When incentives go wrong

      A while back I reproduced that Steven Landsburg quote: “Most of economics can be summarised in four words. People respond to incentives. The rest is commentary.” I want to come back to that quote because it is very relevant to many things going on now. First it is necessary to define what we mean by incentive. Wikipedia states: In economics an incentive is any factor (financial or non-financial) that enables or motivates a particular course of action, or counts as a reason for preferring one choice to the alternatives. “It is an expectation that encourages people to behave in a certain way.” Incentives matter. They are often based on money but not always. When something gets more expensive, people buy less of it. When it gets less expensive, people buy more of it. This idea seems fairly straightforward but many people only pay lip service to it. One of my favourite examples of the role of incentives occurred in Britain in 1996 at the height of the mad cow crisis. Surely when people’s health is at stake, they are not going to respond to such crude incentives. The supermarket chain just couldn’t sell any beef and were forced to sell it at half price. Suddenly people couldn’t get enough beef in their trolleys. Of course not everyone changed their decision but enough people will change so that the overall effect is an important increase in demand. Likewise, if the price of petrol goes up, people will respond in different ways. Some will carry on as before, others will engage in car pooling and if the high price remains long enough some will buy a more fuel efficient car.

People do respond to incentives but actually designing them can prove to be a minefield; trying to predict all the myriad ways in which people will respond to them is not so easy. When talking about incentives it is also important to consider targets and the influence they exert both in the public and private sector. The big problem with setting targets is that they become an end in themselves at the expense of other objectives. This is an example of Goodhart’s law (The law was named after Charles Goodhart, a chief economic advisor at the Bank of England.). This states that any measure adopted as a target changes its meaning. Targets create particular incentives: what’s measured is what matters. This can have tragic consequences. 25 people lost some of their sight because managers at an eye hospital on meeting waiting time targets for new patients rather than following up existing patients. This accusation was made by Dr Richard Harrad, clinical director of the Bristol Eye Hospital. He gave one particularly horrific account:

One particularly sad case was that of an elderly lady who was completely deaf and relied upon signing and lip-reading for communication. She lives with her disabled husband who like her is completely deaf. Her follow-up appointment for glaucoma was delayed several times and during this time her glaucoma deteriorated and she became totally blind.” In a striking parallel of what has happened in the private sector, figures such as operation waiting times become subject to creative accounting.

There is another important theoretical framework that we need to take into account – what is known as the principal-agent problem. In a corporate context the shareholders are the principals and the managers are the agents. In politics the electors are the principals and the politicians are the agents. There  is a problem because there is incomplete and asymmetric information when a principal hires an agent to do something for him. Because the interest of each of the parties may not be aligned the principal has to use different mechanisms in order to get the agent to do what they want. The tool is often performance related pay such as stock options piece rates and commissions. This can be satisfactory if what you want is easy to measure. But you can get a situation where the managers pursue their own agenda and the last few years have shown it can be difficult to control them. One problem is that there may be a lot of small shareholders who have neither the time nor the inclination to control what the managers are doing. The same thing can happen in politics where voters may spend more time considering the pros and cons of buying a new computer than in deciding the best political option. The boards of directors, auditors regulators, supervisors, large shareholders, and the financial media were also unable to control what these managers were doing.

The question of incentives and the principal-agent problem are very important when trying to understand the current outcry over executive remuneration and the disastrous consequences for the banking sector. Alan Greenspan was in a state of shock last year: “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity are in a state of shocked disbelief.” If you want a simple answer the just say greed – put it all down to those avaricious bankers and investors. I do not find this explanation particularly satisfying. Of course people on Wall Street are greedy. They are, always have been and always will be greedy. The real problem is how that greed was channelled by the system of incentives that the banks had in place. The banks had to choose what incentives to offer their managers in order to get them to produce higher profits for the institution. Many of these policies which provided lavish remuneration for the bosses led to perverse incentives that made these bosses drive their companies into the ground.

Stock options show the danger of some incentives. On the surface what could be more logical than to reward those managers who create value for the shareholders. Of course raising the stock price can be done in two ways. You can, of course, genuinely make the company more profitable. Or if that sounds too much like hard work you can fabricate the accounting information to give the illusion of economic success, and create fictitious profits from an artificially inflated  share price. Then all you have to do is sell up before the truth comes out and the and the market capitalisation implodes. Once again we see how if you give an actor a target, you may well find that they will meet this target bit to the exclusion of every other goal.

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