The Power of Incentives

Tanay Jaipuria
Jun 8, 2018 · 4 min read

I previously wrote about compound interest, which Einstein called the most powerful force in the universe. I think incentives are a strong contender for being the second most powerful force.

Incentives are something which motivates a person to perform a certain action. Therefore, the actions one takes is often in line with the incentives they have. Remembering this helps one understand why people behave the way they do.

One of my favourite examples which illustrates the power of incentives is the anecdote of Fedex popularized by Munger:

For FedEx to reliably have overnight delivery, they needed to shift all packages to the appropriate plane in one central location each night. FedEx tried everything but they had a hard time getting it to work — they were unable to shift all the packages. Then, someone realized they were paying the night shift workers by the hour. What if instead, they paid them by the shift, and let everyone go home when all packages were shifted. They tried it out and that system worked wonders.

Incentives Gone Wrong

Source: Berger & Wyse

Given that incentives shape peoples actions, setting the right incentives can help ensure the right behavior. But setting the wrong incentives can mean things can go very wrong.

Take what happened in Hanoi when the government tried to reduce the rat population.

In the early 1900s during the French rule of Vietnam, the rat population in Hanoi was out of control. The government started to offer a bounty to individuals that paid a reward for each rat killed. But to obtain the reward, all people had to do was provide the severed rat tail. Initially, it looked liked this was working, because a lot of bounties were claimed. But then officials noticed that there were rats in Hanoi without tails. Turns out the rat catchers would catch the rats, chop their tails off and release them so the rats could continue to procreate and produce rats there would be more rats and more potential revenue in the future for them.

There’s even a term for this — Cobra effect — which refers to when the proposed solution to a problem makes a problem worse. And it almost always happens because incentives go wrong.

Setting the Right Incentives

So how does one ensure they design the right incentive system so things don’t go wrong?

The first thing to note is that incentives don’t have to be financial rewards. They often are, especially in the class of problems where incentive design can influence the outcome, but they can also be moral incentives (“do the right thing”) or natural (such as curiosity or admiration).

Next, one should always place themselves in the position of the people for whom the incentive is being designed, and think about how they would act given this incentive.

Related to that it’s worth thinking about how someone might try to abuse or game the incentive system. Because with a large enough number of people, someone is bound to try.

The last thing to keep in mind is to always consider the second and third order effects of incentives and keep that in mind when designing them.

Going back to the rat example presented above, obviously requiring rat tails wasn’t the right idea. But what if they required the entire dead rat — that might work better right?

Well, that’s almost exactly what happened in India during the British rule when the government tried to control the cobra population. Turns out it didn’t work better.

The cobra population in Delhi was spiralling out of control and so the government offered a bounty for every dead cobra. This worked initially as a lot of cobras were killed for the bounty. But then, some enterprising people began to breed cobras for the income. The government eventually caught on to this and scrapped the bounty.

Guess what happened? The cobra-breeders set their now-worthless snakes free and the problem was even worse than before the bounty began.

All this to say that designing the right incentives systems is very difficult and there’s often no silver bullet.

Closing Thoughts

If you take away anything from this piece, I hope it is that incentives are powerful.

The next time you’re trying to get an individual or group to behave a certain way or drive towards a certain outcome, think through what incentives you can set to do so. But also think about how they may go wrong, which will help ensure you set the right ones.

And the next time you see someone do something which confuses you, put yourself in their position and think about what incentives they might have.

Incentives are so powerful that even after knowing how powerful they are you’ll likely underestimate them.

“I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. Never a year passes that I don’t get some surprise that pushes my limit a little farther.” — Charlie Munger

Thanks for reading! Feel free to share this post and write a response to share your thoughts. I’m tanayj on twitter if you want to discuss further!

Tanay Jaipuria

Written by

Product @Facebook. Previously @McKinsey. I like tech, econ, strategy and @Manutd. Views and banter my own.

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