27 Jun 2005  Research & Ideas

The Potential Downside of Win-Win

You and your negotiating partner may reach a wonderful agreement for both parties, but have you forgotten people who aren't at the bargaining table, such as your consumers? HBS Professor Max H. Bazerman reflects in this article from Negotiation.

 

Consider this real-world social negotiation. On a Friday night, a husband and wife are trying to decide where to eat and which movie to see. Al prefers restaurant A, and Marie prefers restaurant C. Marie prefers movie D, and Al prefers movie F. They consider compromising on restaurant B, their shared second-choice dinner option, and movie E, their shared second-choice movie option. But these two professionals, both trained in value-creation negotiation, realize that Al cares much more about where they eat dinner, while Marie cares more about which movie they see. Accordingly, they go to restaurant A and movie D and have a wonderful evening. Both enjoy the activity they care more about, making both happier than they would have been if they compromised. On the societal level, while one restaurant won and others lost, and one movie studio won and others lost, the couple's choices had little effect on the restaurant or movie industry. Their contentment left society slightly better off.

It is generally wonderful when parties are able to trade off interests to create value. In fact, one of the most important contributions of the field of negotiation over the last twenty-five years has been to teach students and executives strategies for creating value, or integration. Many negotiation scholars and teachers go one step further, arguing that value creation has a positive impact on society in general. After all, if we can show the world how to make two plus two equal five, we'll all be better off, right?

This is often the case—but not always. Before concluding that value creation in negotiation always benefits society, we must look at how outcomes affect those outside the negotiation. Have you considered the impact of your agreement on your and the other firm's suppliers, customers, and competitors? Perhaps most important, have you considered the impact of your agreement on society in general? A consideration of how those not at the table are affected by your decisions can help you clarify whether the value you've created benefits or harms society as a whole—an important consideration for all managers.

Value creation—and collusion

Suppose that pharmaceutical firm A manufactures a new, beneficial drug and begins selling 100 million pills per year at $3.05 per pill. Each pill costs 5 cents to manufacture, so A is earning $300 million per year. Meanwhile, pharmaceutical firm B creates a drug that treats the same ailment and prepares to bring the drug to market. According to best estimates, this new competition will reduce the price of A's product to $2.55 per pill. B would pick up 40 percent of the market by charging an even lower price of $2.05 per pill. After each firm pays 5 cents per pill, A will sell 60 million pills annually for $150 million, and B will sell 40 million pills annually for $80 million.

But A has another idea and approaches B with a value-creating proposition: What if A paid B $100 million annually to stay out of the market? B would be better off, since $100 million is more than $80 million. A would also do better, since overall earnings of $200 million would exceed $150 million.

Who would be worse off under this proposition? The consumer, who must continue to pay $3.05 per pill, rather than the amount paid if B brought its product to market, $2.05 to $2.55 per pill. Because such agreements restrain competition, the U.S. Federal Trade Commission (FTC) and similar entities in other countries treat them as illegal. If allowed, A and B would be able to collude to create value at the expense of the consumer.

Parasitic integration in the real world

James Gillespie, of the Illinois Institute of Technology's Chicago-Kent College of Law, and I coined the term parasitic integration to describe instances in which the value created by negotiators is taken from parties who are not at the bargaining table. Such arrangements are parasitic because the benefits achieved by negotiators come at the expense of others. Let's look at a pharmaceutical case where, in my opinion, parasitic integration occurred.

Before concluding that value creation in negotiation always benefits society, we must look at how outcomes affect those outside the negotiation.

In April 2001, the FTC filed a complaint accusing pharmaceutical companies Schering-Plough and Upsher-Smith of restricting trade. Upsher-Smith had been preparing to introduce a generic pharmaceutical product that would threaten a near monopoly held by Schering-Plough. Schering-Plough filed a lawsuit accusing Upsher-Smith of violating Schering-Plough's patent. The companies reached an out-of-court settlement in which Upsher-Smith agreed to delay its entry into the market, and Schering-Plough agreed to pay Upsher-Smith $60 million for five unrelated products.

In its lawsuit, the FTC argued that the $60 million payment was not intended for the five products, but rather to keep Upsher-Smith's generic product out of the market. In court, the firms' lawyers argued that the value created by the deal was beneficial to society. The administrative law judge ruled in favor of the firms and against the FTC, arguing primarily that the FTC had not produced evidence connecting the market delay to the $60 million payment.

As an expert witness for the FTC in this case, I was quite disappointed by the outcome. It seemed that the judge required the FTC to produce hard evidence demonstrating the intent to collude. My opinion was that parasitic integration had occurred: The companies made a veiled attempt to skirt the law and create value for themselves, with no apparent concern for the harmful effects of their actions on consumers and, more broadly, society. Fortunately, from my perspective, the FTC commissioners overruled the judge, arguing that the competing firms would not have reached the two agreements independently. The FTC ruling treated the agreement as an attempt to parasitically create value at the expense of consumers.

When is parasitic integration likely?

Parasitic integration often occurs when only two or three firms exist in a small industry. In many of the negotiation simulations used in value-creation training seminars, students represent firms belonging to a small market. Through several rounds, each firm must decide whether to charge a high or low price. If firm F charges a high price and firm G charges a low price, G will pick up market share; the low-price firm wins at the expense of the high-price firm. But the parties would be better off if they both charged high prices rather than low prices. Such negotiations are based on the well-known prisoner's dilemma problem.

Parasitic integration often occurs when only two or three firms exist in a small industry.

When students participating in these exercises figure out how to develop a pattern of mutually high prices, negotiation instructors often praise them for their successful value creation. What's often overlooked is the fact that such value creation also creates losers—the customers forced to pay the resulting industrywide high prices.

Of course, companies are entitled to charge higher prices through legal coordination. Yet when negotiating, parties should consider whether they are creating societal value in the process or simply helping each other extract as much money as possible from the customer base.

Avoiding parasitic integration

The term parasitic integration is not intended to insult most value-creating agreements. In fact, in many cases, value creation should be allowed even when it will impose costs on parties who are away from the table. The U.S. pharmaceutical industry is one of the great success stories of the past century. If pharmaceutical firms hadn't achieved healthy profits, many of the wonder drugs that save lives, reduce the need for surgery, and relieve pain would not exist today. But any analysis that considers the profits of coordinating pharmaceutical firms while ignoring the harm done to consumers is incomplete.

When can we judge value creation to be beneficial to society? One standard would be to call value creation socially beneficial when the value created for the parties at the table exceeds the costs imposed on outsiders. While some of the value created may result from parasitic integration at the expense of others, the overall result is a net increase in value to society.

How can you make this assessment in your negotiations? I recommend that you ask yourself the following sets of questions: (1) Other than the negotiating parties, who is affected by the agreement? (2) How is each of these parties affected? What is the magnitude of these effects? (3) Do I care about these parties? Should I? (4) How does the impact of the agreement on parties not at the table compare with the impact on the negotiating parties?

Training negotiators to create value remains an important component of managerial education. Here, I've attempted to broaden the typical analysis to include those who are not party to a negotiation. I encourage readers to devote more time to finding the right products for their customers, creating the right bundle of goods and services, and developing innovations that improve the world, while perhaps spending less time figuring out how to transfer value among a small number of groups.

Special Interest Parasites?

by Max H. Bazerman

One particularly alarming, yet legal, ongoing case of value creation at the expense of society in the United States is the influence of special-interest groups on elections and government. Special-interest groups, including corporations and nonprofit organizations, contribute large sums of money to political campaigns. In return, politicians provide these groups with privileged access to the federal government and, potentially, with influence over policy. The arrangement benefits politicians, who must keep their campaign coffers full to remain competitive. And the growing market demand for influence suggests that most special-interest groups believe they are receiving a fine return on their investment.

This is a nice integrative agreement—unless you happen to be a citizen who would like elected officials to implement wise policy for everyone, rather than for small, privileged groups. In my February 2005 column, I described how the global fishing crisis and the failure to achieve auditor independence in the United States could be viewed as flawed attempts at compromise. Such failures also can be viewed as a type of parasitic integration that remains an unfortunate part of our political system.

About the author

Max H. Bazerman is the Jesse Isidor Straus Professor of Business Administration at Harvard Business School. In addition to this role, he has formally been affiliated with the Kennedy School of Government, the Harvard Psychology Department, the Center for Basic Research in the Social Sciences, the Harvard University Center on the Environment, and the Program on Negotiation.

Reprinted by permission from "Creating Values, Weighing Values" Negotiation, Vol. 8, No. 4, April 2005.

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