Photo: AFP
Photo: AFP

Lessons from the Volkswagen emissions scandal

We may get away with cheating for some time because of our good reputation. But we will get caught and the repercussions can be terrible

September in the US proved to be an exciting month. The pope was here. It was his first visit to the US and it was also the first time any pontiff delivered an address to the joint session of the US Congress. And, of course, there was much talk about church and state.

Narendra Modi was also here, selling the Make in India—Digital India, that is—plan. So was Chinese President Xi Jinping, the leader of the other billion-plus-people country. He faced off with President Barack Obama on the protection of the environment and with presidential-hopeful, Hillary Clinton, on the protection of women. She called him “shameless" for talking about women’s rights while detaining five women in the past year on charges of dissent. The government-controlled Chinese media called her “arrogant".

Russian President Vladimir Putin and Obama promised to add to the fireworks display as they tried to strong-arm each other on Syria. Eyeball to eyeball, they tried to imagine that they were Nikita Khrushchev and John F. Kennedy, and that Syria of 2015 was Cuba of 1962. But the stand-off proved to be one of those deceptive Diwali firecrackers in which the wick burns fiercely and, as everybody waits with bated breath, the cracker fizzles out.

In the midst of this, the speaker of the House of Representatives John Boehner dramatically resigned (but will stay on till a successor is found) from Congress. Perhaps it was the influence of the pope’s visit to Congress.

The Volkswagen crisis

With all these stories sucking the oxygen out of the air, a significant story began to suffocate and splutter. This is the story of the world’s largest car manufacturer, Volkswagen, which began at last to live up to its name—the car of the common folk—and started to take the common folks for a ride. It was discovered that Volkswagen had been taking us for a ride for more than seven years.

The story is now well known—Volkswagen put into its diesel-model cars a piece of cheat software, which detected whenever an emissions test was being conducted and ran the engine to meet emission standards. In non-testing, usual run-on-the-road scenarios, Volkswagen cars ran amok on the roads spewing pollutants almost 10 times the limit.

There are several dimensions to this story. Are all other diesel car makers also cheating? What will be the repercussions on the environment, and on the company? How should Volkswagen make reparations? Then there is the David and Goliath story of how a small lab in West Virginia University—where a scientist of Indian origin, Arvind Thiruvengadam, emerged to be a central figure—first discovered the deliberate nature of Volkswagen’s emissions cheating, and pulled the loose string that unravelled the knit of the entire Volkswagen sweater.

People have drawn parallels to other companies and recalls—Toyota with its stuck accelerator problem, Johnson & Johnson with its Tylenol problem, Ford with the tyres on its Explorer SUV, Exxon and its Alaskan oil spill. It has also been pointed out that all these companies recovered their reputations and their businesses quite well, and today, the stains on these are hardly visible. The speculation is that perhaps Volkswagen will be able to do the same.

But the Volkswagen case is very different. While the other cases were the result of either an uncontrollable event (a maniac poisoning Tylenol capsules, or an unintended design flaw in Toyota or Ford) or an accident (a ship hitting a rock in the Exxon spill), in the case of Volkswagen, it is deliberate cheating. It is not mere accusation because the company has itself accepted its blame.

I want to dwell, however, on an aspect that has missed much attention—the connection between reputation and cheating. This has significant lessons for entrepreneurs and CEOs. There are two aspects to Volkswagen’s cheating—or for that matter, any company’s cheating. First, there is, as Gurcharan Das has termed it, “The difficulty of being good."

And then, there is the ease of being a cheat. Entrepreneurs can find themselves in either, or, like Volkswagen, in both of these situations. What they do and do not do can make the difference between short-term success and long-term failure on the one hand, and short-term setback and long-term success on the other.

The difficulty of being good

An argument can be made from Volkswagen’s perspective that the emission standards in America, especially in California, made it difficult for the company to even get a diesel car to run on the road, leave alone make profits off it.

This was not a sudden imposition, however. More than 15 years ago, the Environmental Protection Agency established tougher standards for diesel cars. Manufacturers were given a year to comply and between 2004 and 2007, the standards began to be applied in increasing measure. In particular the NOx (nitrogen oxide) and soot regulations were difficult for diesel engines to comply with.

The engineering hurdles were difficult—manufacturers had to comply with tough diesel engine emission standards and, at the same time, they had to provide high performance, fuel-efficient cars. In fact, for a while, Volkswagen and other diesel-engine car makers withdrew from the US market. But the US market is very attractive—second only after China. Although the US only accounted for 6% of its sales (compared with Europe and Russia, which provided 40% of sales), the American market was important from a long-term strategy perspective.

In 2007, after a gap of three years, Volkswagen re-entered the US market with a new clean-diesel model of the popular Jetta. The design was considered an environmental show-stopper—at the Los Angeles Auto Show it became the Green Car of the Year.

It now turns out that Volkswagen, caught between the emission standards and the lucrative market, found it difficult to be good. As experts opined in a Washington Post article, “The temptation to game the system with a defeat device is definitely high because of the technical challenges." So Volkswagen chose to be not good.

The ease of being a cheat

In 1988, two Wharton professors, Franklin Allen and Gerald Faulhaber, published a paper in which they set up an analytical model to answer the central question: what is the impact of a company’s reputation on its actions? In other words, if its customers think the company is outstandingly good, would a company be actually good?

Allen and Faulhaber found an interesting connection between reputation and the company’s success. They set up three scenarios: customers were extremely doubtful about the quality of the company’s products, customers were healthily sceptical (that is, they were willing to believe that the company’s products could be of good quality, but wanted to verify it), and the customers were sold on the idea that the company could only produce high-quality products (there was no need to verify the quality).

If customers were overly sceptical about the quality of the company’s products or services, then Allen and Faulhaber found that it would not be able to sell much in the market, and as a result the company would not be competitive. Not a big surprise—bad reputation leads to lack of sales. In such a situation, the company will want to exit the market, even if its products and services are actually of good quality.

If customers are somewhat circumspect about a company’s reputation, they subject each of its product or service to critical evaluation. The company knows that in such a setting, its ability to thrive in the market depends on the quality of the products and services it takes to the market. So, it becomes more conscious of how it produces, in particular, and what it does, in general.

The third situation—and the one most applicable to Volkswagen—is when the company has an outstanding reputation. Customers believe its production practices are unparalleled, its innovativeness is top-rung, and above all, the quality of its products is unquestionable.

This was the kind of reputation that Volkswagen had built over decades—top-notch German engineering, an innovation capability that allowed it to meet the stringent California emission standards and reliable cars that provided high fuel efficiency.

It is in such situations, Allen and Faulhaber found, that the company is most incentivized to cheat. Good reputation makes it easy to be a cheat.

The lesson for us is twofold: As customers, are we gullible as we consume products and services? As Allen and Faulhaber concluded, “Scepticism, it seems, is most valuable in moderation: not too little, not too much, but just enough!"

But as entrepreneurs, too, we are forced to ask whether we are using our own excellent backgrounds, and the growing reputations of our companies to cheat our customers, to take shortcuts every now and then. Volkswagen has brought to entrepreneurs an important lesson about the long term—something that Allen and Faulhaber’s model does not explore.

What Allen and Faulhaber set up was a two-period model—one period before purchase (production), and the second after purchase (sales). The company can cheat because the customer does not know what the company did in the production stage. But what happens in the long run? What happens if the game is repeated?

The Stanford Marshmallow experiment is easily forgotten in the rough and tumble of business—kids who preferred to wait for 15 minutes to receive two marshmallows did far better in life as compared with kids who took a marshmallow from the jar immediately after the experimenter left. (Interestingly, the Stanford experiment has its roots in an earlier experiment conducted in Trinidad, where it was found that children of East Indian origin preferred to wait for a week to get a 10 cent candy while African-origin children preferred a 1 cent candy immediately.)

What the Volkswagen saga is telling us if we think beyond the short term and consider the problem more strategically is this: We may be able to get away with cheating for some time because of the reputation we have built for ourselves. But we will get caught if we do it again and again. And, when we do get caught, the repercussions can be terrible—Volkswagen’s financial viability has become a point of debate, and many Germans now feel their national reputation is itself at stake. Unlike Toyota, or Ford, or Johnson & Johnson, Volkswagen has a long battle on its hands, and how it emerges from this is a big question mark.

The bottom line lesson for successful entrepreneurship: A good entrepreneur should be good despite the difficulty of being good, and resist temptation despite the ease to be a cheat. It is just a successful strategy in the long run.

Baba Prasad, president and CEO of Vivékin Group, is a thinker in the area of management strategy and innovation.

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