US-China Variation of Prisoners Dilemma – The Factory Game.

Most business school students are familiar with the game theory exercise of ‘Prisoners Dilemma’. It’s a relatively simple game that looks at the economic utility of cooperating with a partner versus competing. Actors can either cooperate for a moderate gain, or attempt to cheat/compete for a higher payout that victimizes the trusting counter-party. Another risk is that if both sides cheat then they both suffer a loss.

Experienced dealmakers will spot a flaw in the design of this experiment. First of all it is a one-off with no future. Second, it is blind with no history. I designed a variation of this experiment for my undergrad negotiating class at NYU’s Shanghai campus. I call it the Factory Game. The two actors are Brand (from the US) and Manufacturer (China). Brand (B) approaches Manufacturer (M) with a unique product and contracts for a specific factory run – with price, quality and IP protection all stipulated in the agreement.

If all goes well (i.e.: cooperation, Win-Win) B receives quality merchandise at a fair price. M receives a fair payment, technological know-how and future orders. But either side may ‘cheat’ (i.e.: competitive Win-Lose behavior). B can cheat by failing to pay in full or by going to another factory with future orders. M cheats by failing to deliver, poor quality production or theft of IP.

To make it more realistic, I set up the game as 3 iterations (or ‘contracts’) of 3 trials each (to simulate repeat business).

In Iteration A the value of the contract was level each time – say 1,000. This was the baseline case, and represented a deal with an unknown partner.

In Iteration B the contract value rose each time – 1,000, 2,000, 4,000. This case represented a growing market or a ‘key-partner’ relationship.

Iteration C had a falling value – 1,000, 500, 250. It was intended to model a saturated market – or a declining relationship.

Payouts were set as a % of the contract value.

W-W yielded a 50 : 50 payout.
W-L => +75 : -25
L-W => -25 : +75
L-L => -10: -10

My pre-experiment assumptions: Actors would quickly see that it was in their best interests to stay ‘honest’ and cooperative as expected outcomes rose, but resort to cheating Win-Lose behavior as returns fell – or when a ‘contract’ was about to expire.

What really happened? — The participants fell victim to their own emotions and ego positions instead of coldly calculating their firm’s interests. Many participants based their decisions not on FUTURE payout possibility, but rather on PAST counter-party behavior. If A cheated last time, then B was gong to cheat this time – regardless of outcome.

One set of teams had the following outcome:
Trial one: Win-Lose when the payout was stable – as one actor attempted to score a short-term win.
Trial two: Lose-Lose – as distrust from trial one completely negated the possibility of maximum gains.
Trial three: Win-Win. Both sides realized that their barn-burning was counter-productive and anti-competitive (vis a vis other student groups!). Unfortunately, the Win-Win behavior only came into play AFTER the market had peaked and the best returns were behind them.

At first it sounds like they were just inexperienced and emotional – after all, the participants are undergrads with limited business history. But we see the same behavior all the time from so-called professional negotiators. What lessons can US negotiators in China draw from this exercise?

    1 – Set the stage for trust, or you will poison the potential relationship from the start.
    Test orders are an American concept while systematically building relationships is Chinese. Americans assume that the relationship will grow from successful transactions. Chinese assume that successful transactions will grow from relationships. The result is that Americans tend to under-promise (“we’ll have to see how well you do on the first order before we discuss raising the volume”) while the Chinese over-promise (“oh yeah, we can definitely do what you want at the right price and quality level” – even if they don’t know what they are doing – yet). Both behaviors tend to undermine trust in the early stages of a US-China business relationship.

    2 – Penalties and missed bonuses are often interpreted by Chinese actors as ‘cheating’ behavior – and a betrayal of trust.
    Americans often employ the ‘carrot and stick’ technique of using potential bonus payments and penalties to enforce positive behavior. Unfortunately, Chinese counter-parties often view this as dishonest and manipulative. It is human nature to count the bonus and ignore the penalty during the pre-execution phase of the deal. Once trust is lost, it is very difficult to restore. A missed bonus – regardless of how justified the American side feels it to be – often triggers negative behavior from the Chinese side.

    3 – Guanxi-building activities like dinners, tours and meetings are the Chinese method of vetting partners.
    You should be doing the same. Use your banquet time to talk about how you and your counter-party define success. What are your goals? How can you work together? American negotiators are often shocked at how much time the Chinese waste on relationship building. Chinese negotiators are equally shocked at how much opportunity the Americans waste by not building proper relationships.

    4 – Overly picky contract terms tend to be counterproductive.
    Your corporate lawyer thinks you can write-out the risk of overseas deals, but in China this can be counter-productive. Detailed contracts with penalties and financial stipulations can make the Chinese side feel that you are not a suitable long term partner. Contract terms that seem normal in the US can trigger the “cheat” switch in China — since they think you are already pulling fancy tricks.

    5 – Relationships are not organic in China.
    Americans tend to feel that close relationships are the product of positive experience and time. Chinese negotiators are a bit more transactional, and expect partners to ‘work at the relationship’ in the early stages. Don’t blow an opportunity by paying lip-service to your Chinese counter-party. When they say, “we want to have a good relationship” it isn’t necessarily a pro-form business platitude. Use the opportunity to define slippery terms like ‘trust’, ‘success’ and ‘long-term’. Assumptions can be lethal in a cross-cultural negotiation.

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