The Importance of Incentives, Part I

As an economist, there are few things that get drilled into you pretty much from Day One as much as one very simple mantra: “incentives matter”. Open up any elementary textbook on the subject (preferably one on microeconomics, because that’s probably closest to what people outside the field would be thinking of when they think of “real economics”), and you’re guaranteed to find that phrase, or a variation thereof, somewhere on the first few pages. In fact, when it comes down to the core fundamentals of what economics as a discipline, an ultra-condensed summary of the entire discipline of Economics in just two points that I’ve come across time and time again is:

One: Incentives matter.

Two: There’s no such thing as a free lunch.

Keeping in mind that it’s probably impossible to really boil down any academic discipline to just two points, I’m nevertheless strongly inclined to agree with this as a great starting point– and we’ll get to that second point about the free lunch (or the non-existence thereof) in a later blog post, but for now let’s focus on the meaning of incentives, because that’s such a fundamental point that’s often misunderstood in a variety of ways:

Now what economists mean when they say “incentives matter” doesn’t seem very surprising or deep at all, at least at first glance – “well duh”, most people would be inclined to respond, “I already knew that, you don’t need a PhD to have that figured out! Surely most people in most situations have different possible choices, and surely they tend to go for the one that’s most beneficial to them”.  To which I would respond that I totally agree, but that’s not what the mantra is really about. From an economist’s point of view, it’s not just about the obvious choices where the incentives are clearly spelled out. Instead it’s about looking at the world in such a way that you’re always asking “What are the (sometimes hidden, and that’s where it gets really interesting!) incentives underlying this situation, and what does that mean for the people making decisions?”.

Let me give you a simple – albeit perhaps not entirely politically correct – example¹:

Bob has been married to Alice for over twenty years now, and while their marriage overall has always been a happy one, Alice has lately been getting more and more annoyed by Bob’s habit of after almost every meal leaving the dirty dishes on the table or the counter instead of putting them in the dishwasher where they belong. It used to not bother her all that much, but lately she’s been noticing it more and more frequently, and the more she’s noticing it the more she‘s becoming annoyed by it.

Now depending on your academic background, you’ll probably have a very different point of view on this; a psychologist will probably start thinking about mutual respect and power dynamics in the marriage, a doctor will be thinking about whether there could be something wrong with Bob’s arms that prohibits him from doing heavy lifting, and an interior designer might be thinking about whether the layout of the house in terms of distance from the dining room table to the dishwasher could be suboptimal, but an economist will simply look at the situation in terms of incentives, and what’s going on in his head will sound something like this:

Bob repeatedly faces a choice between immediately putting away his dirty dishes – which will cost him some small effort – and just leaving them where they are for someone else to clean up – which will leave the house a bit less clean than it would have otherwise been.

I can at this point already hear the cries of “Why is Bob such a heartless bastard, the fact that cleaning up the dishes costs him a small effort shouldn’t matter compared to the respect he has for his wife?” –  and let me stop you right there: not because I disagree (and of course I don’t, come on and get it together, Bob!), but because this is not what economics is about.  Economics is not about what people SHOULD be doing according to some moral framework or even according to common sense (both of these topics are far too complex for economists to be willing to touch with a ten foot pole), but it’s about what incentives people face in every decision they make. In this case it seems to an economist that Bob simply isn’t bothered enough by dirty dishes in the kitchen relative to the effort it takes him to clean them up right away, so he doesn’t – simple as that.

Now before all of this escalates any further and Bob and Alice’s marriage is left in shambles, what would an economist knowing all about incentives and their importance suggest as a solution? As the problem is one of incentive misalignment (that is, Bob’s incentives are skewed in such a way that they lead to the undesirable outcome from the point of view of Alice), then the solution must be to bring them in line – more colloquially known as “don’t hate the player, hate the game“.

What could Alice now do to reach incentive alignment? From a very rational perspective, there are four basic possibilities in this situation:

  1. Increase the payoff of the non-preferred option – e.g. she could say “if you clean up the dishes after every meal, I’ll take out the trash every time – deal?”
  2. Decrease the cost of the non-preferred option – e.g. she could say “I’ll clean up my own dishes right away, why don’t you just put away yours then – you don’t  even have to clean up all the dishes anymore!”
  3. Decrease the payoff of the preferred option – e.g. she could say “if the dirty dishes laying around alone don’t bother you enough, maybe I won’t be the one to clean up anymore and eventually we’ll just run out of clean dishes altogether?”
  4. Increase the cost of the preferred option – e.g. she could say “maybe I’ll just have to start distributing all kinds of decorative knick-knacks around the kitchen so you’ll have nowhere to put your dirty dishes but in the dishwasher?”

Perhaps a framework like this seems to be just a bit of an overkill for a problem that’s as simple as the one at hand, but the whole point is not to suggest that Alice should be consulting a microeconomics textbook in this situation, but to show that framing a decision in the context of incentives provides both a rational and useful way of assessing a situation as well as suggesting a multitude of possible options for achieving a better outcome for both sides – and in the end, those are two things that economists care most about.

To summarize the key takeaway – looking at the world in terms of “what are the incentives that each side faces right now, and how could changing these incentives lead to a better outcome for everyone involved?” seems to be a most helpful way of assessing any situation that involves multiple parties. Now the question that has undoubtedly been going through your mind for the past five minutes is – what does Bob not wanting to put away his damn dishes have to do with how to build better and more accurate business intelligence solutions? That’s EXACTLY what I’ll be talking about in my next post in this series. Until then, I hope that you’ll walk away with a newfound appreciation for the importance of incentives behind even mundane everyday decisions, and with the smug satisfaction of knowing that should my future wife one day stumble across this writing, I’ll be guaranteed to be the one putting away the dishes every day for the rest of my life…

 

¹you’ll see throughout my blog that economists mostly are not overly concerned with political correctness. We’re in the end just really interested in finding out what makes people tick. For the record though, let me make it clear that none of the statements here should be misconstrued as favoring any particular political or religious viewpoint – we’re trying to be agnostic observers of human behavior, but sometimes the more clichéd examples are just the most easily understandable ones…

 

 

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As Chief Scientist at Predictful, Dr. Daniel P. Smith is one of the academic minds of the team behind one of the most innovative new concepts in business intelligence. Daniel holds an MPhil in Finance from the University of Cambridge and a PhD in Finance with a specialization in Behavioral Economics from the University of Mannheim in Germany; in this blog, he will on a regular basis be sharing insights, perspectives and thoughts about the science behind Predictful and the broader academic perspective on what makes people tick, how they form decisions and what all of this means for your business.

 

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