Application of the Prisoners Dilemma: 3rd Party Contracts

Today I brainstormed a method to apply Prisoner’s Dilemma to 3rd Party Contracts.  For those who are not familiar with the Prisoner’s Dilemma, I recommend reading the book entitled “Prisoner’s Dilemma” by William Poundstone”.  The Prisoner’s Dilemma is defined as follows:

A paradox in decision analysis in which two individuals acting in their own best interest pursue a course of action that does not result in the ideal outcome. The typical prisoner’s dilemma is set up in such a way that both parties choose to protect themselves at the expense of the other participant. As a result of following a purely logical thought process to help oneself, both participants find themselves in a worse state than if they had cooperated with each other in the decision-making process. – Investopedia

Two suspects are arrested by the police. The police have insufficient evidence for a conviction, and, having separated the prisoners, visit each of them to offer the same deal. If one testifies for the prosecution against the other (defects) and the other remains silent (cooperates), the defector goes free and the silent accomplice receives the full one-year sentence. If both remain silent, both prisoners are sentenced to only one month in jail for a minor charge. If each betrays the other, each receives a three-month sentence. Each prisoner must choose to betray the other or to remain silent. Each one is assured that the other would not know about the betrayal before the end of the investigation. How should the prisoners act? –Wikipedia

Similar to the Prisoner’s Dilemma, within 3rd party contracts, the optimal outcome for both parties is to mutually cooperate.  This outcome when applied ensures a healthy business relationship through operating efficiency, mutual profitability, effective communication, and shared outcome.  Unfortunately, much like the Prisoners Dilemma, mutual cooperation is least like to occur naturally, specifically when evaluated over many iterations.  In the context of contracting, defection amongst each party is probably the most natural outcome, and will result in conflicts, disputes, service reductions, scope changes, employee turnover, errors, etc.

Below I have outlined the Prisoners Dilemma assumptions and scenarios in the context of 3rd party contracting and recommended several considerations that firms can apply to optimize iterative outcomes.

Assumptions:

  • Contractors and customers want to maximize their own benefits
  • Singular defection between the contractor and costumer produces the most severe penalty for the cooperative party
  • Mutual defection between the contractor and customer produces the most severe outcome for both parties
  • Cooperation produces mutual benefit

Scenarios:

Cooperate / Cooperate: 3rd party relationships are often most effective when both parties cooperate.  Cooperation can be defined by the contractor and customers mutual collaboration in service delivery, planning, and conflict resolution.  Each party has a mutual understanding for the needs of the other, including their demands for profitability, quality of service, knowledge development, and talent retention.  This outcome is often difficult to accomplish with 3rd party contracts because it requires a level of transparency which most firms are likely to be wary of, particularly in the context of divulging too much information critical to the livelihood and long term strategy of each firm.  A contractor who cooperates, adapts to the client needs, is proactive about identifying areas of improvement, yields a healthy profit to achieve the objectives of the firm, and still satisfies the expansive needs of the client.  A client who cooperates, proactively works to resolve issues internally to alleviate conflicts, yields the appropriate value for the services delivered, and continuously works to build a longstanding and healthy relationship.  The contracts in a cooperative vehicle are the guidelines for engagement and not the rules.  This scenario is also the least likely to occur because self interest and changing business needs may require one party to temporary sabotage the cooperative benefits.  On an iterative basis, once defection has been implemented by one party, it is difficult to return to mutual cooperation.  Well structured 3rd party contracts can help to alleviate the probability of defection; however, cooperation is never guaranteed.

Defect / Cooperate:  This scenario represents the most likely scenario to occur amongst 3rd party contractors and customers.  Within complex business relationships, each party from time to time will exercise their right to pursue their own self interest, resulting in a scenario that is not necessarily favorable for their counterpart.  In 3rd party contracting, defection / cooperation may be marked by reductions in service, commitment, resources and an increase in escalation, exception, and dispute.  Unlike the defect / defect scenario, which produces a disruptive stalemate, the defect / cooperate scenario generally represents a give and take relationship that occurs between 3rd parties and their customers.  When a self interest becomes a critical issue, either the customer or 3rd party will exert their defection position to satisfy that need.  In general, 3rd party contracts should be structured to provide a framework for managing defection.  Well written contracts and documented processes by nature produce relationships in equilibrium.  Equilibrium scenarios produce an outcome, whereby, the customer defects in one iteration and contractors defect in the following iteration.  Defection / cooperation does not have to occur on a sequential process; however, over time the defection / cooperation procedures should converge at a natural balance point (ideal would be 50/50).

Defect / Defect: Mutual defection outcomes are the most destructive to the customer and 3rd party contractor on an iterative business.  This scenario can be identified by legal ramifications, constant disputes, high employee turn over, irreparable relationships, unacceptable service quality, financial penalties, or breach of contract.  Mutual defection is the least desired outcome and is most likely the result of a contract that either provides way to much rigidity that the 3rd party cannot deliver on their expectations or the customer cannot accommodate expansion in their business portfolio.  Defection can also be defined by limited capabilities, capacity, or poor financial performance, which results in each party sabotaging the performance of the other.  Mutual defection would most likely result in contract termination or renegotiation and is often a direct result of poor or ineffective contracting procedure.

Strategy:

  1. Understand your contractors likelihood to defect (retaliatory or instinctive)
  2. Understand your own likelihood to defect (retaliatory or instinctive)
  3. Establish minimum requirements to align with desired outcome
  4. Identify and define cooperative processes and benefits with 3rd parties
  5. Create 3rd party contracts that reward cooperation and penalize defection

Follow-up Questions:

  • What are a few examples of cooperation amongst customers and 3rd party contractors?
  • What are a few examples of defection amongst customers and 3rd party contractors?
  • How do I evaluate the likelihood of defection or cooperation amongst contracting parties?
  • How do I create cooperation amongst defect / defect iterative loops?
  • Can defect / defect relationships be managed back to a more manageable scenario?

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