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The Perils of Perverse Incentives

Thanks to Mary Poppins, every child born since the middle of the 20th Century knows full well that a spoonful of sugar helps the medicine go down. Such ‘sweeteners’ (both literal and metaphorical) are a part of everyday life. We use incentives in business, in education, in raising our kids to make things that might not seem immediately beneficial look all the more attractive.

So why should a sales team bend over backwards and put in maximum time and effort to sell a product? Because if they hit certain targets, they will trigger a nice juicy bonus. Why should the consumer buy that brand of baked beans and not the other? Because if they buy one, they get one free. And why should the child do their boring maths homework instead of playing outside? Because if they do, they will get some sweets.

The problem is, when we rely heavily on incentivisation, there is always a risk of it backfiring. People start to use little sweeteners automatically, without thinking through the consequences in the bigger picture. The child who gets sweets for completing every piece of homework (plus a spoonful of sugar with their medicine) gets fat. The company that relies too heavily on BOGOF deals finds no one buys their products when they are normal price anymore, expecting the deal.

Unintended consequences

These are examples of perverse incentives, where an scheme starts to have unintended and negative consequences which often work against the aims of the incentive in the first place.

The history of business and commerce is littered with examples of perverse incentives. When you scan through them, you start to notice a common thread that runs through many – financial inducements that become open to manipulation.

Owners of early Australian transportation ships were paid by the passenger, which incentivised them to pack people onboard like they would other goods. The overcrowding and squalid conditions this caused led to many unnecessary deaths. In more recent time, direct links have been made between the banking crisis of 2008 and bonus culture – investment bankers started to take greater and greater risks with other people’s money in pursuit of their own enormous incentives.

The issue in these examples as in many others is that the incentive itself starts to be seen as the goal by the people pursuing it, not the business or operational objective it is attached to. This is seen as one reason why the USA’s free market healthcare system, where doctors are effectively paid per diagnosis or per prescription, is so expensive and inefficient. The goal has become financial gain first, healthcare second. And this has led to some very high profile abuses, notably the Veterans Affairs health system scandal.

Take care what you incentivise

So money is one issue – if you dangle a cash carrot in front of people in business, you have to put safeguards in place to make sure they don’t find shortcuts to grabbing it. But another issue is the performance indicators we link incentives to. All too often it comes down to crude numbers. And as we all know, people are clever enough to make numbers tell whatever story they want.

There is a school of thought that the metrics we choose to measure success directly determine how people will go about achieving it. Get the metrics wrong, and moreover offer a reward for achieving those targets, and you have effectively incentivised people to operate in the wrong way. The way you have defined success itself is wrong.

In the convict transportation ship example, success should not have been measured by how many people set out from the UK ports, but how many people arrived safely. The measurements used created a perverse incentive. Take the example of the sales team who are incentivised according to how many items they sell. Are crude volumes the only way we measure business success? That is when people start to do and say all sorts to secure a sale, customer service disappears and a year down the line the company wonders why its reputation is in tatters.

There is nothing wrong with a little sugar to sweeten working life. But we should take care about where we apply it, lest people start reaching for the spoon all too often.