The Wrong Kind of Incentives

Structuring incentives to work for the good of society instead of against it is a key part of reconfiguring the prisoner's dilemma we call modern life. But when many people talk about incentives, they mean overt incentives, as in merit pay for teachers.

Cornell law professor Lynn Stout recently had an op-ed in the Los Angeles Times (reprinted in the Star Tribune) that showed why incentivize is an ugly word and a dubious idea. (All emphasis is added.)

Explicit incentives work for simple tasks where an employee controls the outcome and where product quality is easily assessed — for example, offering employees of a moving company $20 for every sofa they move in an hour without damage. It’s pretty clear whether the sofas got moved, and whether they got damaged.

But what about complex, hard-to-monitor tasks where the desired outcome is difficult to measure and subject to influences outside the employee’s control — such as educating a child or restoring a patient to health? It is almost impossible to design objective performance metrics that can’t be met through illegal or undesirable behavior. In the case of education, it could be falsifying student test scores; in the case of health care, it could be controlling blood pressure through medications that make patients feel sick instead of persuading patients to exercise. And when you create a system that inadvertently incentivizes illegal or undesirable behavior, you get more of it.

Stout goes on to describe the alternative to pay for performance:

flat salaries and modest bonuses adjusted annually according to the employer’s opinion of whether the employee had done well. The system relied on subjective, after-the-fact rewards more than objective, predetermined incentives. That required a fair amount of trust and a sense of mutual obligation. Employers had to trust employees to work to earn their predetermined salaries rather than loafing. (Bad employees can be fired, but this solution costs the employer, too.) Employees had to trust that if they stuck around and did a great job, their employers would recognize and reward them.

Standard economic theory predicts that systems based on mutual trust and respect between employer and employee shouldn’t work. But innumerable behavioral studies prove trust is a real phenomenon, and history shows it can indeed motivate employees.

For example, before Congress changed the tax code in 1993 to tie executive pay to objective performance metrics, boards paid CEOs far less. Yet investors enjoyed higher stock market returns than today.

 And that's without even getting into the critiques extrinsic motivation from scholars like Dan Ariely.