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3 pillars of bad incentives

“Never, ever, think about something else when you should be thinking about the power of incentives.” - Charlie Munger

Thank you for joining me for another blog (#34), highlighting decision-making and the brain. This is my public exploration of what drives decision-making and how we can use that information to make better decisions, resulting in better outcomes.

We are currently exploring group dynamics and how that impacts decision-making. Today's question is ‘how do bad incentives create skew outcomes’. Last week we considered broad incentives (Broad incentives ( i.e. people respond to challenging situations by trying to avoid them. They avoid confrontation, causing offence, risking embarrassment or mentally complex situations.

To counter this problem many organisations create incentives to get people to overcome these mental barriers and create specified focus. Incentives are for many employees a significant source of motivation. Today’s key idea is that misaligned incentives can create bad outcomes. Incentives drive people's behaviour and the way they approach decision-making. This might lead to surprising and unintended overall results.

What are incentives and how can they drive behaviour?

Incentives are a part of the environment created to motivate people towards an outcome. Often this is monetary, but could also be recognition (e.g. “employee of the month”) or a culture of fast tracks (more responsibilities, promotions etc.) to encourage the right behaviour.

A famous example of incentives working is Charlie Munger’s FedEx anecdote. FedEx were failing on their deadlines with overnight packages. They tried everything from a process and systems perspective, but they just could not get the packages delivered on time. Margins were also tight so they could not throw more money at the problem. Overnight workers were working the most anti-social hours imaginable so should have in theory been incentivised to finish early. BUT they were being paid by the hour. They were actually paid more to do the job slowly.

A lightbulb moment followed - how about paying each employee per shift rather than by the hour? The employees would get their full pay no matter how long it took. You can imagine what happened - suddenly the packages were being transferred on time or early.

To really understand how incentives can actually create bad outcomes, we need to know about wishful thinking.

Wishful thinking

Wishful thinking is when opinions, decisions and strategy are distorted by what

you would like to happen rather than the overall organisation's objectives. An example is whether you are consciously aware of it or not, if you are paid by the number of ripe apples that you collect (and you are the one to decide whether an apple is ripe or not) your definition of ripe might be that bit more lenient.

We see wishful thinking everywhere – in eastern philosophy it is common to read that 'desire warps reality'.

There are many different flavours of incentive structure I see but feel that most fit into just three pillars that cause unintended bad consequences.

Three pillars of misaligned incentives

1) Narrow Incentives

The incentives have people focused on one metric at the expense of others.

a) Time misalignment: Good long-term policies take time for results and can be unpopular. Politicians' incentives are geared towards getting re-elected in 5years’ time. Why would they take the hard and unpopular decisions today?! We see the same for many long-term decisions.

b) Conflicting incentives: One team (e.g. a sales team) is rewarded for maximising revenue, another is rewarded for minimising costs. Whilst efficiencies will be rewarded it is likely any marketing efforts to increase customers will result in a conflict.

c) Single component rewards: In the Global Financial crisis of 2007-2009 one of the epicentres was US housing. There were firms called originators who were incentivised to go out and find as many borrowers as they could. Wishful thinking meant that these firms who were incentivised only by volumes seemed to be laxed on credit checks. The firms were prioritising quantity over quality. The firms who were actually lending the money ended up receiving a lot of bad quality loans - this did not work out well for them.

2) All for show

In some low accountability environments e.g. politics, what people are seen to do is incentivised more than what they actually do. This results in:

a) Credit capture: Taking credit for the work of others

b) Just do something: An example is private doctors prescribing patients with medication even if they do not need it. This is to avoid the annoyance of people who have paid a lot of money to see them.

c) Face time: Spending loads of hours in the office and making yourself seen and heard.

3) Skewed risk/return

The share of risks and rewards are not well distributed.

a) Upside only: A person captures a share of money made but does not lose anything if they lose money. This encourages risk-taking behaviour. These incentives are often paid annually or shorter and therefore encourage taking short-term risks.

b) Downside only: Another common incentive skew is to pay someone well to do their job without much variability in pay. Given people can get fired for poor performance it encourages ‘coupon clipping’ and ‘not rocking the boat’. This is creates risk aversion and a low innovation environment. Why suggest changes if might lose you your job if it fails?.

c) No skin in the game: In some situations some people are just not incentivised to focus on it. Examples of this situation is where someone is drafted in to opine on a decision but has no upside or downside risk in the situation. This situation leads to indifference and a lack of ownership.

So What?

How is this all relevant to decision-making? Here are three take-aways I want to leave you with before we pick it up next week:

1) Incentives are factors that encourage you to act a certain way. How people are incentivised can hugely impact group dynamics and the working of an organisation.

2) Incentives encourage wishful thinking which distorts decision-making. In these situations you tend to veer towards situations that work out best for you.

3) Bad incentives are often one of ‘all for show’, ‘narrow incentives’ or ‘skewed risk/return’ and cause bad outcomes.

Thank you for joining. Next week – 'the worst committee meeting of all time'.


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