CHAPTER 1
Incentives Matter

‘The theory of economics does not furnish a body of settled conclusions immediately applicable in policy. It is a method rather than a doctrine, an apparatus of mind, a technique of thinking which helps its possessor to draw correct conclusions.’

—John Maynard Keynes1

In early 1998, day care centres around Haifa, in Israel, had a problem. It was a problem common to many of us who have looked after children for a living: late parents.2 After a long day being responsible for other people's children, by 4pm the teachers were ready to go home. And they weren't being paid for staying any longer. But invariably some parents would be late, and someone would have to stay behind and wait with the child. But one day some social scientists turned up (or rather, sent their research assistants) and made a suggestion: why not fine the parents for being late? It is a solution any economist would give.

Over the next few weeks things carried on as normal, as the researchers gathered data before making any changes. Then, they adopted a policy where any parent who was more than 10 minutes late would pay a $3 fine. But instead of reducing lateness, the number of late pickups more than doubled. The incentive backfired.

As an economist, I've heard this example a lot. It's often used to show economists that assuming people's behaviour can be manipulated with financial incentives is naïve and narrow minded. Indeed there is some truth to this. Just because originally there was no fine doesn't mean that there was no incentive to be on time. The social norm is to be on time, and late parents probably felt guilty. Once the arrangement moved from the social to a financial realm, parents realised they could ‘buy’ the right to be late. Indeed they weren't just buying the right to be late, but also the ability to not feel guilty about it. In fact, maybe the lesson of the day care experiment is not that economists overstate their subject matter, but that non-economists understate it. After all, the average monthly cost was about $380. A good economist would suggest that the fine was set at a price that was too low! If the goal was to reduce lateness, raise the fine. And even more importantly, discovering the point at which the fine has an effect will help the day care centre to know just how valuable the parents consider their time to be. This whole experiment might help them to discover which opening hours best suit their customers. Clearly the parents are willing to pay the teachers to stay later. Far from demonstrating the failure of markets, this example is like a cursory foray into their magic.

We tend to think that economics is the study of the economy, and indeed this is an important application. But economics isn't a subject matter; it's a way of thinking. The essence of the economic way of thinking is to understand how incentives and institutions affect people's behaviour. In terms of management, economics can give us important clues about why behaviour may be generating bad outcomes. Understanding concepts such as opportunity cost, price elasticity and price discrimination are tools that managers can use to improve a company's performance. But economics does more than this. It provides us with a way of thinking about human action. Economics is the study of society, and the tools with which we understand social behaviour are of direct relevance to management.

1.1 MANAGERIAL INDIVIDUALISM

In their excellent textbook Managerial Economics, Luke Froeb and Brian McCann offer the following guide to decision making: when you see an outcome that you deem to be undesirable, ask yourself three questions:3

1. Who made the bad decision?
2. Did they have the information they needed?
3. Did they have the right incentives?

All too often the first question isn't even asked, and failure is put down to some collective problem that is ill defined and impossible to alter. The main insight of managerial economics is to focus on the information and incentive mechanisms that help guide decision making. If you do not even know who is making the bad decision, there's little hope of finding out why they did so. This book intends to explore the information channels and incentive mechanisms that create value. It will focus on how markets can be utilised to help solve these problems.

The reason why economists make individual choice the centre of analysis is because we posit that only individuals choose.4 This is not the same thing as saying that only individuals matter, or that ‘society’ is nothing more than a group of individuals. It stems from a concept called ‘methodological individualism’, which Jon Elster defines as ‘the doctrine that all social phenomena (their structure and their change) are in principle explicable only in terms of individuals – their properties, goals and beliefs’.5 We can talk about how ‘Heinz have decided to build a new factory’ but according to methodological individualism the literal interpretation that the company itself made the decision is false. Families, businesses and nations might have common interests and work together to achieve shared goals, but it is only as individuals that we make decisions. This doesn't imply that social phenomena aren't important. On the contrary, it is precisely because we wish to understand social phenomena that we see it through the lens of individual choice. We need to understand the preferences and constraints of individual members, to see how collective decisions get made, because social entities are the result of individual action.

This is why the first question – identifying the decision maker – is so important. It is only then that we can look into the circumstances in which the decision was made and what their objectives were. Economics helps to reveal the information and incentive systems within which we operate. The crucial point is that although these institutions influence our choices, we also have choices about how to shape them. In short there's a feedback mechanism between individuals and institutions, but with us in the driving seat. Institutions are, as John Commons defines them, ‘collective action in control, liberation and expansion of individual action’.6

In this book we will make two key behavioural assumptions:

1. The rationality assumption – incentives affect behaviour (at the margin)

   The idea that incentives matter seems obvious but is often counterintuitive. My brother-in-law enjoys adventure and on a recent skiing trip realised that he was travelling faster than 30mph. My parents were worried that he might hurt himself if he crashed, so they bought him a helmet. Guess what? The next day he promptly reached 58mph! All safety equipment has a curious potential to backfire, because it alters your incentives to take risks. Although helmets mean that you are less likely to be injured if you have an accident, they also affect the probability of having an accident in the first place. In the case of skiing a helmet reduces the cost of an accident. All else being equal, this makes you more willing to risk having one. This may not be a large effect, and perhaps if you wore a helmet you'd think that you'd be just as careful as without. But the helmet is incentivising you to be more reckless, not less. Not only this, but it can affect other people's behaviour. If you wear a helmet you also reduce the cost to other people of them crashing into you. At the margin, it could lead to more accidents.7

   Think of the difference between Rugby and American Football. Both are similar sports but one key difference is that the players of the latter wear helmets. Which one do you think has the most neck and spinal injuries? The obvious answer would be Rugby, because they don't wear hard protection.8 But because of this they face a higher cost of putting their head into a dangerous situation. Maybe they are less likely to enter tackles headfirst? Indeed not only do American Footballers face a higher rate of neck and head injuries, there are calls by some to ban helmets for this very reason.9 A 2013 book on the subject claimed that in 1999 the NFL paid compensation to retired players after accepting they had suffered brain damage.10 Since the year 2000 neurosurgeons have been warning the league that the sport was causing depression, dementia and brain damage.11

2. The self-interest assumption – people pursue their own self-interest

   Again, to economists this assumption is self-evident and trivial. Maybe we don't really know what other people's interests are. Either way, we put our own interests ahead of the interests of others. This does not imply that we are narrowly selfish. It doesn't mean that we're motivated by material possessions, or monetary gains. The welfare of your children, or colleagues, may be your primary goal. Your self-interest may well be altruistic. But it's what drives your economic decision making. As Gary Becker said,

   I have tried to pry economists away from narrow assumptions about self-interest. Behaviour is driven by a much richer set of values and preferences. Individuals maximise welfare as they conceive it, whether they be selfish, altruistic, loyal, spiteful, or...