically uses two practices: input monitoring and output incentives.17 It practices input monitoring by watching over the employees to see how hard they are working. Imagine the landowner patrolling the fields to see how hard the sharecropper is working. Analytical Alberto exercised this type of control over the organization. It also practices output incentives by giving the employee a compensation reward that increases as the observed output increases. Output incentives make it unnecessary for managers to watch the employee all the time to see how hard they are working.
The principal–agent model is a workhorse model of employer-employee relationships in economics because it describes behavior well, it is elegant and tractable, and it provides valuable insights about how to design not only labor contracts but also a host of financial contracts. For example, it helps us understand why executives should be given bonuses and stock options, and why vesting schedules are often structured the way they are. It explains why insurance contracts have deductibles.
An essential element of the model is moral hazard. Moral means “ethical,” “good,” “right,” “honorable,” or “principled.” Hazard means “danger,” “exposure,” “vulnerability,” “threat,” “risk,” or “peril.” Thus, moral hazard means that moral behavior is imperiled. A moral hazard arises when an individual chooses self-interest over the collective interest and acts in a manner that violates the spirit of the contractual relationship, although not necessarily the legal aspects of the contract itself.
This selfishness is powerful and contagious. For example, when a boss chooses self-interest over the collective interest, the direct report reciprocates. The direct report pursues self-interest too, even if doing so sacrifices the common good. Over time, pursuing self-interest becomes the culture of the organization, its social contract. Unity is lost, and the social network is frayed. When this fraying occurs, the individual and the system become less productive. If the choice of self-interest spreads, the organization loses unified effort, and it becomes a collection of individuals all seeking their self-interest. Alberto came to realize the consequences of this loss of unity after his initial experience as a CEO.
People who have a conventional mind-set pursue self-interest. Absent output-based rewards or input monitoring, the sharecropper goofs off. Absent deductibles, the insured will “overuse” insurance. The classic illustration of overuse is a person driving their car into a lake and then reporting it as stolen in order to collect the insurance money because the car was worth less than the insured value. Overuse is also observed in health insurance: absent copay provisions, people tend to overuse medical services.
The principal–agent model says that the party in the contracting relationship that suffers due to the moral hazard—the employer or the insurance company—is “smart” enough to recognize the moral hazard and design input monitoring and output-based contracts to attenuate its effects. This attenuation leads to what is called a “non-cooperative Nash equilibrium” in which the employer anticipates the employee’s strategic behavior and then designs a contract to attenuate the effects of that behavior, and the employee behaves in exactly the manner the employer anticipated.
John Nash (the mathematician depicted in A Beautiful Mind) came up with this concept to describe the kind of equilibrium that relationships settle into when each party acts in their own self-interest and the other party recognizes this and therefore acts the same way. In the sharecropper example, if the landowner mistakenly pays the sharecropper a fixed wage and then is too busy one day to monitor his activity, the sharecropper will indeed goof off, validating the landowner’s expectation of his behavior.
The sharecropper’s view is that a landowner interested in maximizing crop output would either pay him more for producing more or watch over him more closely, so if the landowner is doing neither, then why not goof off? The sharecropper rationally expects the landowner to view the sharecropper as being self-interested, and the landowner rationally expects the sharecropper to view the landowner as being self-interested; caring only about profit (and not the sharecropper’s welfare). An equilibrium is reached when each party’s expectation about how the other will behave is indeed the way each party behaves.
Before we explain how the principal–agent model should be modified to incorporate higher purpose, we note that it was developed to fill a need in economics to have a framework within which we could understand how to deal contractually with self-interested behavior. That is, the model highlighted a prevalent problem and showed that contracts could be designed to deal with it. The first and most profound insight of the principal–agent model is that incentives matter because people respond to incentives in their contracts. The second major insight is that people are both effort averse and risk averse. So they will work hard only if by doing so they perceive they will be better off, and they dislike uncertainty in the compensation they receive for working hard.
First, the point that individuals respond to contractual incentives is empirically valid. For example, the Health and Medicine Division (formerly the Institute for Medicine) estimates that unnecessary medical services, excessive administrative costs, and fraud account for about $300 billion a year in health-care spending in the United States, which was about 30 percent of the total spending on health care in 2009.18 Some observers have suggested that much of this is due to perverse economic incentives generated by contractual features embedded in the current system.19 One of these contractual features is fee-for-service payments to doctors that encourage potentially unnecessary services. Another is copayments by patients that may be too small to discourage them from asking for unnecessary and expensive medical services.
For example, a doctor told us he was working the night shift in the emergency room of a hospital. A woman came in late at night with a cut she had suffered on a finger. This was something she could have taken care of herself and then gone to her doctor in the morning to get a checkup to see if anything else was needed. Instead, relying on laws that require her to be treated without question, she came to the emergency room. When the doctor was done treating her, he asked, “Why did you come to the emergency room for this? You could have just gone to your doctor in the morning. This was not an emergency.” She responded, “Doctor, that would have meant taking two hours away from work, for which I would lose pay, and then I would be seen by a nurse practitioner only. By coming to the emergency room, I don’t lose time away from work and a real doctor treats me.”
This is rational behavior on her part, but such behavior by many people leads to huge negative externalities for the whole system, driving up health-care costs and possibly denying someone really in need of emergency medical services timely access to a doctor. This is the power of incentives at work. When we build bad incentive systems, we get bad behavior. That is exactly what the principal–agent model predicts.
Second, perhaps the strongest evidence in support of aversion to effort and risk is that people buy insurance of all sorts. If you are not risk averse, you do not need insurance. Moreover, the insight that individuals are effort averse and will not work hard unless incentivized by their wage contract to do so is also empirically supported. One study used data from a windshield fitting company to estimate the change in performance that occurred when the firm introduced piece-rate compensation. Productivity rose by about 35 percent.20 Another study used data on tree planters in British Columbia, where in some instances piece rates were used, and in others fixed wages were used. The incentive effects of piece rates led to behavioral changes that accounted for between 6 percent and 35 percent increases in productivity.21 Yet another study of British jockeys showed that the use of bonuses attached to victories improved performance.22
Numerous other studies argue against incentives. They find that incentives may be counterproductive and may cause employees to focus on the wrong things—driving only measured performance at the expense of important output variables that are difficult to measure and not included in computing bonuses. However, economists George Baker, Michael Jensen, and Kevin Murphy suggest that this is not an indictment of incentives but rather a statement that perhaps incentives work too well.23 That is, you need to design incentives in compensation contracts to incentivize the behavior you want—behavior that affects both easy-to-measure outputs as well as outputs that are hard to measure—recognizing that the incentives will have powerful effects on behavior.
We do not seek to negate these insights but to take them as a given and build on them. We will show that an important role of higher purpose is to change incentives and influence employee behavior. Moreover, higher purpose may also reduce the uncertainty that employees perceive.
While an accurate descriptor of behavior on average, the Nash equilibrium in the principal–agent model also involves waste and inefficiency. For example, the output-based contract typically imposes too much risk on the risk-averse employee, even risk that is beyond their control. Think again of the sharecropper. The sharecropper may work really hard, but the weather may turn out to be too hot and dry for a good crop. Output will be low, and the person will make a low wage despite their hard work. They are exposed to the risk of bad weather.
Knowing this, the sharecropper will be unwilling to accept a contract where his wage depends only on output and will need to be paid some amount of fixed wage. Recall the assumption that employees prefer the status quo because it reduces uncertainty. Of course, the bigger the component of his wage that is fixed, the less hard he will work, making the relationship less efficient. A catch-22, indeed!
Moreover, because the employee is effort averse, he tends to minimize effort. That is, he works less hard than he would if he were an employee-owner. He works less hard because when he is an employee-owner, he gets to keep all of the profit from his hard work, whereas when he works for someone else, he has to do the work but share the profit. When organizations expect employees to be narrowly self-interested, employees behave in a way that validates that assumption, and a culture emerges that gives rise to a Nash equilibrium.24 The conventional culture constrains the emergence of excellence.
This culture of self-interest is the general rule highlighted by the principal–agent model. For example, consider the widely accepted idea that incentives to innovate are typically far stronger for independent entrepreneurs than for the employees of companies. This is an important reason why companies often outsource innovation when speed of innovation is important.
When a company wants to innovate for economic gain, it assumes its self-interested employees will come up with innovations only if they are motivated by the rewards associated with coming up with those breakthroughs, so it will put in place compensation rewards for new ideas. Employees will believe that the only purpose of the innovation is economic gain for the company, so they will work only as hard as the compensation rewards induce them to.
Both the firm and the employees are correct, therefore, in their beliefs about each other. The employees will then compare their personal profit (compensation reward) from innovation within the firm with the personal cost of working hard for it. Because the company will give the employee only a fraction of the profit from the innovation, the reward for the employee is never as great as it would be if the employee were an independent innovator who could keep all of the profit from the innovation for himself. Thus, an independent entrepreneur (who is both a principal and an agent) will always work harder to innovate than an employee (who is only an agent) will.
This sort of equilibrium behavior is costly to the firm, something the principal–agent model recognizes but views as an inevitable consequence of individual self-interest and rational behavior. In some instances, this creates organizational crises that traumatize people.
A friend of ours, a woman who works on the first line of a large organization, told us of a downsizing that she had experienced. One day the employees were called into a large room. Some people’s names were read. These people were asked to walk with security officers to clear their desks and proceed to their cars. They were fired.
As our friend told the story, she began to shake. A year after the event, she was still working for the firm but was still in trauma. She said she has been looking for a new job since that day. She and her peers were, in essence, just going through the motions.
What happened here? The organization’s executives, facing a hard problem, did the best they could. They solved their hard problem by using conventional assumptions and executed a conventional solution. In the process they demonstrated a conventional view of work and leadership. Their actions turned the culture more negative. The employees subsequently put in minimum effort and expected similar behavior of one another.
In engaging in a conventional downsizing, the managers destroyed commitment, and they destroyed financial value. Since no one could imagine differently, no one was held accountable for this great destruction of value. They did what they had to do, and in doing so, they failed to take advantage of a great opportunity to create value because they could not imagine the opportunity.
This kind of action not only affects the employees; it also affects the people who execute the strategy. Recently, we spoke with a woman who is a senior HR executive in a Fortune 100 company. She told of a major financial crisis. The company had to downsize, and she led a firing process similar to the one just described. We were surprised to see that as she told the story, she began to shake. Even years after the event and though she was the boss and not the victim, she was traumatized.
For organizations that follow the principal–agent model, these sorts of episodes are predictable. Is there any way out of it? What is a leader to do?
Here is what one purpose-driven leader did. His name is Ricardo Levy. For decades he has been a successful entrepreneur. Today he is retired and he teaches entrepreneurship at Stanford University. Ricardo’s company once experienced a financial recession, and he needed to downsize 20 percent of his workforce. He held a meeting to make the announcement. At the conclusion of the meeting, everyone, including the people that were about to be fired, stood up and gave him a standing ovation.
Here is a puzzle: what did Ricardo do?
We have posed this puzzle to many groups of executives, and they look at us in disbelief. We tell them they have three minutes to figure out what Ricardo did. The amazing thing is, in three minutes they move from an inability to imagine such a thing to the correct answer. Their ability to do that suggests that inside all of us is an alternative perspective, a positive mind-set that we often do not access. Stop and think: What is your answer? What did Ricardo do?
Ricardo told us that he never kept his people in the dark. He was always transparent and told them the condition of the company. The people also believed him to be fully sincere and genuine. He said,
I do not use the word honest here. I use the word genuine. The people can feel it. I guess you could use the word love. I loved them, and I loved what I was doing. They absolutely knew I would never take such a step unless there was no other alternative. They knew it was essential for survival, and they knew I was fully aware of the pain I was inflicting. My employees knew from my past actions that I was going to take care, as best as I could, of every one of them. That day I was present with everybody. A leader is not a mechanic. You have to be totally in the moment with your whole being. When you become a leader, you are promising to care for your people and the organization.
Ricardo often uses the word authentic. He told us that with authentic leadership you can take your people to an elevated condition. You can leave the transactional world of self-interest. You can provide purpose and vision, and you can connect the people to the highest good. They begin to sacrifice for the authentic purpose, and a sacred space emerges. In that space, you find a community of purpose, trust, transparency. People can tell the truth. People listen. Conflict turns to collaboration and collaboration turns to high performance, and the people live in a valued community of shared identity.
Ricardo violated an assumption of the principal–agent model. He reacted not from self-interest but from care for the common good. If the employees had viewed Ricardo as self-interested, they would have thought that he was downsizing not because it was the only option left but because doing it would increase profits and fatten Ricardo’s wallet. They would not have given him a standing ovation when he announced the downsizing. But, more subtly, Ricardo would have anticipated that that is how they would view him and he would have dealt with them accordingly before the downsizing, essentially validating their beliefs, like in the principal–agent model. That would have defined the social contract of the organization. The only way to break out of this self-enforcing system of beliefs is for Ricardo to behave differently before the crisis. He did so by changing his own behavior, changing his own beliefs about his employees, and creating a different relationship with them.
Recently, Ricardo faced a new leadership crisis, one that pitted valued relationships against organizational performance. He was deeply torn but forced to decide. He called us and talked through what happened. He said he had had to fearfully step into the unknown—and stay there until he knew what to do. Entering that crucible of transformation, he felt extreme anxiety. As he wrestled with his paradoxical tensions, he could feel a change take place. Suddenly, he knew what to do.
In the transformational moment he gained understanding—complexity reduced to simplicity. His crucible became what he called “a chalice, filled with life-giving refreshment.” In describing the transformative moment on the phone, he began to slow as he struggled to express all that had transpired. He was, in real time, learning from his own observations.
In the transformational moment he seemed to be leaving the analytical realm. He was viewing the whole context. His fear turned to confidence, hope, and love. In that moment he also found a new voice: he could suddenly speak both logically and with genuine feeling.
He slowed again as he made sense of what had happened in real time. He mentioned the word covenant and paused. Then he said, “When you find the leader within, you discover that you have a covenant. The people expect the leader to see the way, and the leader is promising to do their best to find the way. In uncertainty, this means entering the cauldron and suffering the process of deep learning. The commitment to learning is an act of carrying the people in love.”
We were mesmerized by Ricardo’s concept of covenant and explored it with him at length. We could see that Ricardo was also trying to fully understand and articulate it. A few days later, he sent us an excited email message with a link to a speech given by Rabbi Lord Jonathan Sacks, which helped Ricardo understand. (The speech was given at the American Enterprise Institute annual dinner in 2017 and can be seen at https://www.youtube.com/watch?v=i347EuoPQJU.)
In the speech, the rabbi, who is also a member of the British House of Lords, gave an extraordinary account of the current American enterprise, its history, and its necessary direction. The words of this “outsider,” a British baron and Jewish rabbi, brought a standing ovation from a deeply appreciative American audience. What could he have possibly told Americans about America that would lead to such appreciation?
Rabbi Sacks began by describing the existing politics of anger, disintegration, and conflict that are manifest in America and across the Western world. He then turned to biblical history. He said that democratic capitalism takes root from the Judeo-Christian tradition. Of course, similar notions are also enshrined in other faiths, but they may have had different influences on the governance of the state.
He then turned to the political theory contained in the Hebrew Bible and discussed the founding of the earthly kingdom of Israel. The people told the prophet Samuel they wanted to be like other nations and have a king. God told Samuel that in establishing a king they would be rejecting God. Eventually, they established the kingdom.
In establishing a state, the Israelites were creating a social contract, in essence, the same social contract later articulated by Thomas Hobbes. The people gave up certain rights in exchange for benefits flowing from a centralized authority. In a social contract, each actor seeks self-interest; in commerce, the social contract produces a market; and in politics, the social contract produces a state.
Yet centuries before the Israelites established their state, they established a covenant. A covenant occurs when two or more people come together with respect and trust, and make mutual promises to help one another do what no one can do alone. In this establishment of purpose and action, they shift from “me” to “us.” A collective identity emerged. Rabbi Sacks said the idea is well captured in the sacred American phrase “We the people.”
A market exists to create and distribute wealth, and a state exists to create and distribute power. A covenant is not about the acquisition of wealth or power. It is about belonging and collective responsibility. While a social contract creates a state, it does not create an integrated system. A covenant brings forth a united society. Because Israel had a covenant society before it had a contractual state, it had a strong collective identity or culture. The collective identity could be maintained even in times of severe challenge.
The notion of a covenant reflects the inclusive mind-set. Covenant and contract can exist in a mutually enhancing relationship. The United States is the only country, other than ancient Israel, that has the dual foundation of covenant and contract. In America, the covenant was established in the Declaration of Independence, and the contract was established in the Constitution. This dual foundation happened because the founding fathers understood that freedom requires both a state (based on contracts) and a society (based on a covenant).
Rabbi Sacks said that today in America and in Europe the social contract remains, but the covenant is in decay. Collective identity is devolving to smaller and smaller groups of self-interest. The lack of a shared moral code does not allow people of different perspectives to “reason together.” The ability to listen to a person of a different perspective is crucial to the whole.
The state cannot solve all problems, and those who believe the state can solve all the problems are prone to magical thinking. The far right dreams of “a golden past that never was,” and the far left yearns for “a utopian future that never will be.” As conflict arises, it gives birth to populism and the hunger for a strong leader who will solve all problems. This hunger leads to a tyranny where the right or left dominates and freedom of expression begins to vanish. Anger replaces reason.
Rabbi Sacks said that the notion of covenant may be difficult to entertain in any country other than the United States because of its history: “We hold these truths to be self-evident that all men are created equal and endowed by their creator with certain inalienable rights.” He said that the good news in this time of conflict is that a covenant is renewable. Nations can renew and rebuild community. In a community you have real friends, people you can depend on, people who will care for you when you are in need.
Ricardo and Rabbi Sacks help us understand the covenant of leadership and the emergence of high-performing organizations. The covenant of leadership is a sacred agreement you make with your best self, your dynamic self, your growing self. It gives you the ability to pursue an authentic higher purpose. It gives you the ability to imagine the organization as having a social contract and a social covenant. It gives you the ability to recognize the necessity to continually renew both.
When Shauri discovered her own authentic higher purpose, she made a covenant with herself to become her best self. When Alberto discovered as CEO the difference between his social contract to the organization and his covenant as a leader, it changed him and his ability to lead the organization.
When you establish a covenant that guides the organization, you create an exception to the rule that is the principal–agent model. The covenant inspires employees to transcend the conventional mentality of financial exchange and become intrinsically motivated. It allows them to find a higher purpose in the work, and it alters how they behave. If farmers are harvesting crops only to make money for themselves, they are in an economic exchange. If they believe that in addition to generating profit, the people of their country survive because of their effort, then they may become intrinsically motivated.
Similarly, employees will work harder if they believe that, in addition to producing profit for the firm, the innovation they are seeking will also benefit society. An employee who works hard to come up with a better electric car views that as a contribution to combating climate change. An employee who works hard to develop drugs to cure cancer views that as a way to help prolong people’s lives.
Researchers have shown that employees work harder when they view their organization as authentically working for the good of society.25 The embrace of a higher purpose can motivate employees to voluntarily work harder for the common good because individuals also care about things besides explicit compensation rewards—things such as society, integrity, honesty, social identity and reputation, corporate social responsibility, moral behavior, and intrinsic motivation.26 We build on this idea in chapter 5 in developing an economic theory of higher purpose.