Part 1: When Incentives Fail. A Story about Rats, Cobras, Nails, and Atrocities.
Part 2: Avoiding Perverse Incentives
When a measure becomes a target, it ceases to be a good measure.
Perverse incentives are compensations with unintended or undesirable consequences that encourage people to act in unethical or harmful ways.
Telltale signs of perverse incentives might include:
- Having short-term vision over long-term goals. A business might hand out bonuses for meeting quarterly targets or profits at the expense of the business’s sustainability. Take the example of laws that provide tax breaks for companies that create jobs in economically disadvantaged areas. This incentive might lead to creating low–paying jobs with poor working conditions. Or consider government programs that provide financial bonuses to schools based on test scores. These rewards might create situations where schools focus more on improving test scores than providing a well-rounded education.
- Discouraging cooperation or collaboration. For example, a company that rewards individual performance over team performance. Rewarding team performance might also lead to overwork, burnout or high turnover if the rewards system doesn’t consider supporting team members’ well-being and professional development. Or imagine the case of a hospital that rewards the department with the lowest costs. Reducing costs becomes more important than offering high-quality patient care, which could lead to inadequate staffing support, unreliable but cheap medical supplies, rushed appointments, early discharge, or unsatisfactory follow-up care.
- Creating conflicts of interest. Financial advisors could receive commissions for recommending specific financial products to clients, putting the advisor’s economic gains and clients’ best interests at odds.
How to Fight against the Negative Consequences of Perverse Incentives?
Let’s consider a practical example: a company that wants to offer bonuses to employees who meet specific sales targets. The potential downside of such rewards is that employees could engage in aggressive sales tactics or cutthroat competition between co-workers.
One way to design this financial incentive is to devise a holistic approach by considering financial gains, high customer satisfaction ratings and team cooperation. Then, it might become necessary to adjust incentives by regularly reviewing and gathering feedback from clients and employees. If clients complain about high-pressure sales tactics, it would be more financially positive to focus on customer satisfaction than sales targets. This change of optics is highly dependent on the company and stakeholders’ mission and values, as more often than not, money talk.
To effectively challenge the negative consequences of incentives, it is crucial to involve a diverse group of people with different ages, backgrounds, experiences, needs, and perspectives to alleviate the potential biases or inequalities of the incentive’s design and implementation.
That means when proposing incentives for schools, we want to include all stakeholders, especially children, as they will be the most affected by those incentives. For example, a financial reward for schools with the lowest student absence rates sounds good. But why are children skipping school? Listening to children can bring to light blind spots: family problems, lack of engagement during school hours, feeling pressured to attend school even when children are unwell, and spreading infectious viruses, which could affect absenteeism rates. Struggling children might not attend school if they don’t have proper support from teachers or peers. Including children in these discussions promotes a sense of ownership and engagement as they become better equipped to understand the purpose of the social program and how to achieve its targets.
Ignoring or marginalizing social groups creates social policies that lack a larger perspective.
Here’s an example. When agricultural researchers want to improve a new rice seed, they often […] go talk to the farmers about the traits they want to see in an improved seed.
This is a great idea. But many of the researchers are men, and they often talk only to male farmers. The woman farmer very often isn’t part of the conversation because she is too busy on other tasks in the household, or because it’s culturally inappropriate for a male professional to speak with a woman, or because the researcher doesn’t realize how critical her input is.
The men buy it, and the women plant it, and then the women (who do most of the harvesting) see that the rice stalk grows too short, and they have to stoop over to harvest it. After a while, the women tell their husbands they want a taller plant that doesn’t break their backs during harvest. So the farmers don’t buy the seeds anymore, and a whole lot of time and money and research has been wasted that could have been saved if only someone had talked to the women. Both men and women prefer traits like high yield; obviously, they want to produce more crops if they can.
But because women’s jobs on the farm include harvesting and cooking, they also prefer rice varieties that grow to the right height and don’t take as long to cook. So the IRRI [International Rice Research Institute] researchers make a point of talking to men and women when they consult with farmers on the traits they want in the improved seeds.
Melinda French Gates – The Moment of Lift: How Empowering Women Changes the World
A possible framework to design an incentive could look like this:
- Gather input from all possible stakeholders, especially looking for categories that might be ignored. Honest discussions help identify potential unintended consequences. A third party, with no financial gains from incentives, could be included to serve as an objective monitor.
- Define the goals of the incentive clearly. Admit the possibility of unforeseen outcomes and hurtful feedback.
- Review and evaluate the program’s effectiveness regularly (possibly from a third unbiased party). This would allow for adjustments to be made. As I wrote in another article, When Incentives Fail. A Story about Rats, Cobras, Nails, and Atrocities, during the prisoners’ transportation from England to Australia towards the end of the 18th century, many convicts died, causing outrage to the public. Then, the government decided to pay a bonus for each convict that arrived in Australia alive, which led to more passengers surviving the harsh transport conditions.
- Transparency is crucial. Keeping stakeholders engaged and up to date at all stages is mandatory.
But what if we twist the perverse incentives problem like Alexander the Great did with his Gordian node? What if the solution to perverse incentives is there are no incentives at all?
The founder of the clothing brand Patagonia, Yvon Chouinard, announced in September 2022 the ownership transfer of Patagonia to the Patagonia Purpose Trust and the non-profit organization Holdfast Collective. As Chouinard wrote in his letter, titled Earth is now our only shareholder:
We needed to find a way to put more money into fighting the [environmental] crisis while keeping the company’s values intact.
One option was to sell Patagonia and donate all the money. But we couldn’t be sure a new owner would maintain our values or keep our team of people around the world employed.
Another path was to take the company public. What a disaster that would have been. Even public companies with good intentions are under too much pressure to create short-term gain at the expense of long-term vitality and responsibility.
Truth be told, there were no good options available. So, we created our own.
Patagonia Purpose Trust has 100% voting rights and makes business decisions. Its goal is to protect Patagonia’s mission which has a long history of ethical business decisions: social responsibility programs, taking care of employees’ welfare through medical insurance, subsidized, on-site child care or self-development programs.
After reinvesting in the business, all the profits from Patagonia are received by the Holdfast Collective, a non-profit organization dedicated to fighting the environmental crisis. Holdfast Collective owns 98% of the business, and Patagonia Purpose Trust holds 2%. The entity that takes the business decisions, Patagonia Purpose Trust, has no financial incentives to gain. The entity that uses the profits, Holdfast Collective, has no business deciding power.
This business setup is possible because Patagonia is a privately held company that doesn’t try to optimize profits for shareholders, as might be the case with publicly listed companies. Patagonia is worth about $3 billion and all the excess profit to be used by the Holdfast Collective is about $100 million annually.
“Our deeds determine us, as much as we determine our deeds.”
George Eliot
And it is the same with incentives: they shape initiatives as much as initiatives determine them, with severe consequences for individuals, organizations or whole societies if we let insidious incentives cloud our judgement.