Incentives matter

There are few forces more powerful than incentives. Incentives drive thinking and behavior. To understand someone’s thinking, you must understand their incentives. When you encounter a behavior problem, trace the incentives and you’ll often find the root cause.

An incentive is anything that motivates an individual to behave in a specific way. The basic rule of incentives is that you get what you reward for. Dumb incentives lead to dumb outcomes and vice versa.

Incentives can be positive or negative. They can reward or punish. They can be a carrot or a stick.

Incentives have two key components: the desired behavior and the reward or punishment associated with that behavior.

The better an incentive is understood, the more powerful its effect on behavior. And prompt incentives work much better than delayed incentives.[1] An annual bonus isn’t as effective as a monthly commission. An annual review isn’t as useful as real-time feedback.

The best incentives are simple, meaningful, and immediate. Most incentives fail because they are too complex, too small, or too delayed.

Behavior flows from incentives. Incentives are the invisible cause and behavior is the visible effect. Therefore, you can use incentives to motivate people to behave in the ways you desire. Effective incentives communicate how you want people to behave and motivate people to behave that way.

Money is a common incentive that drives behavior, but it’s not the only one that works. People also change their behavior and thinking for sex, friendship, companionship, advancement in status, and other nonmonetary items. For example, public recognition can be used as a reward (praise) or punishment (criticism).

Incentives influence performance, but they don’t always improve it. Thoughtful incentives lead to predictable outcomes. Unthoughtful incentives lead to unintended consequences. Different situations call for different incentives. Adapt incentives to the reality of the situation.

Since 1995, Geico has used a simple bonus program to align employee compensation goals with shareholder goals. At Geico, two variables determine annual bonus compensation for all of its employees. The first variable is growth in policies, which rewards the growth of new business without punishing employees for lack of profitability. The second variable is the profitability of the seasoned business, which rewards the profitability on existing policies without punishing employees for investing in growth. It’s very simple. Everyone understands it and it avoids misaligned incentives. You’ve got to think incentives through. If you just reward profit, you risk discouraging growth.[2]

Incentives should be aligned. When you criticize people for doing something they are financially incentivized to do, you create misaligned incentives. Creating an incentive to do one thing can cause people to ignore other things. One wrong incentive can ruin an entire system. When Spotify pays artists by the song, songs get shorter.[3]

Incentives can lead to bias which can lead to rationalized bad behavior. As Charlie Munger is fond of saying, “I’ve never seen a management consultant’s report that didn’t end with the same advice: ‘This problem needs more management consulting services.’”

Most people don’t spend enough time thinking through and designing the right incentives. As a result, most incentive systems create unintended consequences. To create effective incentives, you have to think through and eliminate unintended results. This requires second-order thinking.

When you introduce an incentive, people will find the shortest path to it. They will game it. The solution is to create anti-gaming systems. Make bad behavior hard with tough internal audit systems, severe public punishment for wrongdoers, and misbehavior-preventing routines and machines. For example, cash registers are machines that help prevent theft.

FedEx's overnight delivery service relied on a core system of having airplanes meet in one place in the middle of the night to shift packages from plane-to-plane. If there are delays in this simple exchange, FedEx can’t deliver on its promise to customers. It took a while for FedEx to figure this out. They tried everything and nothing worked until someone got the idea of paying the workers by the shift and letting them go home when the work was done instead of paying them by the hour.[4]

Incentives matter. They introduce bias that affects people’s thinking and behavior. The most important rule in life and business might be to “get incentives right”.

Notes:

[1] Source: The Psychology of Human Misjudgment

[2] Source: The power of incentives

[3] Source: The economics of streaming is making songs shorter

[4] Source: A Lesson on Elementary Worldly Wisdom

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