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The Distorting Power of Incentives

“The rabbit runs faster than the fox, because the rabbit is running for his life while the fox is only running for his dinner.”
— R. Dawkins

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Simply put, incentives matter a lot. Incentives are at the root of a lot of situations we face and yet we often fail to account for them. They carry the power to distort our behavior and blind us to reality.

Pebbles of Perception- How a Few Good Choices Make All The Difference

Even accounting for them is often not enough. As Charlie Munger cautions, “I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. Never a year passes that I don’t get some surprise that pushes my limit a little farther.”

In Pebbles of Perception: How a Few Good Choices Make All The Difference, Laurence Endersen writes:

We can only see a situation with true clarity when we take the time to carefully consider the interests at hand. And we understand it even better when we consider how the situation might be different if the underlying interests were different.

But … just as we often fail to understand them, we can also overly focus on them. To the man with a hammer, everything looks like a nail.

Imagine the nature of a football game where the first goal scorer took all the spoils. There would be one hell of a scramble to score the first goal and it might make compelling viewing. The carrot is effective, but it is too pointed. We suddenly focus on the incentive and forget about the second order consequences. What we see is that narrow incentives influence performance, but they may not improve it. Studies of loan officer approvals during the recent US mortgage crisis showed that the loan officers actually believed the cases with the highest commission were more creditworthy. The effect was worse than naked self-interest: the incentive actually blinded their judgement.

Understanding incentives comes through second-and-third-level thinking. Many incentive systems have backfired because people failed to consider other interests and incentives.

An example is monetary rewards offered to help exterminate unwanted animals such as rats and snakes. What authorities failed to foresee was that people would start to breed the rats and snakes. Forcing people to have overly complex passwords can be another perverse incentive. When faced with this complexity we simply write down our passwords somewhere “safe”.

As to good incentives, money is not enough.

Good incentives acknowledge recognition, public perception, and the value of pursuing work that we can be proud of. So yes, if we want to persuade, we should appeal to interests not reason. But when it comes to interests, appeal not just to net worth but also to self-worth.

There are a few things worth keeping in mind.

First, the behavior you see is usually the result of incentives you don’t see. Consider the sharp elbows you see in a typical workplace. Looking at this behavior in isolation it makes little sense. However, odds are, this is rewarded in some way.

Second, we generally get the behavior we reward.

Third, creating effective incentive systems is hard work. We need to consider not only the first level of incentives but also the second and third and how they will impact the system.

Enderson concludes:

Incentives matter greatly – underestimate them at your peril. People will navigate the shortest path to the incentive. The curious among us will pay particular attention to incentives, monetary or otherwise.