7.5 Value profile: trust  (Page 4/5)

Prisoner's dilemma

Imagine that two patriotic spies, A and B, have just been captured by the enemy. Both are placed in separate interrogation cells and are being pressured to confess and provide details about their spying activities. A and B would like to coordinate their actions but the enemy has kept them apart to prevent this. In their malevolence they wish to pit A against B in order to get the desired information. To do this, they have set forth the following systems of motivations, i.e., punishments and rewards.

Options

1. If both A and B confess then A and B are put in jail for five years each. The net loss in this scenario is 10. This is the least desirable alternative from the collective standpoint.
2. If one (A or B) confesses while the other does not, the confessor is released immediately while the non-confessor gets seven years in prison. This is the self-interest maximizing option for the confessor and the worst possible option for the non-confessing prisoner. Loss for confessor: 0. Loss for non-confessor: 7. Net loss: 7
3. If both do not confess then after six months of half-hearted interrogation (most of this time is for processing the prisoners' release), both are set free for lack of evidence. While not maximizing self-interest (this lies in one confessing while the other remains silent) this does maximize overall welfare by producing a net loss of only 1.

The Prisoner's Dilemma is designed to model the reality of corporate governance where the directors/owners of a corporation delegate responsibility for the corporation's operations to managers who are charged with pursuing, not their own interests, but those of their directors. The problem of corporate governance is how to institutionalize this cooperative arrangement. Can managers be left alone and trusted to pursue the best interests of the corporation? This is the position of stewardship theory. Or is it necessary to design a system of external controls and incentives (mostly punishments but some financial rewards) to keep the managers from diverting the operations of the corporation toward their exclusive, self-interests?

The latter approach is taken by agency theory. Here human nature precludes that managers will carry out the interests of directors unless externally motivated to do so. Naturally inclined to maximize self-interest, managers must be forced in the direction of director and owner interest through external incentives such as punishments and rewards (formulated in terms of incentives for producing results of value to the corporation as a whole).