When there’s an important job to fill, it seems obvious that an offer should go to the best person for the role. Ditto when there is a big contract to be awarded, or capital to be reallocated across an organization: whichever supplier or division will serve the firm best ought to win the opportunity.
That’s just good business. Right?
Yet there is a wrinkle, according to new research by Daniel Barron, an assistant professor of strategy at the Kellogg School, and Michael Powell, an associate professor in the same department: sometimes it might be in a firm’s interest to promote the wrong person, or sign a contract with the wrong supplier, because that party has performed very well previously.
This allows the firm to fulfill an earlier promise that excellent work would be rewarded in the future. This is crucial for a firm trying to establish credibility with its employees.
“That means from the perspective of today, I’m going to be doing stuff that’s really weird,” Barron says. “I may be promoting someone that I know is not going to be that great of a manager. But I need to because that’s the only way to credibly reward them for their past efforts.”
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Yet, picking the wrong candidate or supplier comes at an obvious cost, so there are trade-offs to consider.
The Importance of Credibility
Why is credibility so important? Because it is motivating.
Say you are an auto manufacturer. You want to install a new audio system in your next model—something impressive, something truly innovative. And you would like one of your suppliers to develop and produce the part for you.
How do you design the contract with your supplier so you actually get what you want? It’s a trickier problem than it sounds. After all, it is hard to include terms like “impressive” or “innovative” in a formal contract.
Furthermore, “if I wrote, ‘here’s exactly what it should look like,’ I’ve already designed the part for them and they have nothing to do,” says Barron. “I don’t just want them to check all the boxes and be done. I really want them to exert their best effort in this. Their best effort is, frequently, very tough to motivate with a formal contract.”
It is similarly hard to draw up a formal employment contract that specifies the care, effort, and ingenuity you want out of a top-notch employee.
So instead, firms dangle promises—implicitly or even explicitly: Lead a high-performing analytics team, and the next promotion is yours. Knock that audio system out of the park, and you will have our business for the next five years.
The key, however, is that these promises are informal. “There’s no court backing that up,” says Barron. This means that the promises are only effective motivators if they are viewed as credible.
Plenty of Trade-offs
To explore the importance of these credible promises to a firm, the researchers used game theory to model the firm’s contracts with its employees and suppliers. The contracts included formal terms, but they also included the promise that performance that went above and beyond these terms would be rewarded. With multiple contracts up for grabs over time, each party had the chance to reward or punish the other based on its previous actions. In the model, these rewards and punishments were monetary—but “in practice, they might take the form of good or bad terms in future contracts,” says Barron.
“If I’m a worker and I know that Dan is not going to promote me even if I do a good job because of someone else who would be a better fit for that position, then I’m not going to do a good job.” - Michael Powell
In the model, a firm’s credibility—and thus its ability to motivate excellent performance—comes from rewarding past successes, regardless of whether a given employer or supplier is the best choice for new work moving forward.
“If I’m a worker and I know that Dan is not going to promote me even if I do a good job because of someone else who would be a better fit for that position, then I’m not going to do a good job,” says Powell.
But the reality is that it isn’t always possible—or wise—to keep every informal promise that good work will be rewarded. After all, sometimes the costs of assigning work to the wrong party are just too high.
And there are rarely enough rewards to go around. “If I allocate more capital to one division, it might be harder to allocate capital to another division,” says Powell. “Or if I promote one worker and I only have one slot, that means I’m not promoting another worker.”
“We need to balance out who really needs the credibility,” says Barron. “Which relationship needs the credibility at each moment in time?” It is precisely this balance that the model was designed to identify.
So when is the benefit of motivating someone today bigger than the cost of demotivating someone else, as well as the cost of passing over the best person for the task? “That is the key trade-off,” says Powell.
Their model suggests that rewarding past excellence is most beneficial when an employee or supplier has truly excelled previously, while competing parties have not, and when the costs of favoring the party that has previously excelled are relatively low. These conditions are likeliest to motivate future excellence from the winning employee or supplier, while being least demotivating for the losing ones.
Takeaways for Firms
The broader takeaway, says Barron, is that there are some situations where the benefits of rewarding past performance are so strong that they can overcome the benefits of actually giving the job to the right person. “That is where you promote the wrong guy,” says Barron.
“Doing something that looks like it might not be efficient today may actually help to cultivate long-term relationships.” - Daniel Powell
His advice for firms: “If you’re going to do the best thing going forward, understand what implicit promises you may be breaking and how that’s going to affect people’s incentives going forward. Are people no longer going to trust you in the future because you promised to promote Mike, and now it seems best to promote someone else?”
In the late 1980s and early 1990s, U.S. manufacturers generally held open auctions, where suppliers bid on each contract without the expectation that strong performance on one contract would give them an edge in future bids. Japanese manufacturers, on the other hand, were able to motivate their suppliers to go above and beyond the terms of their contracts by restricting themselves to a fairly small set of long-term suppliers. “They did so in a way that was history dependent,” says Barron. “That is, over time, a supplier could break into this closed supply chain—if they performed well.”
Ultimately, this arrangement allowed the Japanese manufacturers to procure better work from their suppliers than the US manufacturers, and at lower costs, he says. “Doing something that looks like it might not be efficient today may actually help to cultivate long-term relationships—started in the past—going forward, and therefore actually be more efficient.”
Jessica Love is editor in chief of Kellogg Insight.
Barron, Daniel and Michael Powell (2017). Policies in Relational Contracts. Working Paper.
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