We have recently seen a number of big corporate frauds and stock market scandals. The question arises: is it just the case of a few bad apples or is it a deeper systemic problem? The answer, we've found, lies in conflicts of interest. What happens when you put good people in situations that create conflict? They usually succumb to temptation. You see it in everybody, be it politicians or businessmen. So, how do we understand these influences in order to prevent them?
In our experiments, we find that a lot of people cheat by just a little bit. In standard economics, cheating is supposedly a straight cost-benefit analysis. People look at the odds of getting caught and the associated punishment, and then cheat when it makes sense to do so. However, in our experiments we find that people do not act strictly according to this model; they cheat only to the extent that they can continue to feel good about themselves and rationalise their actions. You can call it a Personal Fudge Factor, a limit up to which human beings comfortably cheat without feeling bad about it.
There are ways this Fudge Factor can expand or compress. It compresses (and people cheat less) when you remind them about their commitment to honesty or ask them to recite the Ten Commandments. The Fudge Factor expands under other conditions. If people see others cheating, they grow more comfortable doing the same. If people are not cheating in cash, but in intangible things like stock options, then they tend to cheat more. Still, even in these cases where we see more cheating, we see a lot of people cheating to a limited degree.
Now, consider situations where conflicts of interest facilitate or even promote dishonest behaviors. Take the case of a doctor or a banker and assume that Approach A would benefit his client and Approach B would benefit himself. Does the doctor/banker see things in a way that is better for his client, or do his choices reflect his own best interests? Because most of us look at things to favour ourselves, he will probably (unwittingly, even), be able to shade reality just by a bit, see it from a more comfortable perspective, and as a consequence cheat by a little bit and go for the option more suitable with his selfish interests.
If you look at the entire economy of cheating, blue-collar crime is insignificant — it is morally upsetting, but negligible financially. On the other hand, the cost of cheating by “good people” is enormous because they cheat continuously, just a little at a time, but because this is done by a lot of people and a lot of times, it accumulates rather quickly. We performed experiments of this type on about 15,000 people. Of this, only 10 people cheated a lot and the cost of their cheating was about $100 (akin to our blue collar bandits). But about 10,000 people cheated a little bit, costing us more than $20,000! As you can see, the difference is impressive, and I suspect that it reflects on the ratio of the cost of blue and white-collar crime to society.
There are two main points here. First, conflicts of interest are real, deep-seated and very hard to overcome. Moreover, it is not that clear to people when they have conflicts of interest, and as a consequence it is unlikely that politicians or bankers will see the influence of these forces on their decisions. These challenges might be even more pronounced in a developing country like India where the rules are not always that clear and conflicts of interest proliferate.
Second, there is a significant financial toll attributed to these conflicts of interest. But, because they are not visible or outlandish (like a robbery), they lack the same sense of depravity or emotional response, and we often fail to try and control them. This is where we need to correct our approach. We need to remember the accumulation of a lot of people cheating a little bit and start thinking of ways to eliminate the conflicts of interest that push people to cheat.
But is it possible to completely eliminate these conflicts of interest? Most likely not. Still, we can do our best to try. What should we do? What we need to do is understand where the conflicts of interest are coming from and avoid those sticky situations from the start. Simply changing penalties and punishments, or picking a new more complex way to pay executives is unlikely to work and what we need to understand is that if we were faced with the same conflicts of interests we too would behave the same way — and this is why we can't put people in situations of conflicts of interests and expect them to ignore their incentives — we must try to eliminate conflicts of interests as much as we can.
Dan Ariely is the best-selling author of The Upside of Irrationality: The Unexpected Benefits of Defying Logic at Work and at Home and Predictably Irrational, Revised and Expanded Edition: The Hidden Forces That Shape Our Decisions.