Monday, May 19, 2008

Where to draw the line?

It is the nature of boundaries to create incentive differentials. Entities are generally designed to maximize their own utility without regard for the utility of others so there is one set of incentives for what lies inside of an entity's border and another for what lies outside. Furthermore, there are an infinite number of boundaries we can draw, as matter can be broken down into forever smaller particles on the one end, and as individuals and groups of individuals can choose to create larger or simply different aggregations of people on the other. Not all of those boundaries are salient to all decisions or considerations. One must, therefore, choose boundaries with extreme foresight and caution.

[Notes: There is a wealth of debate on what, precisely, individual humans seek to maximize. I mentioned utility not in the technical sense but as an exemplar of a broader category of potential primary objectives that drive human behavior. I don't take a stong position here on what that objective is. Rather, I am concerned with the impact on objective-maximizing behavior (whatever that objective may be) of decisions regarding which boundaries to attend to. Also, I recognize that sometimes people engage in behavior that appears to place a higher value on the utility of others. I would simply argue that this can always be explained either by a perception they have that their long-term utility is better served by minimizing their short-term utility or by their focus on a boundary other than their skin.]

My skin creates a boundary between me and every other organism (and any other entity) which - if I accept the saliency of that boundary - causes me to value my own survival, success and pleasure more than that of others.

Nations are set apart from other nations primarily through geographic boundaries. These boundaries create incentive differentials as nations are generally more inclined to protect and preserve that which falls within their boundaries more than that which falls without.

Corporations are set apart from other business entities by several parallel boundaries: between their employees and the employees of other companies, between their assets and the assets of others, between their intellectual property, brands, ideas and those of others... These boundaries creates incentive differentials. Companies seek to maximize their own value and generally do not concern themselves with the value that may accrue to other companies (insofar as their own value is independant of the value of others). Boundaries are also drawn within a corporate entity such as between functions, business units, teams and regions.

It is critically important to note that:

1) Boundaries are arbitrary. We draw them where we do as a matter of will. The question is not whether they are right or wrong, but whether they serve our purposes or not.
2) Boundary selection has very tangible implications on incentives and decision making.

When I say that boundaries are arbitrary, I do not mean that there is no reason for them to be placed where they are. I just mean that there is no law of nature that says they must be placed there, or, if there is, that there are many other boundaries that are equally sensible. Matter is fluid and continuous. The fact that we consider our self to stop at our skin and not include the air around us, the bike we are sitting on or the person we are embracing, is a decision. One that happens to be fairly conventional and normative, but still a decision. I recently read an article ( that talks about the difficulty in determining where to draw the line between our bodies and the thousands of bacteria species that colonize us (and perform often critical functions). Certainly national boundaries are arbitrary. Someone got there first. That's how it happened. But there's no reason it had to be that way. And business boundaries are the same. We buy and sell parts of each other wth regularity. And we all understand that these boundaries are easily changed.

The impact of boundary selection is also very clear. Within one's body, there are many examples. One could select a diet that might be optimal for weight management but suboptimal for cardiovascular health. Similarly, in the moral dimension, one could find a conflict between two deeply held principles and opt to pursue one at the expense of the other. But in both cases, the very need for a decision is predicated on the fact that there is a boundary drawn. Once a boundary is drawn, there is an incentive differential that often leads to the need to make a decision favoring what lies on one side of the boundary over what lies on the other.

In business, it is very much the same. When we choose to pay attention to certain boundaries, we typically find incentive misalignment that leads to suboptimal results for the entire company. This could be a product launch in business unit A which will compete with business unit B. Each business unit has an incentive to maximize its own performance. The shareholders have an incentive to maximize the return of the corporate entity. Who do you think wins? Or, function A can have an incentive to minimize product returns and function B can have an incentive to maximize revenue. Who wins? Is the company better off?

In all of these cases, the selection of which boundaries to consider "real" is critically important. We are not forced by nature to pay attention to the boundary between Marketing and Finance. We don't even have to have separate departments. That's a choice we make. And when we do, we create an incentive differential that has to be managed.

So make sure you: 1) know which boundaries are the salient ones for your organization 2) determine the impact of those decisions and 3) figure out whether you'd be better off erasing some boundaries and/or adding others.

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