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15
Getting Incentives Right:
Lessons for Business,
Sports, Politics, and Life
CHAPTER OUTLINE
Lesson One: You Get What You Pay For
Lesson Two: Tie Pay to Performance
to Reduce Risk
N
Lesson Three: Money Isn’t Everything
Takeaway
BA basketball player Tim Hardaway was promised a big
bonus if he made a lot of assists.The incentive plan worked.
Hardaway passed the ball a lot, especially toward the end of
the season when it looked like he might not make his bonus. But did the team
owners encourage the right thing? Hardaway later admitted that to get his
bonus he had sometimes passed even when he should have shot the ball.
Incentives matter—this is one of the key lessons of this book—but getting
the incentives right is not always easy. Managers of businesses and sports teams,
voters, politicians, parents, all must think about and choose incentives. This
chapter is all about getting the incentives right and what happens when we get
the incentives wrong.
Lesson One: You Get What You Pay For
Every May, Chicago public school students take a standardized test. Students are
used to being tested, graded, and rewarded accordingly, but beginning in May
1996 teachers and principals had a lot more than usual on the line: Schools with
low scores would be closed, teachers reassigned, and principals fired.The idea, of
course, was to give educators stronger incentives to work harder and better. If
grading was good for the students, why not for the teachers?
Stronger incentives do give teachers and principals an incentive to put in
extra hours and search for better teaching methods. But how else can teachers
raise the grades of their students? Here’s a hint: some students also use this
method.That’s right—they cheat. Indeed, teachers can cheat a lot better than
students because they know which answers are correct! Two economists who
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314 • PA R T 3 • Firms and Factor Markets
understand incentives, Brian Jacob and Steven Levitt (the latter of Freakonomics
fame), started to look carefully at test data and asked: would teachers really cheat
to raise student grades?1 Sure enough, Jacob and Levitt found odd patterns in
the data—students who got easy answers wrong and hard answers right, groups
of students who had exactly the same right and wrong answers, and students
who received high grades during a test year but low grades the year after. Most
telling for an economist was that the indicators of cheating were much stronger
after the penalty for low-performing schools went into effect than before!
Perhaps you think that teachers cheating to raise student grades is a good
idea! But it wasn’t what the proponents of strong incentives for teachers had
in mind. Not all teachers cheated, but cheating was surprisingly common.
Jacob and Levitt estimated that cheating occurred in at least 4 percent to
5 percent of classrooms. Other researchers have found that after the introduction of strong incentives a lot more students are declared learning disabled. 2
Why? Test scores of students called “learning disabled” are usually not counted
when it comes to rewarding teachers and principals.
Does all this mean that strong incentives
for teachers is a bad idea? Not necessarily.
Students who learn more, earn more. If
strong incentives for teachers do increase
true scores, even by a small amount, maybe
it’s a good idea even if some of the better
scores are due to cheating.3
A similar example of incentives for
cheating comes from corporate finance. In
the 1980s, chief executive officers (CEOs)
were given much stronger incentives to increase their firm’s stock price. Instead of
being paid a straight salary, they were
awarded stock options.These are complicated financial instruments, but what you
need to know is that they pay off only
Can Incentives Cheat Death?
if the stock rises above a certain price. As
In the last week of 1999, New York hospitals reported fewer deaths than
with strong incentives for teaching, strong
usual.The following week there were more deaths than usual.Why? Could
incentives encouraged CEOs to work harder
it be that people willed themselves to live to see the dawn of the twentyand smarter. It also encouraged them to
first century?
cheat by manipulating earnings reports to
If death can be postponed for major events, then why not to save on taxes?
Two economists,Wojciech Kopczuk and Joel Slemrod found that a $10,000
make their firms appear more profitable
reduction in the estate tax can postpone death by about a week! To be fair,
than they really were. Enron and the other
however, it could also be that the heirs to the inheritance alter death certificates
scandals of the 1990s and first decade of the
so as to lower their taxes.
2000s were in part the result.Were strong
incentives worth it? If the shareholders
thought that on average the costs of cheating exceeded the benefits of encouraging harder work, they would offer their CEOs fewer options and other strong incentives. But so far most of these incentives have stayed in place, albeit with more
monitoring of potentially bad behavior.*
* The shareholders are not the only ones who are harmed when a corporation like Enron collapses so their
choice of CEO incentive scheme may not reflect what is best for society as a whole. In Chapter 9, we
discussed problems like this, called externality problems, in more detail.
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When designing an incentive scheme remember this: You get what you pay
for.That sounds good but there is a problem.What if what you pay for is not
exactly what you want? If you pay for higher test scores, you will get higher
test scores. But test scores are an imperfect measure of what you really want—
more productive teachers and more knowledgeable students.What you pay for
is higher stock prices, but what you really want is a more profitable firm.
Usually stock prices reflect a firm’s fundamental value, but even the market
can be fooled sometimes!
The closer “what you pay for” is to “what you want,” then the more you can
rely on strong incentives. Careful design of an incentive scheme can narrow the
gap between what you want and what you can pay for. After Jacob and Levitt
published their results, the administrators of Chicago Public Schools, to their
credit, fired some teachers and instituted new procedures to make cheating
more difficult. After the Enron scandal, investors demanded more independent
financial audits.The stronger the incentives, the more it pays to invest in careful
measurement and auditing, and vice versa.
If you can’t bridge the gap between “what you pay for” and “what you want,”
then weak incentive schemes can be better than strong incentive schemes.
Should the management of prisons be contracted out to the private sector? The
owners of a private firm have a strong incentive to cut costs and improve productivity because they get to keep the resulting profits. If a public prison cuts
costs, there is more money in the public treasury but no one gets to buy a yacht
so the incentive to cut costs is much weaker.
In 1985, Kentucky became the first state to contract out a prison to a forprofit firm. Private prisons today hold about 120,000 prisoners in the United
States, about 5 percent of all prisoners. Should efficient private prisons replace
inefficient public prisons? Three economists—Oliver Hart, Andrei Shleifer, and
Robert Vishny (HSV)—say no. HSV don’t question that the profit motive gives
private prisons stronger incentives than public prisons to cut costs—HSV say
that’s the problem! Suppose that we care about costs but we also care about
prisoner rehabilitation, civil rights, and low levels of inmate and guard violence.
What we pay for is cheap prisons, but what we want is cheap but high quality
prisons. If we can’t measure and pay for quality, then strong incentives could
encourage cost cutting at the expense of quality.
The principle is a general one, a strong incentive scheme that incentivizes
the wrong thing can be worse than a weak incentive scheme. One car dealer in
California advertises that its sales staff is not paid on commission.4 Why would
a store advertise that its sales staff do not have strong incentives to help you?
The answer is clear to anyone who has tried to buy a car. High-pressure dealers
who pounce on you the moment you enter the showroom and bombard you
with high-pressure sales tactics (“I can get you 15 percent off the sticker, but
you have to act NOW!”) may sell cars to first-time buyers, but the strategy is
too unpleasant to win many repeat customers. Car dealers who rely on repeat
business usually prefer a low-pressure, informative sales staff.
In theory, a car dealer could have strong incentives and repeat business by
paying its sales staff based on their “nice” sales tactics, but in practice it’s too
expensive to monitor how salespeople interact with clients. Cheating by the
sales staff would be difficult to detect and thus would be common. Paying the
COURTESY EVERETT COLLECTION
Prisons for Profit?
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sales staff a salary instead of a commission calms them down a bit. Of course,
there is a price to be paid for weak incentives. Imagine that Joe’s Honda pays
its sales staff on commission while Pete’s Subaru pays its staff a straight salary.
Which dealership do you expect to be open late at night and on Sundays?
What about prisons? Are HSV correct that weak-incentive public prisons
are better than strong incentive private prisons? Not necessarily. HSV assume
that cutting quality is the way to cut cost. But sometimes higher quality is also
a path to lower costs. Low levels of inmate and guard violence, for example, are
likely to reduce costs. And respect for prisoner’s civil rights? That can save on
legal bills.When quality and cost cutting go together, a private firm has a strong
incentive to increase quality.
HSV may also underestimate how well quality can be measured. Measuring
output pays off more when incentives are high. Unsurprisingly, therefore,
private prison companies and government purchasers have made extensive
efforts to measure the quality of private prisons.
Finally, don’t forget that weak incentives reduce the incentive to cut costs
but they don’t increase the incentive to produce high quality! Public prisons
might use their slack budget constraints to offer high-quality rehabilitation
programs, or they might instead offer prison guards above-market wages.
Which do you think is more likely?
Nevertheless, whether HSV are right or wrong about private prisons, their
argument is clever.The usual argument against government bureaucracy is that
without the profit incentive, public bureaucracies won’t have an incentive to
cut costs. HSV suggest this is exactly why public bureaucracies may sometimes
be better than private firms.5
Piece Rates vs. Hourly Wages
A piece rate is any payment
system that pays workers directly
for their output.
A majority of workers are paid by the hour but a significant number are paid
by the piece. An hourly wage pays workers for their inputs (of time); a piece
rate pays workers directly for their output. Agricultural workers, for example,
are often paid by the number of pieces of fruit or vegetable that they pick.
Garment workers are often paid per item completed. Salespeople are often paid
in part by the number of sales that they make.When should workers be paid by
the hour and when should they be paid by the piece?
Piece rates increase the incentive to work hard and can work well when
output is easy to measure so “what you pay for” is close to “what you want.”
Piece rates are common in agricultural work because it’s easy to measure the
number of apples picked and this is close to what the employer wants. Even
in agricultural work, however, the employer wants not just apples but ripe
and unbruised apples so piece rates usually require some form of quality
control. Piece rates do not work well when quality is important but quality
control is expensive.
In the early days of computing, IBM paid its programmers per line of code.
Can you see the problem? When IBM paid by the line, IBM programmers
produced lots of code but in their rush to earn more money the programmers
often wrote low quality code. IBM’s incentive scheme rewarded what was measurable—lines of code—at the expense of what IBM really wanted but what
was difficult to measure, high quality code. IBM quickly stopped paying its
workers by the line and switched to hourly wages. Hourly wages reduced the
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incentive to work hard but hourly wages also reduced the incentive to rush the
work before it was ready.
The advantage of piece rates is that, if used properly, they can greatly increase productivity. The auto-glass installer Safelite Glass Corporation
switched from an hourly wage system to a piece rate in 1994. Safelite was able
to handle the quality control issue by linking every job with a worker so that
if a quality problem arose, the worker who was responsible for that windshield
installation had to fix it on his or her own time. Productivity quickly improved by an astonishing 44 percent.6 About half of the increase in productivity was due to the same workers working harder, including lower absenteeism
and fewer sick days, but the other half of the productivity increase was due to
another important effect of piece rates. A piece-rate system attracts more productive workers.
Consider two firms, one of which pays workers according to a piece rate,
the other pays workers an hourly wage. Now consider two workers, one of
which can install five windshields a day, the other just three.Which worker will
be attracted to which firm? The piece rate firm will attract the more productive worker because piece rates give productive workers a chance to earn more
money.The hourly wage plan will attract workers who are relatively less productive or even “lazy.”
The differences between workers in productivity can be surprisingly
large. One California wine grower switched from paying grape pickers by
the hour to paying by the pound. Previously, the firm had paid its workers
$6.20 per hour. Under piece rates the average pay was effectively $6.84 per
hour, about the same as before, but some workers were making as much as
$24.85 an hour.
When some workers are more productive than other workers, piece rates
will tend to increase inequality in earnings. Under the hourly wage, every
grape picker earned $6.20 an hour. Under the piece rate some earned $6.84
while others earned $24.85. Information technology is making it easier to
measure the output of all kinds of workers, not just grape pickers. As a result, performance pay (piece rates, commissions, bonuses, and other rewards
tied directly to output) is becoming more common in the U.S. economy
and this is one important reason why the inequality of earnings has also
increased.7
The increase in effective pay under piece rates explains why both firms and
employees can benefit from piece rates. Under hourly wages, workers don’t
have an incentive to work harder even when they can do so at low cost. Piece
rates benefit productive workers by giving them an opportunity to use their
skills to make more money. Piece rates also benefit firms by increasing productivity more than wages.
Even though firms and workers can both benefit from piece rates, piece rates
are sometimes not implemented because of issues of distrust.Workers fear that
if they respond to a new piece rate plan by increasing productivity (and thus
wages) that the firm will respond by reducing the piece rate in the next period
(for example, paying less per pound of grapes picked). In the old Soviet Union,
factory managers who increased productivity in response to new incentives
were often denounced because their increased performance proved that they
had previously been lazy! Of course, this greatly reduced the incentive to increase productivity. Similarly, workers won’t work harder if they expect that
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> Lincoln Electric is a firm famous
for using piece rates. Lincoln
Electric also has a policy of
guaranteed employment. How
are these two policies related?
> 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 on automatically.
Where would you expect waiters to be more attentive?
higher productivity will be punished with lower piece rates. Firms that want to
introduce piece rates must build trust with their workers.
▼
CHECK YOURSELF
Lesson Two: Tie Pay to Performance
to Reduce Risk
Consider an auto dealer who wants to motivate her sales staff. Let’s assume that
all the auto dealer cares about is sales, so she is not worried that strong incentives will make her sales staff too pushy. Are strong incentives now the best?
Maybe not.
Auto sales depend on more than hard work. Sales also depend on factors the
staff has no control over, such as the price and quality of the car, the price of
gas, and the state of the economy. If the sales staff has strong incentives, they are
going to do great when the economy is booming but poorly when the economy
is in a recession.
When sales vary for reasons having little to do with hard work, strong
incentives may be more expensive than they are worth. Most people don’t like
risk.Which would you prefer, $100 for sure or a gamble that pays $200 with
probability 0.5 and $0 with probability 0.5? Gambling in Las Vegas can be fun
but most people will prefer $100 for certain over a gamble with the same
expected payoff. Similarly, suppose that there are two jobs: Job one pays
$100,000 a year for sure, job two pays $200,000 in a good year but just $0 in a
bad year. Suppose also that good and bad years are equally likely so, on average,
job two also pays $100,000 a year.Which job would you prefer? If the wages
are the same on average most people will prefer job one, the less risky job. How
high would the average wage have to be for you to prefer job two? $110,000,
$150,000, $175,000? The precise number is less important than the principle:
the riskier payments are to workers, the more a firm must pay on average.Thus,
if a firm’s sales staff has to bear the risk of a bad economy or a low quality car,
they will demand a big bonus for every sale. But if staff members demand a big
bonus, what is left over for the owner? If the sales staff is sufficiently afraid to
face these risks, the owner and the staff might not be able to agree on a mutually profitable strong incentive plan.*
Weak incentives insulate the sales staff from risk. If the owner is better able
than the sales staff to bear the risk of a recession (perhaps because she is wealthier),
weak incentives may be mutually profitable. In essence, the owner can sell the
staff “recession insurance” by paying them with a fixed or nearly fixed salary.
The sales staff “buy” the insurance by accepting smaller bonuses but of course
their pay stream is more stable.
Bearing the risk of a recession might be worth it if hard work from the
sales force is also the critical factor in sales. But if the state of the economy is
a significant determinant of sales, then strong incentives have created risk
with very little motivational advantage. Imagine if rewards were based solely
on luck—what incentive would there be to exert effort? Similarly, if rewards
are mostly based on luck, the incentive to exert effort will be low and many
potential employees won’t want to face those risks at a price the owner is
willing to pay.
* Or worse, the sales staff may be eager to sell cars when the economy is good but the staff may quit the day
the economy turns sour.
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Tournament Theory
Improving Executive Compensation with Pay
for Relative Performance
A good compensation scheme ties rewards to actions that an agent controls.
How would you use the idea of pay for relative performance to tie executive pay
more closely to actions that executives control?
Today, a large fraction of an executive’s pay is tied to the stock price of their
firm. When the value of their firm rises, executives are often able to cash in
stock options at profitable prices. But many factors other than executive effort
or ability influence the price of a stock. When the economy does well, for
A tournament is a compensation
scheme in which payment is based
on relative performance.
ALAN SMITH/CSM /LANDOV
When sales depend heavily on outside factors such as the state of the economy,
tying bonuses to sales will reward or penalize agents for outcomes that are often beyond their control—thus, shifting risk to the agent but giving the agent
little incentive to exert effort. One way a manager can reduce an agent’s risk is
to tie rewards more closely to actions that a sales agent does control. A surprising way to do this is to pay bonuses based not on a sales agent’s absolute number of sales but on their sales relative to other agents—for example, giving a
bonus to the sales agents with the highest, second highest, and third highest
sales. For obvious reasons, economists call a compensation scheme in which pay
is based on relative performance, a tournament.
If they are used cleverly, tournaments can tie rewards more closely to actions
that an agent controls, thereby improving productivity and pay.To see how a
tournament works in the business world, let’s start with sports, an area where
we are all used to thinking about tournaments.
Imagine a golf game in which players are paid based on the total number of
strokes to finish the course (by the nature of golf, fewer strokes mean better
play and thus higher payments). If the weather is bad, scores will be high and
agents won’t earn very much even if they work hard. If the weather is good (clear
day, no wind), scores will be low and agents will earn a lot even if they don’t
work very hard. Either way, when players are paid based on their absolute scores,
random forces—such as the weather—will influence how much the players earn.
Now imagine that players are playing in a tournament with a fixed number
of prizes, which of course is usually the case.The fixed number of prizes means
that the players are competing against each other rather than against some external standard of achievement. Since every player plays with the same weather, the
weather no longer influences rewards.Thus, a tournament limits the amount of
risk from the external environment. A lot of sporting events, not just golf, are
organized in the form of tournaments.Tournaments are also common in the
business world.
For instance, paying sales agents based on relative sales will reduce environment risk, risk from external factors that are common to all the agents.When
sales agents are paid based on relative sales, factors that the agents do not control
such as the state of the economy, the quality of the product, and the price of
competing products will no longer influence agent rewards. Here is the key: When
factors that an agent doesn’t control no longer influence rewards, then factors that
an agent does control—factors like effort—become more important determinants of rewards.Thus, pay for relative performance such as that used in a tournament can reduce risk and tie rewards more closely to actions that an agent
controls.This will mean harder work, less risk, more output, and higher pay.
Bonus!
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example, the price of most stocks goes up. Similarly, when the price of oil goes
up the stock price of firms in the oil industry tends to go up—and surprisingly
so does the pay of executives in the oil industry despite the fact that these
executives have no control over the price of oil.8 Of course, when the price of
oil falls these executives are paid less despite the fact that they may be working
as hard, or harder, than ever.The bottom line is that quite a bit of executive pay
appears to be based on luck. But payment based on luck is not a good compensation scheme on either the upside or downside.
Is there a better way to pay executives? Instead of paying based on how well
their stock performs, how about paying executives based on how well their
stock performs relative to other firms in the same industry? If executives were paid
based on relative performance, they wouldn’t reap big windfall profits when the
industry boomed (due to no virtue of their own) but neither would they necessarily be paid less when the industry declined (due to no fault of their own).
Pay for relative performance seems to make a lot of sense but it has not been
widely adopted. As a result, some observers suspect that the complicated stock
option schemes currently used to reward executives are less about creating
incentives than about creative accounting that takes advantage of shareholders
who do not closely monitor how much the executives are being paid. Interestingly, firms that have at least one very large shareholder—and thus at least one
shareholder with an incentive to monitor the firm closely—do appear to base
more executive pay on relative performance.9
Environment Risk and Ability Risk
A tournament insulates rewards from risks due to outside factors that are common to all the players but it adds another type of risk called ability risk. Imagine that you had to compete in a golf game against Tiger Woods.Would you
put in more effort if you were paid based on the number of strokes or if you
were paid based on who wins the game? The probability that you could beat
Tiger Woods at golf is so low that if all you cared about was money, it would
make sense to give up right away—why exert effort in a hopeless cause? Of
course, for the same reason,Tiger Woods won’t need to try very hard either!
Remember, an ideal incentive scheme ties rewards to factors that an agent
controls, such as effort. But winning at golf takes more than effort, it also takes
ability. As far as an agent is concerned someone else’s ability is just like the
weather or the state of the economy, it’s not under his control. A golf tournament between players with highly unequal abilities doesn’t tie rewards to effort,
it ties rewards to ability and that often causes people to shirk and slack.Thus,
tournaments work best when the risk from the outside environment is more
important than ability risk.
Tournaments can be structured to reduce ability risk. At a professional golf
tournament, for example, players play in rounds with the weakest players being
eliminated in early rounds so when the final and most important round is
played the players have similar abilities. Similarly, tournaments are often split
into age classes or experience classes (beginner, intermediate, expert) so that
abilities are similar and each player has a strong incentive to work hard. In amateur but serious golf games, when players of different ability compete together,
the high ability players will often be handicapped, which makes competition
more intense for all the players. A manager who wants a lot of effort will also
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TIME MAGAZINE © 2008 TIME INC.
structure tournaments so that rewards are closely tied to effort. A manager, for
example, might create junior and senior sales positions with tournaments
played within each class of employee.
Tournaments in business might seem a bit unusual but they are quite common. About a third of U.S. corporations evaluate employees based on relative
performance.10 Under the hard-nosed CEO Jack Welch, managers at General
Electric were required to divide employees into three groups—the top 20 percent,
the middle 70 percent, and the bottom 10 percent—with the bottom 10 percent
often being shown the door. Even when employees are not explicitly rewarded
based on relative performance, tournaments are often implicit. Lawyers, for
example, compete to earn the prize of becoming a partner. Or becoming the
president of a corporation is a lot like winning a tournament. Imagine that a
corporation has eight vice presidents and one president—the vice presidents
compete to become the next president.The fact that moving up the corporate
ladder is like competing in a tournament may also shed some light on the large
salaries and perks of many corporate presidents. Personal chefs, corporate jets,
and lavish parties might be a sign of the abuse of power but the perks of presidency may also motivate the eight vice presidents. In part, corporate presidents
are paid a lot to motivate those beneath them.
Tournaments are wonderful at encouraging competition but sometimes
competition can be too fierce. In a tournament, when one player falters the
others gain, so tournaments can discourage cooperation. One corporate vice
president might be unwilling to mentor another if she sees a competitor waiting
to take away her job.Thus, as usual, compensation schemes must be carefully
designed to balance a variety of goals.
Tournaments and Grades
Let’s apply some of the insights from tournament theory to a competition that
you are very familiar with, the competition for grades. Some professors grade
on a curve while others use an absolute scale.When a professor “grades on a
curve,” there are a fixed number of “prizes,”As, Bs, Cs, for each class.The competition for grades becomes a tournament.
The costs and benefits of being graded on a curve are just like the more
general analysis of tournaments. Grading on a curve reduces environment risk
but increases ability risk. Can you think of some examples of environment risk?
Suppose that your professor is hard to understand—perhaps the professor has an
accent or teaches the material too quickly or is simply not a good teacher (unlike
us!). Fortunately, if the professor grades on a curve, his or her bad performance
doesn’t mean you have to fail. Bad teaching will reduce how much you learn but
bad teaching harms everyone’s performance. If the professor grades on a curve,
bad teaching need not reduce your grade or reduce your incentive to study.
A bad teacher who grades on an absolute scale, however, is double trouble.
First, bad teaching means that you won’t learn much. Second, if the grading is
on an absolute scale, not learning much means that even if you work hard you
will get a low grade.There isn’t much incentive to work hard in that case.
Grading on a curve, however, does have disadvantages—grading on a curve
means that you will be competing directly with the other students in the class.
If you happen to be in a class with a handful of super-brilliant students, it’s like
golfing against Tiger Woods (unless you are the academic Tiger Woods). Even if
Tournaments can encourage too
much competition.
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> At one prominent university,
a professor’s first name and
middle initial are “Harvey C.”
Undergraduates refer to him as
“Harvey C-minus” 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? Isn’t
competition a good thing?
▼
CHECK YOURSELF
you learn a lot and work hard, you won’t get a high grade and that reduces
your incentive to study.
Grading on a curve, therefore, creates better incentives to study when the
big risk is that the professor will be bad (an environment risk), but it reduces
the incentive to study when students are of very different abilities (ability risk).
Grading on an absolute scale creates better incentives to study when students
are of very different abilities (ability risk) but reduces the incentive to study
when the big risk is that professors will be bad (environment risk).
What are some other effects of grading on a curve? Remember, tournaments
tend to reduce cooperation. If your professor grades on a curve, other students
might be less willing to help you with your homework (or you might be less
willing to help them!). Study groups will probably be less common. Some students might even try to sabotage other students.Tournaments can also encourage
the wrong kinds of cooperation. If a professor grades on a curve, in theory all the
students could get together and agree not to study very much.This probably
wouldn’t be a problem in a large class, but if two sales agents regularly compete
for the “salesman of the month” award they could collude to reduce effort and
rotate the prize between them.
Here’s another problem for you to think about. Suppose that the environment
risk is not bad professors but rather hard material. Imagine, for example, that
some classes are more difficult than other classes (quantum physics 101 vs. handball 101). If you really wanted to learn a little about quantum physics, but you
were afraid of reducing your GPA, what type of grading system would you prefer? And to ask the classic economist’s question: under what conditions? See
Thinking and Problem Solving question 6 for further discussion of this
question.
Lesson Three: Money Isn’t Everything
Incentives are powerful but not all powerful incentives are for money. If you
want to keep business or school club meetings short, make everyone stand until
the meeting is over. All of a sudden the cost of talking is higher so people have
an incentive to talk less.
In addition to money, other powerful rewards include the feeling of identification and belonging that comes from being part of a team, the joy that comes
from a job well done, and the status that comes from success on one’s own
terms. Intrinsic motivation is when you want to do something simply for
feelings of enjoyment and pride. Ideally, firms would like their employees to be
motivated by intrinsic rewards like pride in a job well done as well as extrinsic
rewards like money.
A good manager will get workers to enjoy doing what the manager wants.
One way of doing this is to encourage workers to identify with the corporation
and its goals in the same way that sports fans identify with their team. Many
workers, for example, are given shares of stock in the company they work in.
Currently about 20 million American employees own a part of their employers.11
Since most workers don’t have much control over the value of the entire company, this doesn’t make sense as a monetary incentive. But workers are more
likely to identify with their company if they are also part owners of their
company.Workers who identify with their company see corporate success as
their success. Bostonians celebrated when the Red Sox won the World Series
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even though the fans didn’t receive any monetary rewards. In a company
with strong worker identification, high profits are a cause for celebration even
if the workers don’t receive raises.Workers who identify with their company
are more likely to see themselves in the same boat as other workers and to
think and act more like a team or sometimes even like a family.This is also
why many companies run staff retreats or invest in a softball team.
Successful businesses take great care to create the right corporate culture.
Corporate culture is the shared collection of values and norms that govern how
people interact in an organization or firm. Sometimes it is said that corporate
culture is “how things get done around here.”
The American military is one of the most successful creators of a powerful
“corporate culture.” In the military, a team member may sacrifice his or her life
for the sake of the team. Business corporations can rarely rely on this intensity
of identification but a strong corporate culture can help workers improve.
Recall that one of the big problems with monetary incentives is that the firm
can’t always measure what it wants and a firm that can’t measure quality, for
example, may be worried about creating strong incentives for quantity. But a
firm with workers who value high quality for its own sake can have the best of
both worlds—high quantity and high quality. Corporate culture helps firms
incentivize what is difficult to measure.
Corporate culture is in part responsible for the ascendancy of Wal-Mart,
starting in the 1970s. In the 1970s, CEO Sam Walton spent several days a week
visiting each store. He typically would gather the employees together in a rousing
corporate cheer. He then walked around the store and encouraged people to
tell him what the problems were or what the company was doing wrong. Most
managers were encouraged to visit stores and find out what was on the minds
of workers.The flow of useful information up to the bosses became a company
norm, and workers grew more and more willing to share what they knew.
When something in the company went wrong, usually the mistake was discovered
quickly and there was someone ready to set it right.
In other cases, corporate culture malfunctions. As Wal-Mart was growing,
Kmart, one of its main competitors, was on the road to bankruptcy. At Kmart,
employees tended to hide problems from managers rather than volunteer
solutions. Usually control was centralized and the attitude was that the home
office knows best. Each time the company had a problem it looked for a “quick
fix” rather than going to the root of the difficulty.The tradition of failure bred on
itself and members of the company simply did not work together very
well. Kmart has come out of bankruptcy but it remains unclear whether the
company enjoys much of a future. Most customers vote with their feet and go to
Wal-Mart.12
The importance of morale and good relations extends beyond the business
corporation.You can see these same principles at work in your everyday life.
Intrinsic and extrinsic motivation can work together but not always.When
intrinsic motivation is strong, people are sometimes insulted by offers of
money. If you ask a friend to give you a ride to the airport, the friend would
probably say yes (well, some friends . . . maybe not all of your friends). Offer
your friend $20 for a ride and all of a sudden the friend feels like a taxi driver, not a friend.The friend who might have done it for free will turn down
the job for $20. In one advice column, a woman complained that her husband promised to “pay her by the pound” to lose weight (the advice column
did not say whether the husband was an economist).This marriage probably
Corporate culture is the shared
collection of values and norms
that govern how people interact
in an organization or firm.
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> 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?
> Some parents and increasingly
some schools are using cash to
pay students for good grades.
Good idea or not?
▼
CHECK YOURSELF
was not a happy one, and we should not expect this proposed transaction to
succeed.
Similarly, it is not always possible to pay a son or a daughter to do the dirty
dishes. Nagging doesn’t always work well either but paying money can be
worse.When the parents pay money, the daughter feels less familial obligation.
Once she says to herself “Doing the dishes is a job for money,” the daughter is
no more obligated to do her parent’s dishes than she is to get a job at a restaurant
to do other people’s dishes.
In these cases, payment causes external motivation to replace internal
motivation.Yet for some tasks, internal motivation is what gets the job done,
and in these cases payment can be counterproductive.
Note that payment from a restaurant will get the same daughter to show up
for work on time. Having her own job—which is a signal of adulthood and independence—is “cool” and makes the daughter feel like a grown-up. Money
from parents, which feels like an allowance for tots, or feels like a means of parental
control, will not boost the daughter’s internal motivation to do the dishes.
The lesson is this: Monetary rewards are most effective when they are supported by intrinsic motivation and measures of social status. Good entrepreneurs
understand these connections, and they design their workplaces so that money,
intrinsic motivation, and status incentives work together. Money can’t buy you
love, however, and sometimes love is the incentive that makes family and
personal relationships work well. Money can’t buy you duty or honor either so
even within firms and other organizations such as the military, monetary
incentives must be used with care. Understanding when extrinsic and intrinsic
rewards complement one another and when they are at odds is today more of
an art than a science. Questions like these are on the cutting edge of social
psychology and behavioral economics.
Takeaway
Incentives are a double-edged sword.When aligned with the social interest, incentives
can be powerful forces for good but misaligned incentives can be equally powerful
forces for bad. One of the goals of economics is to understand what institutions
generate good incentives.
On a less grand level, getting the incentives right is an important goal of managers
who want to motivate employees, stockholders who want to motivate managers,
parents who want to motivate children, and consumers who want to motivate real
estate agents, physicians, or lawyers among many others.
In this chapter, we discussed three lessons to help get the incentives right. Lesson
one is: you get what you pay for but what you pay for is not always what you want.
Sometimes the gap between what you pay for and what you want arises because
the incentive plan is badly designed. More often the gap arises because measuring
exactly what you want is difficult so you must pay for something that is more easily
measurable but is not exactly what you want.When the gap between what you pay
for and what you want is large, strong incentives can be worse than weak incentives. As it becomes easier to measure things like quality, however, strong incentive
plans are becoming more common.
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Lesson two is tie pay to performance to reduce risk. Strong incentives put more
risk on agents from factors beyond their control and to bear this risk the agents will
demand greater compensation. Sales agents on commission, for example, bear the
risk that the economy goes into a downturn or that the product they sell is of low
quality. As a result of this increased financial risk, sales agents on commission must
be paid higher average wages than sales agents on salary. A firm must ask whether
the strong incentives created by commissions increase sales enough to justify the
higher average wages.
A good incentive plan will reduce unnecessary risk by tying rewards to actions
that an agent controls and that are effective in increasing output. Different incentive plans like commissions, bonuses, and tournaments impose different types of
risks on agents.Which incentive plan is best will depend on which risks are most
important.
Lesson three is that money isn’t everything. In addition to earning money,
workers want to enjoy their work, identify with a team, and be respected.
Successful corporations provide these rewards as well as monetary rewards. Monetary rewards can be paid only for what is measurable but a successful corporate
culture can help firms incentivize what is difficult to measure. Monetary rewards
are most effective when they are supported by intrinsic motivation and measures
of social status.
CHAPTER REVIEW
KEY CONCEPTS
Piece rate, p. 316
Tournament, p. 319
Corporate culture, p. 323
FACTS AND TOOLS
1. This chapter had three big lessons. Each of the
following situations illustrates one and (we
think) only one of those lessons.Which one?
a. Militaries throughout the world give medals,
citations, and other public honors to
members of the military who excel in their
duties.
b. People tip for good service after their meal is
concluded.
c. Real estate agents work on commission, but
office managers at a real estate office are paid
a straight salary.
d. In Pennsylvania in 2009, two judges received
$2.6 million in bribes from a juvenile prison.
The more people they sent to jail, the more
they received from the prison owners.What
tipped off prosecutors was that the judges were
sentencing teens to such harsh sentences for
relatively minor crimes. One teenager was sent
to prison for putting up a Facebook page that
said mean things about her school principal;
another accidentally bought a stolen bicycle.
(Both judges pled guilty.)
2. An American church sends 10 missionaries
to Panama for three years to try to find new
converts. Every six months, the missionary with
the most new converts gets to be the supervising
missionary for the next six months.This basically
means that he or she gets to drive a car, while
the other 9 have to walk or ride bicycles. Clearly,
this is a tournament. Now consider the following
two cases. For which case will the church’s
incentive plan work best? (Hint:Think about
ability risk vs. environment risk.)
Case I: Missionaries specialize in different
regions: Some stay in rich neighborhoods for
the whole six months, others stay in the poor
neighborhoods for the whole six months.
Case II: Missionaries move from region to
region every few weeks, so that all missionaries
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3.
4.
5.
6.
7.
8.
spend a little time in every kind of Panamanian
neighborhood.
Punishments can be an incentive, not just
rewards. Consider an assembly line.Why
wouldn’t you necessarily want to reward the
fastest worker on the assembly line? What other
incentive system might work?
Many professional athletes get a bonus if they
win a championship. Is this kind of incentive
better or worse than Tim Hardaway’s assist
bonus? Why?
Let’s return to Big Idea Four (thinking on the
margin) back in Chapter 1.Why are calls to give
harsher penalties to drug dealers and kidnappers
often met with warnings by economists?
Why are salespeople so much more likely than
other kinds of workers to be paid on a “piece
rate” (i.e., on commission)? What is it about
the kind of work they do that makes the highcommission 1 low-base-salary combination
the equilibrium outcome?
Unlike in the previous question, sometimes,
piece rates don’t work so well.Why might the
following incentive mechanisms turn out to be
more trouble than they’re worth?
a. An industrial materials company pays welders
by the number of welds per hour. Of course,
the company only pays for necessary welds.
b. A magazine publisher pays its authors to
write “serial novels” one chapter at a time.
The authors are paid by the word (common
in the nineteenth century:This is how Dickens
and Dostoyevsky made their livings).
The typical corporate executive’s incentive
package offers higher pay when the company’s
stock does well. One proposal for such executive
merit pay is to instead pay executives based on
whether their firm’s stock price does better or
worse than the stock price of the average firm
in their own industry. Does this proposal solve
an environment risk problem or an ability risk
problem? How can you tell?
THINKING AND PROBLEM SOLVING
1. In 1975, economist Sam Peltzman published a
study of the effects of recent safety regulations for
automobiles. His results were surprising: increased
safety standards for automobiles had no
measurable effect on passenger fatalities.
Pedestrian fatalities in automobile accidents,
however, increased. (This is now known as the
Peltzman effect and has been tested repeatedly
over the decades.)
a. Why might more pedestrians be killed when
a car has more safety features?
b. Economists have looked for ways out of
Peltzman’s dilemma. Here’s one possible
solution: Gordon Tullock, our colleague at
George Mason, has argued that cars could
have long spikes jutting out of the steering
column pointed directly at the driver’s heart.
Keeping Peltzman’s paper and the role of
incentives in mind, would you expect this
safety mechanism to result in an increase,
decrease, or no change in automobile
accident fatalities? Why?
c. Would a pedestrian who never drives or
rides in cars tend to favor Tullock’s solution?
Why or why not?
2. One reason it’s hard for a manager to set up
good incentives is because it’s easy for employees
to lie about how they’ll respond to incentives.
For example: Simple Books pays Mary Sue to
proofread chapters of new books.After an
author writes a draft of a book, Simple sends
chapters out to proofreaders like Mary Sue to
make sure that spelling, punctuation, and basic
facts are correct.
As you can imagine, some books are easy to
proofread (perhaps Westerns and romances),
while others are hard to proofread (perhaps
engineering textbooks). But what’s hard or easy
is often in the eye of the beholder: Simple can’t
tell which books are particularly easy for Mary
Sue to proof, so they have to take her word for
it. Let’s see how this fact influences the
publishing industry.
In the figure below, Q* is the number of
chapters in the new book, Burned:The Secret
History of Toast. It’s a strange mix of chemistry
and history, so Simple isn’t sure how Mary Sue
will feel about proofing it.The marginal cost
curve shows Mary Sue’s true willingness to
work:The more chapters she has to read, the
more you have to pay her. If Simple offers to
pay her $50 per chapter, as shown, she’ll actually
finish the job.
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Price
Marginal cost of
work (supply)
Price paid
per chapter
(demand)
$50/Chapter
Q*
Quantity of
chapters proofed
by Mary Sue
a. If Mary Sue wants to bluff, claiming that the
book is actually painful to read, what is that
equivalent to?
Supply curve shifting left
Supply curve shifting right
Demand curve shifting down
Demand curve shifting up
Once you decide, make the appropriate shift
in the figure above.
b. The publisher just has to have Mary Sue
proof all Q* chapters of Burned:All the other
proofreaders are busy.They’ll pay what they
need to for her to finish the book.This is the
same as another curve shift in a certain direction: Draw in this shift in the figure above.
c. What did Mary Sue’s complaining do to her
price per chapter? What did it do to her
work load?
d. (Bonus) You’ve seen how Mary Sue’s bluffing
influenced the outcome.What are some
things that Simple might do to keep this
from happening?
3. Who do you think is in favor of forbidding
baseball player contracts from including bonuses
based on playing skill? Owners or players? Why?
4. In the short, readable classic Congress:The
Electoral Connection, David Mayhew uses the
basic ideas of incentives and information as a
pair of lenses through which to view members
of Congress.What he saw was quite simple:The
urge for reelection drives everything.Thus,
members are driven by self-interest to give the
voters in their home district as much as possible.
Of course, voters face the same problem in
judging members of Congress that any manager
faces when evaluating an employee: Some
outputs are harder to measure than others, so
voters focus on measurable outputs.With that in
mind, what will voters be most likely to care
about? Choose one from each pair and briefly
explain why you made that choice.
a. How many dollars come to the district for
new hospitals and highways vs. how many dollars are spent on top-secret military research.
b. How well the member behaved in private
meetings with Chinese leaders vs. how the
member sounded on Meet the Press.
c. How well the member did in reforming the
Justice Department vs. how well the member
did at the Turkey Toss back in the district last
Thanksgiving.
(As you’ve seen, voters’ focus on the
visible can easily drive the member’s entire
career. Mayhew’s book was an important
early work in “public choice,” the use of
basic microeconomic ideas like self-interest
and strategy to study political behavior. For
more on the topic, Kenneth Shepsle and
Mark Bonchek’s short textbook Analyzing
Politics is highly recommended. See also
Chapter 19 of this textbook.)
5. In the movie business, character actors are
typically paid a fixed fee while movie “stars” are
typically paid a share of the box office revenues.
Why the difference? Try to give two explanations
based on the ideas in this chapter.
6. Let’s return to the question we posed in the
chapter: Suppose that the big environment risk
is not bad professors but rather hard material.
Imagine, for example, that some classes are
more difficult than other classes (quantum
physics 101 vs. handball 101). If you really
wanted to learn a little about quantum physics
but you were afraid of reducing your GPA,
you’d face a tough choice.A curve is better for
you than an absolute scale but even if your
professor grades on a curve, you’re probably still
sitting in a class with other well-trained physics
majors. Let’s see if we can find a work-around.
a. At your school, are there certain times of the
day when the less serious, more fun-loving
tend to take their classes? If so, when is it? If
you sign up for a section scheduled then, you
might look better on the curve.
b. Some schools offer simplified (we won’t say
“dumbed down”) versions of some hard
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DAVID HOWELLS/CORBIS
courses. Does your school offer anything like
this? If so, does it allow majors to take the
same sections as the non-majors? How is this
sorting related to tournament theory?
c. If you were a professor, which teaching
schedule would you rather have:Two
sections where the majors and non-majors
are mixed together, or one section with the
majors, and one with the non-majors?
7. When an accused defendant is brought before a
judge to schedule a trial, the judge may release
the defendant on his or her “own recognizance”
or the judge may demand that the defendant
post bail, an amount of cash that the defendant
must give to the court and that will be forfeited
if the defendant fails to appear. Many defendants
don’t have the cash so they borrow the money
from a bail bondsperson. So if the defendant fails
to appear, the bail bondsperson is out the
money, unless the defendant is recaptured within
90–180 days.To recover their money, a bail
bondsperson will hire bail enforcement agents,
also known as bounty hunters, to track down
the missing defendant. If the bounty hunters
don’t find the defendant, they don’t get paid.
This Dog knows how to hunt.
a. If defendants released on their own
recognizance fail to appear, they are pursued
by the police, but if they are released on
bail borrowed from a bondsperson and
they fail to appear they will be pursued by
bounty hunters.Which type of defendant do
you think is more likely to fail to appear and
which type is more likely to be recaptured if
they do fail to appear? Why?
b. Perhaps surprisingly, bounty hunters tend to
be quite courteous and respectful even to
defendants who have tried to skip town. Can
you think of one reason why?
8. a. Why do so many charitable activities like
marathons, walks, and 5K runs give the
participants “free” t-shirts, wristbands, hats,
bumper stickers, and so forth?
b. Charitable organizations could probably
make a lot of money for their cause by
selling these items on their websites, but you
usually have to actually attend the “2012
Cancer Run” in order to get the “2012
Cancer Run” t-shirt.Why?
CHALLENGES
1. Let’s tie together this chapter’s story on
incentives with Chapter 13’s story about cartels.
Suppose your economics professor grades on a
curve:The average score on each test becomes a
B–. If all of the students in your class form a
conspiracy to cut back on studying, point out
how this cartel might break down just like
OPEC’s cartel breaks down during some
decades.
2. What type of systems in the United States help
overcome the incentives of physicians to order
medically unnecessary tests?
3. In his path-breaking book Managerial Dilemmas,
political scientist Gary Miller says that a good
corporate culture is one that gets workers to
work together even when they face prisoner’s
dilemmas (we discussed the prisoner’s dilemma
in detail in Chapter 13). In a healthy corporate
culture, you feel guilty if you’re being lazy while
your buddy is working. Let’s sum up “guilt” as
simply as possible: It’s some number “X” that
represents how you feel.These figures are
adapted from Figure 13.3.
Stan
Kyle
Work
Shirk
Work
(4, 4)
(2, X)
Shirk
(X, 2)
(3, 3)
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a. What does X have to be in order to keep
this from being a prisoner’s dilemma?
Answer with a range (e.g., greater than
12.5, less than - 2).
b. Now, there are two Nash equilibria in this
problem.What are they? Using the language
of Chapter 13, what kind of game has this
just become?
c. There’s an idea buried in the questions from
Chapter 13 that will “point” Stan and Kyle
toward the best possible outcome.What is it?
(Keep in mind that a good corporate culture
can help with this part, too.)
4. a. Many HMOs pay their doctors based, in
part, on how many patients the doctor sees
in a day.What problems does this incentive
system create?
b. If HMOs pay their doctors a fixed salary, what
problems does this incentive system create?
c. Ideally, we would like to pay doctors based on
how long their patients live! What problems
exist in implementing this type of system?
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