Modern Principles: Microeconomics Tyler Cowen and Alex Tabarrok Copyright © 2010 Worth Publishers Modern Principles: Microeconomics Cowen/Tabarrok Chapter 15 Getting Incentives Right: Lessons for Business, Sports, Politics, and Life

Slide 2 of 17 Getting Incentives Right One of the most basic principles of economics is that incentives matter. Getting incentives right, however, is not always easy. Managers of businesses and sports teams, voters, politicians, and parents all must think about incentives very carefully.

Slide 3 of 17 Getting Incentives Right Getting incentives right and what happens when incentives go wrong involve three simple lessons: 1.You Get What You Pay For 2.Tie Pay to Performance To Reduce Risk 3.Money Isn’t Everything

Slide 4 of 17 Getting Incentives Right 1.You get what you pay for. When designing an incentive scheme, it is important to remember this simple lesson. However, what you pay for sometimes is not exactly what you want. The closer “what you pay for” is to “what you want,” the more reliable are strong incentives. Careful design of an incentive scheme can bridge the gap between these goals.

Slide 5 of 17 Getting Incentives Right If bridging the gap between these goals is not possible, then weak incentive schemes can be better than strong ones. In other words, a strong incentive scheme that incentivizes the wrong thing can be worse than a weak incentive scheme.  This is especially the case when it is costly to monitor and enforce a strong incentive scheme.

Slide 6 of 17  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 automatically. Where would you expect waiters to be more attentive?

Slide 7 of 17 Getting Incentives Right 2.Tie Pay to Performance to Reduce Risk If external events are significant, then strong incentives create risk with relatively little motivational advantage. In this case weak incentives may insulate agents from additional risk.

Slide 8 of 17 Getting Incentives Right Tournament Theory structures rewards not on absolute measures but in terms of results relative to other agents. With a fixed level of rewards, agents compete against each other rather than against some external standard of achievement. Thus, tournaments reduce the risks of external events by tying rewards more closely to actions that an agent controls. As such, tournaments create greater effort, less risk, more output, and higher compensation.

Slide 9 of 17 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. Someone else’s ability is outside the control of any individual agent.

Slide 10 of 17 Getting Incentives Right Rewards tied to ability often cause people to reduce effort. Thus, tournaments work best when external risks are more important than ability risks. Tournaments can be structured to reduce ability risk.  Tournaments are often structured so that agents only compete against others of similar ability levels.

Slide 11 of 17 Getting Incentives Right Since tournaments encourage strong competition, agents rarely have incentives to cooperate. Tournaments can, in fact, create too much competition where the goals of the group are diminished by the goals of individual group members.

Slide 12 of 17  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?

Slide 13 of 17 Getting Incentives Right 3.Money isn’t everything. Incentives are powerful, but not all powerful incentives are for money. Intrinsic motivation arises when an agent engages in an activity simply for the feelings of enjoyment and pride. Incentive schemes are stronger when agents are motivated by intrinsic rewards as well as extrinsic rewards like money.

Slide 14 of 17 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.

Slide 15 of 17  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?

Slide 16 of 17 One of the most basic principles of economics is that incentives matter, but getting incentives right is not always easy. Three lessons for getting incentives right: 1.You Get What You Pay For 2.Tie Pay to Performance To Reduce Risk 3.Money Isn’t Everything