Getting Incentives Right: Lessons for
Business, Sports, Politics, and Life
Chapter 15
© 2010 WORTH PUBLISHERS MODERN PRINCIPLES: MICROECONOMICS COWEN AND TABARROK
1
SEE THE INVISIBLE HAND
Can you spot the teacher? Trick question…. She’s not here today.
Teachers are absent throughout the developing world. Spot checks by
the World Bank, for example, indicate that on a typical day 11% of
teachers are absent in Peru, 16% are absent in Bangladesh, 27% in
Uganda and 25% in India. Is this an incentive problem?
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Chapter Outline
• Lesson One: You Get What You Pay For
• Lesson Two: Tie Pay to Performance to
Reduce Risk
• Lesson Three: Money isn’t Everything
• Takeaway
• See the Invisible Hand Blog (click) for more
examples
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Getting Incentives Right
• A key principles of economics: incentives
matter.
– But getting incentives right is not always
easy.
• Managers of businesses and sports teams,
voters, politicians, and parents all must
choose incentives very carefully.
• How do you get the incentives right and
what happens when we get the incentives
wrong?
4
Getting Incentives Right
Three simple lessons:
1. You get what you pay for.
2. Tie Pay to Performance to
Reduce Risk.
3. Money isn’t everything.
5
Try it!
In the United States,
restaurant customers have
the option of adding a tip
to the restaurant bill. In
much of Europe a “tip” is
added automatically.
Where would you expect
waiters to be more
attentive?
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Getting Incentives Right
1. You get what you pay for.
• The problem: low test scores in schools.
• The solution: Hire, fire and pay teachers
based on how well their students perform
on tests.
• Backfire: The teachers in Chicago cheated
to raise their student's grades!
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Problems with Incentives
• The closer “what you pay for” is to “what
you want,” the more reliable are strong
incentives.
– If bridging the gap between these goals is not
possible, then weak incentive schemes can be
better than strong ones.
Should inefficient public prisons be
replaced by efficient private prisons?
Would there be any unintended
consequences?
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Getting Incentives Right
2. Tie Pay to Performance to Reduce
Risk
• Piece Rate: any payment system that
pays workers directly for their output (as
opposed to hourly wages)
Would Dog hunt so well if he
were paid by the hour?
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Getting Incentives Right
• Piece Rates:
• Increase incentive
• Work well when output is easy to
measure
• Work well when quality control is easy
and cheap
• May attract more productive workers
• Increase wage inequality
• Are becoming more common in the U.S.
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Tournament Theory
• Tournament: a compensation scheme in
which payment is based on relative
performance
• With a fixed level of rewards, agents
compete against each other rather than
against some external standard of
achievement.
– Tournaments focus rewards towards factors that
agents have control over (effort) and away
from environmental factors they don’t control
(weather, economic climate).
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Getting Incentives Right
• When used appropriately, tournaments
create greater effort, less risk, more output,
and higher compensation.
12
Improving Executive Compensation
with Pay for Relative Performance
• Many executives’ compensation packages
are tied to the value of their firm’s stock.
– How much of this value is really under the
executive’s control?
– E.g. recession and/or economic growth affect
substantially affect stock prices.
• Better strategy may be to pay based on
stock performance relative to industry.
– Interestingly, this scheme has not been widely
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adopted…
Getting Incentives Right
• While they reduce external risks,
tournaments can add another type of
risk.
•Ability Risk refers to the risk of competing
against other agents with an inherently higher
level of skill and ability.
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Getting Incentives Right
• Other peoples’ ability is beyond the
control of any individual.
– If the competition is too strong, it may
reduce the incentive to try at all.
– Tournaments can be structured to
overcome this problem.
– Tournaments are often structured so that
agents only compete against others of
similar ability levels.
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Getting Incentives Right
•IfSince
tournaments
encourage
strong
Kerrigan is out of
competition, agents rarely have
Harding’s
league,
incentives to cooperate.
Harding has no
• Tournaments can create too much
incentive
to
try
competition—where the goals of the
harder—only
to break
group are diminished
by the goals of
Kerrigan’s
knees….
individual group
members.
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SEE THE INVISIBLE HAND
• At one prominent university, a professor’s first
name and middle initial are “Harvey C.”
Undergraduates refer to him a “Harvey Cminus” because he is a notoriously hard
grader. What are this professor’s incentives to
be known as a hard grader? What type of
students does he attract? Who does he
encourage to stay away? Why might this
professor not want to grade on a curve?
• How can a tournament create too much
competition?
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Getting Incentives Right
3. Money isn’t everything.
• Incentives are powerful, but not all powerful
incentives are for money.
• Intrinsic motivation is present when an
activity creates enjoyment and pride.
• Incentive schemes are stronger when
agents are motivated by intrinsic rewards
as well as extrinsic rewards like money.
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SEE THE INVISIBLE HAND
What’s he doing it for?
Not money alone.
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Getting Incentives Right
• Successful organizations accomplish this
goal by creating the right corporate
culture.
– Corporate Culture is the shared
collection of values and norms that
govern how individuals interact in an
organization.
• Extrinsic monetary rewards are most
effective when they are supported by
intrinsic motivation.
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Try it!
Think-Pair-Share:
Is Christmas wasteful?
Instead of presents,
wouldn’t it be more
efficient to give cash
which can be used to buy
what the recipient really
wants? Why don’t we see
cash gifts more often?
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Try it!
Think-Pair-Share:
Some parents and
increasingly some
schools are using cash
to pay students for good
grades. Is this a good
idea or not?
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Key Concepts
• Piece rate
• Tournament
• Corporate culture
23
Try it!
Piece rates do not work
well when:
a) workers use tools in
production.
b) quality is not
important.
c) quality control is
important and simple
to perform.
d) quality is important but
quality control is
expensive.
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Try it!
Piece rates do not work
well when:
a) workers use tools in
production.
b) quality is not
important.
c) quality control is
important and simple
to perform.
d) quality is important but
quality control is
expensive.
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Try it!
Which of the following is an example of
tournament pay?
a) Giving a bonus to the sales agent with
the highest sales.
b) Giving a bonus to sales agents based
on the gross amount of their sales.
c) Giving a bonus to the sales agent with
the most hours of working.
d) Giving a bonus to sales agents based
on the hours of overtime work.
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Try it!
Which of the following is an example of
tournament pay?
a) Giving a bonus to the sales agent with
the highest sales.
b) Giving a bonus to sales agents based
on the gross amount of their sales.
c) Giving a bonus to the sales agent with
the most hours of working.
d) Giving a bonus to sales agents based
on the hours of overtime work.
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Try it!
You and Bill Gates are junior executives
of a software company. If both of you are
in a tournament vying for promotion to
CEO, there is likely to be substantial:
a) ability risk.
b) effort on your part to get promoted.
c) effort on Bill Gates part to get
promoted.
d) All the answers are correct.
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Try it!
You and Bill Gates are junior executives
of a software company. If both of you are
in a tournament vying for promotion to
CEO, there is likely to be substantial:
a) ability risk.
b) effort on your part to get promoted.
c) effort on Bill Gates part to get
promoted.
d) All the answers are correct.
29
Try it!
The winner of the American Idol gets a
recording contract. You, an average
person, are randomly picked to be a
surprise entrant in the final round. Which
of the following risks is most likely to
occur in this tournament?
a)
b)
c)
d)
environment risk
sales risk
risk of recession
ability risk
30
Try it!
The winner of the American Idol gets a
recording contract. You, an average
person, are randomly picked to be a
surprise entrant in the final round. Which
of the following risks is most likely to
occur in this tournament?
a)
b)
c)
d)
environment risk
sales risk
risk of recession
ability risk
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