THE EIGHTFOLD PATH TO CREDIBILITY

In most situations, mere verbal promises should not be trusted. As Sam Goldwyn put it, “A verbal contract isn’t worth the paper it’s written on.”² An incident in The Maltese Falcon by Dashiell Hammett, which became a movie classic with Humphrey Bogart as Sam Spade and Sydney Greenstreet as Gutman, further illustrates the point. Gutman gives Sam Spade an envelope containing ten thousand dollars.

Spade looked up smiling. He said mildly: “We were talking about more money than this.”

“Yes sir, we were,” Gutman agreed, “but we were talking then. This is actual money, genuine coin of the realm, sir. With a dollar of this you can buy more than with ten dollars of talk.”³

Indeed, this lesson can be traced all the way back to the eighteenth-century philosopher Thomas Hobbes: “The bonds of words are too weak to bridle men’s avarice.”⁴ Women’s too, as King Lear discovered. Words must be backed up by appropriate strategic actions if they are to have an effect on the other players’ beliefs and actions.*

We classify the actions that can enhance the credibility of your unconditional and conditional strategic moves and that can help you practice brinkmanship into eight categories, which are based on three broad principles. We will state them first and then illustrate each.

The first principle is to change the payoffs of the game. The idea is to make it in your interest to follow through on your commitment: turn a threat into a warning, a promise into an assurance. This can be done through two broad classes of tactics:

1. Write contracts to back up your resolve.

2. Establish and use a reputation.

Both these tactics make it more costly to break the commitment than to keep it.

A second avenue is to change the game by limiting your ability to back out of a commitment. In this category, we consider three possibilities:

3. Cut off communication.

4. Burn bridges behind you.

5. Leave the outcome beyond your control, or even to chance.

These two principles can be combined: the available actions and their payoffs can both be changed.

If a large commitment is broken down into many smaller ones, then the gain from breaking a little one may be more than offset by the loss of the remaining contract. Thus we have:

6. Move in small steps.

A third route is to use others to help you maintain commitment. A team may achieve credibility more easily than an individual. Or you may simply hire others to act in your behalf.

7. Develop credibility through teamwork.

8. Employ mandated agents.

We now proceed to illustrate the use of each of these devices. But remember, what we offer is only a basic guide to what is essentially an art.

Contracts

A straightforward way to make your commitment credible is to agree to pay a penalty if you fail to follow through. If your kitchen remodeler gets a large payment up front, he is tempted to slow down the work. But a contract that specifies payment linked to the progress of the work and penalty clauses for delay can make it in his interest to stick to the schedule. The contract is the device that makes the remodeler’s promise of completion credible.

Actually, it’s not quite that simple. Imagine that a dieting man offers to pay $500 to anyone who catches him eating fattening food. Every time the man thinks of a dessert, he knows that it just isn’t worth $500. Don’t dismiss this example as incredible; just such a contract was offered by a Mr. Nick Russo—except the amount was $25,000. According to the Wall Street Journal , “So, fed up with various weight-loss programs, Mr. Russo decided to take his problem to the public. In addition to going on a 1,000-calorie-a-day diet, he is offering a bounty—$25,000 to the charity of one’s choosing

—to anyone who spots him eating in a restaurant. He has peppered local eateries…with ‘wanted’

pictures of himself.”⁵

But this contract has a fatal flaw: there is no mechanism to prevent renegotiation. With visions of éclairs dancing in his head, Mr. Russo should point out that no one will ever actually get the $25,000 bounty because he will never violate the contract. Hence the contract is worthless to the enforcers.

Renegotiation would be in their mutual interest. For example, Mr. Russo might offer to buy a round of drinks in exchange for being released from the contract. The restaurant diners prefer a drink to nothing and let him out of the contract.* For the contracting approach to be successful, the party that enforces the action or collects the penalty must have some independent incentive to do so. In the dieting problem, Mr. Russo’s family might also want him to be skinnier and thus would not be tempted by a mere free drink.

The contracting approach is better suited to business dealings. A broken contract typically produces damages, so that the injured party is not willing to give up on the contract for naught. For example, a producer might demand a penalty from a supplier who fails to deliver. The producer is not indifferent about whether the supplier delivers or not. He would rather get his supply than receive the penalty sum. Renegotiating the contract is no longer a mutually attractive option. What happens if the supplier tries the dieter’s argument? Suppose he attempts to renegotiate on the grounds that the penalty is so large that the contract will always be honored and the producer will never receive the penalty. This is just what the producer wants, and hence he is not interested in renegotiation. The contract works because the producer is not solely interested in the penalty; he cares about the actions promised in the contract.

In some instances, the contract holder might lose his job if he allows the contract to be rewritten.

Thomas Schelling provides a remarkable example of how these ideas have been implemented.⁶ In Denver, one rehabilitation center treats wealthy cocaine addicts by having them write a self-incriminating letter that will be made public if they fail random urine analysis. After placing themselves voluntarily in this position, many people will try to buy their way out of the contract. But the person who holds the contract will lose his job if the contract is rewritten; the center will lose its reputation if it fails to fire employees who allow contracts to be rewritten.

The ABC Primetime program on dieting, which we described in chapter 1, had a similar feature.

According to the contract, any dieters who failed to lose the stipulated 15 pounds over two months would have their bikini photos displayed on Primetime and on the ABC web site. As it turned out, one woman failed narrowly but was forgiven by the program’s producers. She had lost 13 pounds, dropped two dress sizes, and looked great. What mattered was not whether ABC actually broadcast the photos but whether the dieters believed they would.

This act of kindness would seem to have destroyed ABC’s credibility to enforce such contracts in a follow-up program. Nonetheless, the show was repeated. The second time around, the dieters were

the administrative staff of Bridgeport’s minor league baseball team, the Bluefish. Since ABC could no longer be counted on to broadcast the pictures, this time the team agreed to display them on its jumbotron screen at a home game on the night of the weigh-in. Once again, most dieters succeeded, but one woman just missed the 15-pound goal. She asserted that it would cause her great psychological damage if the pictures went up. This implied the threat of a lawsuit, and so ABC and the team backed down. Now participants in any future rounds are unlikely to regard the device as credible, and Barry and ABC will have to think up something else.*

Most contracts specify that some third party will be in charge of enforcing it. A third party does not have any personal interest in whether the contract is upheld. Its incentive to enforce the contract comes from other sources.

Our colleagues Ian Ayres and Dean Karlan have started a company to offer just this sort of third-party contract enforcement. They call it the Commitment Store (www.stickK.com). If you want to lose weight, you can go online and sign up for how much you want to lose and what happens if you fail. For example, you can post a $250 bond that will go to a designated charity if you don’t reach your goal. (If you succeed, you get your money back.) There is also a pari-mutuel option. You and a friend can wager that you will each lose 15 pounds over the next two months. If you both succeed, the money is returned. But if one fails while the other succeeds, then the loser pays the winner. If you both fail, then the one who loses the most is the winner.

How can you trust the Commitment Store to keep its word? One reason is that they don’t have anything to gain. If you fail, the money goes to a charity, not them. Another reason is that they have a reputation to keep. If they are willing to renegotiate, then their service is of no value. And, were they to renegotiate, you might even be able to sue them for breach of contract.

This naturally leads us to the contract-enforcing institution that we know best: the court system.

Judges or juries don’t stand to gain anything directly whether one side or the other wins a civil case arising from a contract dispute (at least so long as the system is not corrupt). They are motivated to weigh the facts of the case in light of the laws and render an impartial verdict. For the jurors, this is mainly because their education and socialization have taught them to regard this as an important part of a citizen’s duties, but also for fear of punishment if they are found to have violated the oath they took when the jury was formed. The judges have their professional pride and ethic that motivates them to be careful and deliver correct verdicts. They have strong career reasons as well: if they make too many errors and are repeatedly overruled on appeal by higher courts, they will not be promoted.

In many countries, alas, the state’s courts are corrupt, slow, biased, or simply unreliable. In such situations, other nongovernmental contract-enforcement institutions emerge. Medieval Europe developed a code called Lex Mercatoria, or Merchant Law, for the enforcement of commercial contracts which was applied by private judges at trade fairs.⁷

If the government does not provide contract enforcement as a service to its citizens, someone might do so for a profit. Organized crime often fills the niches of enforcement left unfilled or vacated by formal law.* Diego Gambetta, a professor of sociology at Oxford, conducted a case study on the Sicilian Mafia’s role of providing protection to private economic activity, including enforcement of property rights and contracts. He quotes a cattle rancher he interviewed: “When the butcher comes to me to buy an animal, he knows that I want to cheat him [by giving him a low-quality animal]. But I know that he wants to cheat me [by reneging on payment]. Thus we need Peppe [that is, a third party]

to make us agree. And we both pay Peppe a percentage of the deal.”⁸ The reason why the rancher and the butcher could not use the formal Italian law was that they were doing informal deals to avoid taxes.

Gambetta’s Peppe enforces contracts among his customers using two methods. First, he acts as a store of information about the past behavior of traders in his territory. A trader becomes Peppe’s

customer by paying him a retainer. When considering a deal with a stranger, the customer asks Peppe what he knows about the trader’s past record. If this record is flawed, the customer can refuse the deal.

In this role, Peppe is like a credit-rating agency or a Better Business Bureau. Second, Peppe can mete out punishment, typically involving physical violence, to someone who cheats one of his customers.

Of course Peppe may collude with the other party to double-cross the customer; the only thing that keeps Peppe honest is concern for his long-run reputation.

Alternative institutions of enforcement, such as the Mafia, get their credibility by developing a reputation. They may also develop expertise, which enables them to evaluate evidence faster or more accurately than the court system can. These advantages can prevail even when the court system is reliable and fair, and the alternative tribunals coexist with the formal machinery of the law. Many industries have such arbitration panels to adjudicate disputes among their members and between their members and customers. Lisa Bernstein, a professor at the University of Chicago Law School, conducted a now famous study of the tribunal system used by New York diamond traders. She found that this system has some further advantages; it can impose severe sanctions on members who break contracts and then defy the panel’s judgment. The panel posts the name and photograph of the miscreant on the bulletin board at the Diamond Traders’ Club. This effectively drives the offender out of business. He also faces social ostracism because many of the traders are part of a tightly knit social and religious network.⁹

Thus we have numerous institutions and mechanisms for enforcing contracts. But none of them is proof against renegotiation. The matter comes to the attention and under the adjudication of a third party only when one of the two parties to the contract decides to bring it there. But if the two main parties to the contract have the temptation to renegotiate, they can do so at their joint will and the original contract will not be enforced.

Therefore, contracts alone cannot overcome the credibility problem. Success can be enhanced by using some additional tools for credibility, such as employing parties with independent interests in enforcement or having a sufficiently strong reputation at stake. In fact, if the reputation effect is strong enough, it may be unnecessary to formalize a contract. This is the sense of a person’s word being his bond.

A wonderful example of how a strong reputation can obviate the need for a contract comes from the Verdi opera Rigoletto. Gambetta quotes:

“Kill the hunchback?! What the devil do you mean?” snaps Sparafucile, opera’s prototype of the honorable hit man, at the suggestion that he might kill his client Rigoletto. “Am I a thief? Am I a bandit? What client of mine has ever been cheated? This man pays me and he buys my loyalty.”¹⁰

Sparafucile’s agreement with Rigoletto did not need to specify: “It is hereby agreed that the party of the first part shall not under any circumstances kill the party of the second part.”

Reputation

If you try a strategic move in a game and then back off, you may lose your reputation for credibility. In a once-in-a-lifetime situation, reputation may be unimportant and therefore of little commitment value. But you typically play several games with different rivals at the same time, or the

same rivals at different times. Future rivals will remember your past actions and may hear of your past actions in dealing with others. Therefore you have an incentive to establish a reputation, and this serves to make your future strategic moves credible.

Gambetta, in his study of the Sicilian Mafia, examines how its members can create and maintain a reputation for toughness to lend credibility to their threats. Which devices work, and which ones don’t? Wearing dark glasses won’t work. Anyone can do that; it does not serve to differentiate a truly tough person. A Sicilian accent won’t help; in Sicily almost everyone has a Sicilian accent, and even elsewhere it is just as likely to be an accident of birth as a mark of toughness. No, says Gambetta, the only thing that really works is a record of committing acts of toughness, including murder.

“Ultimately, the test consists of the ability to use violence both at the outset of one’s career and later, when an established reputation is under attack from authentic and bogus rivals alike.”¹¹ In most business contexts we merely talk of “cutthroat competition”; Mafiosi practice it!

Sometimes a public declaration of your resolve can work by putting your reputation on the line in a public way. During the tense period of the cold war in the early 1960s, President John F. Kennedy made several speeches to create and uphold just such a public reputation. The process began with his inaugural address: “Let every nation know, whether it wishes us well or ill, that we shall pay any price, bear any burden, meet any hardship, support any friend, oppose any foe, to assure the survival and the success of liberty.” During the Berlin crisis in 1961, he explained the importance of the U.S.

reputation in terms that illustrate the idea of strategic reputation: “If we do not meet our commitments to Berlin, where will we later stand? If we are not true to our word there, all that we have achieved in collective security, which relies on these words, will mean nothing.” And perhaps most famously during the Cuban missile crisis, he declared: “any nuclear missile launched from Cuba against any nation in the Western Hemisphere [would be regarded] as an attack on the United States, requiring a full retaliatory response against the Soviet Union.”¹²

However, if a public official makes such a declaration and then acts contrary to it, his reputation can suffer irreparable damage. In his campaign for the presidency in 1988, George H. W. Bush famously declared: “Read my lips: no new taxes.” But economic circumstances compelled him to raise taxes a year later, and this contributed importantly to his defeated bid for reelection in 1992.