Understanding the power and limits of incentives

Two businessmen are talking to each other in a New Yorker cartoon by Tim O'Brien. Standing behind his big desk, smoking a cigar, one says, "Personally, I prefer the stick to the carrot. I tried threatening them with a carrot once, and it didn't work a damn." This made me think about incentives.

Many of us are motivated by incentives — a carrot being the most obvious. But we often miss the subtle for the obvious. Unless we try to understand why an incentive is working, we will look only at the result and be baffled by why it is often not repeatable. Worse, we will reward behavior that is different from what we sought.

Here is a simple example. You want your child to perform chores around the house, so you tie their allowance to work that they do. Carrot is cash, outcome is chores get done. But you just tied a payment to something in which all members of a household must participate to make things run. Now try to get that kid to do something else. How much is that worth to you? An incentive other than cash would be helping them understand how the work that they are doing removes it from someone else and appreciating them for it. They learn intrinsic rewards which is far better than pay to play.

Allowances are important teaching tools, but they should be about money management. If children want to earn more, then there may be a special project for which you can negotiate.

Another issue with cash incentives is that you are putting a dollar price on something for which there may be other, more valuable incentives. A client with a small company was discussing how much of a bonus she should pay for some extra work that one of her employees took on. Bonuses can cause some problems. Are you going to give a bonus every time the work is performed? Are you pricing the work in the same way that the person doing it thinks it's worth? Once the financial exchange has taken place, it is game over.

A good employer believes in reciprocity. The best employees are those who take on responsibility because they see a need for the work to be done and they derive satisfaction from meeting that need. An employer provides rewards in tangible and intangible ways. They identify the person as high potential, create a path for growth in the firm (which leads to higher compensation), and shares the success of the individual with other employees. With our client, we were trying to help her develop great employees, not simply pay for a task that was executed.

Every financial decision is ultimately about incentives. When your employer provides a match for your 401(k), they do so in part as an incentive for your participation. The government doesn't treat your contribution as income as an incentive for you to take some responsibility for your retirement. When you choose to fund your 401(k), your incentive is to create more money that you will spend tomorrow.

I was talking to a client who was struggling with layoffs that he would have to make after he bought an underperforming business. There was little likelihood that the business would have survived had he not stepped in, yet jobs will be lost. As an incentive for people to stay, he is offering them an opportunity to work at his other facility when he closes the old one. Several people will accept this offer, even if it means being dislocated from their current community. For those declining, the incentives were not enough for them to move. In a two-dimensional world, is the employer good for saving a foundering business or bad for moving it? The reality is that the world is not two-dimensional; decisions are not always right or wrong.

If we don't understand incentives, we can't comprehend charity. But one of our most compelling incentives is a need for congruity between our actions and our values. When we help someone, we feel better about ourselves — not because we are superior to them, but because we're more connected to them. We may also receive some societal incentives — recognition, for example — for charitable efforts, but regardless of the motivations, we are incented for the action.

While you may not actually threaten with carrots, to be effective, you want to know why people are motivated to make the choices that serve them best.