Setting the right incentives for high flyers

I have always thought that the word “incentivise” is one of the more unnecessary words in the English language as it takes a perfectly ordinary noun and transforms it into an ugly verb. Call me old fashioned, but I always thought that incentives were designed to motivate people to behave in particular ways. The verb “incentivise” first made an appearance in the US in 1968 but it did not gain currency on this side of the Atlantic until the early 1990s. Indeed, its entry into everyday language in the UK coincided with a shift to a more market-oriented economy in the post-Thatcher era. Aside from linguistic considerations, the study of incentives is one of the most important areas in economics. Setting the correct incentives to ensure the desired outcomes is crucial.

Incentives can either take a monetary or non-monetary form. Monetary incentives are well understood – people often get paid a bonus for hitting their targets, which in the case of company executives can run into the millions. But a common problem in all organisations is that people may prefer to pursue their own interest instead of the firm’s common goals which potentially leads to a conflict of interest. One resolution to this problem is to align the interests of the firm and the workers by appealing to their intellectual engagement. For example, Google is a highly innovative hi-tech company which allows its engineers to develop new ideas off their own bat because they may turn out to be game changing ideas. In other environments it may not be so easy to generate such intellectual development. Many US companies instituted employee of the month programmes to recognise particularly outstanding workers. For all the scepticism which these awards may generate, there is evidence to suggest that recognition by the management for a job well done goes a long way.

In this vein, I was struck by a neat little paper recently published on the CEPR’s Vox website which attempts to quantify this effect. The example in this instance looks at the behaviour of Luftwaffe pilots in World War II in response to the public praise lavished on high-performing pilots (i.e. those who shot down many enemy aircraft, here). Careful analysis of 5000 individual records, which looks at the impact the recognition accorded to indviduals had on their former colleagues, shows that this led to an improvement in the performance of all pilots who were known to have served with him. However, the good pilots (the “aces”) performed significantly better without taking more risks, but average pilots performed only slightly better but with a higher risk of being killed. The conclusion of this analysis is that singling out one worker for individual praise acts as an incentive for others to try harder.

The analogy is extended to suggest that such praise which encourages risk taking is a major problem in the financial services industry if it encourages traders to take ever bigger bets without understanding the risks they are running. Whilst there is some merit in the conclusion, it is not the whole story because traders received monetary rewards for the results which they generated. Indeed, most good traders I have ever known may be susceptible to a bit of flattery but they were very clear-eyed about the monetary rewards flowing from the actions they were taking (economists on the other hand are suckers for flattery). Nonetheless, the paper does provide a neat insight into the statistical analysis of the risk-taking business.

But if you get the incentives wrong, the consequences can be catastrophic. During Mao’s Great Leap Forward in late-1950s China, the government aimed to transform a largely agrarian economy into an industrial powerhouse. But in the dash for modernisation too many resources were diverted away from farming, which resulted in a catastrophic collapse in agricultural output and a famine which killed at least 20 million people. One of the reasons why provincial governments continued with their disastrous policy, despite evidence that it was not working, was because Mao himself lavished great praise on those who followed his instructions.

It is often claimed that monetary incentives can distort the behaviour of firms, so that they follow policies which maximise the utility function of those receiving the incentives rather than the wider constituency of shareholders. There is a substantial amount of evidence to show that companies have pursued short-term policies to inflate share prices, which benefits senior management who are paid in stock options, but which tend to have serious adverse longer-term effects. But as the Chinese example shows, it is important to ensure that we align non-monetary incentive structures too, for they can potentially inflict even more damage.