Human Nature #3: Incentives

Steven Levitt and Stephen Dubner, in their book Freakonomics, open with the following:

Economics is, at root, the study of incentives: how people get what they want, or need, especially when other people want or need the same thing.

We all learn to respond to incentives, negative and positive, from the outset of life. If you toddle over the hot stove and touch it, you burn a finger. But if you bring home straight A’s from school, you get a new bike.

This post will explore the power of incentives in the context of psychology, public policy, business, investing, and self-interest.

The psychology of reward and punishment

Behavioral psychologists have long argued that we do what is rewarding and avoid what we are punished for. This process, of learned behavior, is called reinforcement. Any action that is constantly reinforced will become stronger over time.

This is important because if we reward actions that are undesirable, they will also become stronger. This is how habits and addictions are formed. The most powerful learned behaviors, and most difficult to extinguish, are behaviors that are rewarded variably. Gambling is the classic example. Since gamblers don’t know when the reward will come, they try again and again, and the dopamine payoff is magnified when the reward finally arrives. This is why a gambling addiction can be so hard to break.

In a flipped scenario, punishment can negatively reinforce an action that is desirable. If we go for a run and get hit by a car, we would think twice before ever running again. But if we go for a run and find 100 dollars on the floor, we might be eager to go on our next run as soon as possible. In both of these cases, we are over-learning from our bad or good experiences. Rewards and punishments tend to be context dependent.

The incentives of public policy

Russ Roberts, in his post Incentives Matter, gives some examples of the power of incentives in setting public policy. He shares the following:

Towards the end of the 18th century, England began sending convicts to Australia. The transportation was privately provided but publicly funded. A lot of convicts died along the way, from disease due to overcrowding, poor nutrition and little or no medical treatment. Between 1790 and 1792, 12% of the convicts died, to the dismay of many good-hearted English men and women who thought that banishment to Australia shouldn’t be a death sentence. On one ship 37% perished.

How might captains be convinced to take better care of their human cargo?

You might lecture the captains on the cruelty of death, and the clergy from their pulpits did just that. You might increase the funds allotted by the state provided to the captains based on the number of passengers they carried. You might urge the captains to spend more of those funds for the care of their passengers. (Some entrepreneurial captains hoarded food and medicine meant for the convicts and sold them upon arrival in Australia.) You might urge the captains to spend the money more carefully. Shame them into better behavior.

But a different approach was tried. The government decided to pay the captains a bonus for each convict that walked off the boat in Australia alive.

This simple change worked like a charm. Mortality fell to virtually zero. In 1793, on the first three boats making the trip to Australia under the new set of incentives, a single convict died out of 322 transported, an amazing improvement.

Roberts goes on to share the following example:

During a period of hyperinflation in Chile, the story is told that the government’s imposition of a maximum price made it unprofitable for suppliers to sell bread—the legal maximum was below the cost of production.

A simple prediction would be that bread would disappear from the shelves. But that prediction underestimated the ingenuity of bakers in responding to incentives. Their first response was to shrink the loaf of bread until the cost of a loaf fell below the legally mandated price. The government then mandated a minimum weight for a loaf of bread. The bakers responded by selling the bread raw, so that the weight of the raw dough could meet the minimum. As inflation climbed, it became unprofitable to sell even the raw dough to meet the minimum. So the enterprising bakers sold the raw dough in bags with water so the minimum weight could be achieved.

Both of these examples show the power of incentives but with conflicting results. The first is an example of a policy that uses incentives to get a desired response. The second is an example of a policy that ignores incentives and gets an undesired response in turn. The most famous example of a policy ignoring incentives and backfiring is the cobra law of colonial India. Wikipedia explains it the following way:

The British government was concerned about the number of venomous cobra snakes in Delhi. The government therefore offered a bounty for every dead cobra. Initially this was a successful strategy as large numbers of snakes were killed for the reward. Eventually, however, enterprising people began to breed cobras for the income. When the government became aware of this, the reward program was scrapped, causing the cobra breeders to set the now-worthless snakes free. As a result, the wild cobra population further increased. The apparent solution for the problem made the situation even worse.

A similar incident occurred in Hanoi, Vietnam, under French colonial rule. The colonial regime created a bounty program that paid a reward for each rat killed. To obtain the bounty, people would provide the severed rat tail. Colonial officials, however, began noticing rats in Hanoi with no tails. The Vietnamese rat catchers would capture rats, lop off their tails, and then release them back into the sewers so that they could procreate and produce more rats, thereby increasing the rat catchers’ revenue. Historian Michael Vann argues that the cobra example from British India cannot be proven, but that the rats in Vietnam case can be proven, so the term could be changed to the “rat effect”.

All of these examples prove the same thing, that incentives matter. We would do well to remember this whenever we are considering policies for our own endeavors.

The incentives of business and investing

Charlie Munger has a great antidote about the power of incentives as they relate to business. He notes the following:

From all business, my favorite case on incentives is Federal Express. The heart and soul of their system – which creates the integrity of the product – is having all their airplanes come to one place in the middle of the night and shift all the packages from plane to plane. If there are delays, the whole operation can’t deliver a product full of integrity to Federal Express customers. And it was always screwed up. They could never get it done on time. They tried everything – moral suasion, threats, you name it. And nothing worked. Finally, somebody got the idea to pay all those people not so much an hour, but so much a shift – and when it’s all done, they can all go home. Well, their problems cleared up overnight.

This was a situation where understanding incentives saved the business model of a company that would go on to become one of the greatest success stories of our time. Incentives have the power to save a company, but they also have the power to destroy one.

The story of Enron, is fundamentally a story of warped incentives. People were paid bonuses based on mark to market accounting. This meant that if a person closed a deal that was projected to bring in money over the course of multiple decades, they would be rewarded today. Even if that deal blew up after a few years, the person that originally closed it would still be sitting pretty. The accountants were happy to put their stamp of approval on this arrangement since not doing so would mean the loss of millions of dollars in business. Upton Sinclair has that great quote:

“It is difficult to get a man to understand something when his salary depends upon him not understanding it.”

This environment of warped incentives led to one of the greatest business collapse in modern history.

As investors, it is important that we understand how the management of our companies are incentivized. We want our management to be rewarded for individual performance and not for effort or length of time spent in an organization. We want to make sure we only reward people after their performance pays off and not before. Warren Buffett puts it this way:

Goals should be (1) tailored to the economics of the specific operating business; (2) simple in character so that the degree to which they are being realized can be easily measured; and (3) directly related to the daily activities of plan participants. As a corollary, we shun “lottery ticket” arrangements, such as options on Berkshire shares, whose ultimate value – which could range from zero to huge – is totally out of the control of the person whose behavior we would like to affect. In our view, a system that produces quixotic payoffs will not only be wasteful for owners but may actually discourage the focused behavior we value in managers.

Self-interest and incentives

Peter Bevelin, in his book Seeking Wisdom, notes the following:

There is an old saying: “Never ask the village barber if you need a haircut.” We are biased by our incentives as are others including lawyers, accountants, doctors, consultants, salesmen, organizations, the media, etc. What is good for them may not be good for us. Advisors are paid salesmen and may trick us into buying what we don’t need.

Why did so many mortgage brokers approve loans they knew wouldn’t be paid back during 2005? Why did credit rating agencies rate those mortgages as AAA? Why do managers seek short term results at the cost of long term survivability? Why do hedge fund managers continue to grow their assets under management at the cost of performance. The answer in all those cases is that it is in their self-interest.

We need to remember that people have their own interests, and often those interests will conflict with ours. Anyone trying to sell you something has an incentive to put the transaction above the truth. We would do well to remember this.

Conclusion

Incentives come in three basic types: economic, social, and moral. These incentives have a powerful effect to change behavior to something better or worse. It is important that we understand the motivations people have in order to better predict how they will act. This mental model, of seeing what people have to gain or lose from the present system, is one of the few mental models that will accurately in predict the future.

The counterfactual of this can be seen everyday through the tragedy of the commons. When it is in no ones immediate self-interest to protect a common resource, we can predict that the common resource will be destroyed.

References:
http://www.econlib.org/library/Columns/y2006/Robertsincentives.html#http://www.npr.org/templates/story/story.php?storyId=4583937
https://en.wikipedia.org/wiki/Behaviorism
https://en.wikipedia.org/wiki/Cobra_effect
https://www.amazon.com/Seeking-Wisdom-Darwin-Munger-3rd/