Today’s economics mantra: YOU GET WHAT YOU PAY FOR. Actually, that should be every day’s economics mantra. As someone who writes about incentives, I end up hearing a lot of stories about various compensation and pay for performance schemes in organizations (and in households, relationships, etc., actually). These stories tend to range from the only mildly offensive to the truly heinous. Obviously the heinous stories are the most interesting to me, but I’ll take what I can get. I eventually plan to publish a book on how to design good incentives in organizations, and it’s helpful to have a litany of anecdotes to pull from. Here are a couple to get the party started (I welcome comments and emails with other anecdotes, for the record)…
First, the only mildly offensive:
I posted a while back about how my mother’s semantics lesson resulted in me shoving raisins up my nose. (No, this was not last week. Okay, that one time when I was drunk, but it was funny, ok?) My friend Dave responded with a story about how when he was little he would pour soda out of the cans and bottles in his parents’ house so that he could get the cash for the deposit and/or recycling. This is clearly not profit-maximizing from the parents’ perspective, but it was completely rational thing for Dave to do.
Lesson learned? Smart kids are often huge pains in the ass. Well, yes, but not entirely the point…the actual problem was that the benefits and costs of the soda situation were decoupled for Dave- he got the benefit of the empty bottles and cans without having to think about the cost of buying the soda in the first place. So Dave maximized his payout without thinking of what costs that imposed on his parents. Note that Dave wasn’t really doing anything wrong (unless his parents were prescient enough to anticipate and regulate the behavior), but I am guessing that once his parents got wind of this they put a new rule in place.
Now, the truly heinous:
Maybe you read the above example and thought “Oh, that’s cute, but people figure out how to behave as they get older.” I think the last decade or so of scandals has taught us that that is really not the case. (Enron anyone?) Furthermore, it’s often not even the case that organizations are more clever at designing incentive systems than Dave’s parents were, they just get to try them out on a larger scale.
Consider another friend of mine who works for a consulting firm. (This story is intentionally vague to protect the identities of the not-so-innocent.) This consulting firm is actually a subsidiary of a larger company, and there are bonuses handed down from the parent company to the consulting firm. The bonus is a function of top-line revenue. Now consider that the consulting firm has a non-profit as one of its clients. Normally, non-profits get lower rates because the work done for them is partially a matter of goodwill. However, in this case the rate charged to the non-profit was actually higher than that of a regular client. Why would this be?
The situation makes more sense when you consider that the consulting firm also made a sizeable donation to the non-profit- what was really happening was that the firm was charging an inflated rate in order to put it in the revenue numbers (and thus increase the bonus from the parent company) and then donating most of the charge back. The firm could do so without tax consequences, since the client had non-profit status, and everyone was happy. Or were they?
The parent company would probably not be too happy to know about this, since it’s paying for something that doesn’t create value. That said, the consulting firm is technically playing within the rules of the game. (What’s the saying- “Don’t hate the playa, hate the game?”) The parent company basically did the same thing that the parents above (note the nice parallelism there) did- they decoupled benefits (or revenue) from costs. This gave the consulting firm an incentive to think only about the top-line numbers and ignore the costs that they were putting on the books. This is likely problematic for the parent company, since it stands to reason that they care more about the overall profitability of its subsidiaries and not just the revenue that they can put on the books.
Lesson learned? Even adults know how to, and will, game the system. But the lesson goes beyond that…corollary to lesson learned: Incent what you ultimately want to achieve, not just what is easy to measure. In this case, it is likely that revenue is directly attributable to individual companies, whereas costs are often shared across subsidiaries. As a result, revenue is the easy thing to measure and thus the easy thing to incent. If the parent company tried to incent based on subsidiary profitability, there would probably be a lot of fighting over how shared costs are allocated, among other problems.
So what is a manager to do? Is it better to incent the wrong thing (or part of the right thing) or nothing at all? People usually assume in this case that something is better than nothing, but that is not always true. My take on whether “something” or “nothing” is the better answer depends on how much potential there is to manipulate the system and some much focusing on the “something” detracts from the overall objective.
One final editorial comment: you may be sitting here thinking “yeah, this happens sometimes, but I believe that a lot of people are basically upstanding and ethical individuals and thus wouldn’t take advantage of such a situation.” Granted, in the examples I gave it *should* be at least a little clear to people that they are not abiding by the spirit of the incentive, but that isn’t always the case. It’s quite possible that when a manager says “I am providing you a specific incentive for doing X and nothing else”, the employee honestly interprets that as “X is the only thing that matters to me.” In other words, never underestimate the signalling component of incentives.
I’ll leave you with a related excerpt from Arrested Development, one of my favorite shows ever:
(setup: George Michael and Maeby are working at a frozen banana stand.)
George Michael: Well, this is the cash drawer. My dad’s going to come by at the end of the weekend and the number of bananas has to match the amount of money in here.
Maeby: Oh, so it all has to even out?
George Michael: Exactly.
Maeby: Easy. Banana… (throws a banana into a garbage bin…) Buck. (and takes a buck from the register) Banana… Take a buck. (doing it again as George Michael just watches)
(later that day, at lunch…)
George Michael: You know, I think we might be doubling our losses here. Because, I mean, for every dollar you take, you’re actually taking two dollars because we paid for the bananas.
Maeby: (laughs) Oh, my God, you’re right.
So maybe (maeby?) people aren’t always good at gaming the system, but they certainly do try. 🙂