The power of incentives and their effects
An incentive motivates people to perform behaviour that they would not do without that incentive.
How do you deal with advice that seems to benefit the advisor?
Why do some companies offer their employees a financial incentive to leave?
Why is it important to frame incentives in the right way?
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In many situations, we want others to behave the way we want them to. We want children to keep their rooms clean, partners to share household chores equally, and colleagues to support and encourage each other. A powerful method to influence behaviour is to provide incentives. Besides incentives, other effective techniques to influence behaviour include liking, social proof, authority, reciprocity, consistency and scarcity.
An incentive is something that motivates people to engage in behaviour they would not perform without it. Incentives can take the form of rewards, such as salaries, monetary bonuses, promotions, public recognition, praise, social status, awards or airline miles. Conversely, disincentives are punishments or costs, like fines, social exclusion, late payment charges, taxes, or reprimands. People are drawn to behaviours that lead to rewards and avoid those that result in punishments. Incentives are like tools; they are not inherently good or bad; their value depends on how they are used.
Incentives send a signal to the people being incentivised about what's important, significantly impacting their interpretation of a situation and their resulting behaviour. Rewarding employees for positive customer feedback (quality) signals that a company values satisfied customers and high-quality service or products. Paying employees based on their production (quantity) signals that a company prioritises efficiency and productivity. For an incentive to be effective, it is crucial that its signals convey the right message.
Incentives shape people’s behaviour
Incentives are powerful tools that shape people’s behaviour.
👉 In a study, participants were divided into three groups and asked to recommend either option A or B to someone else. In the first group, option A was the most recommended. In the second group, where participants were offered a dollar to recommend option B, the majority recommended B. In the third group, participants initially chose between A and B without disclosing their choice. Afterwards, they were offered a dollar to recommend B. Most of them did. This indicates that they changed their minds and convinced themselves that B was the better option.
👉 Incentive-caused bias is our tendency to align our choices and behaviour with incentives that promise the greatest personal gain, often disregarding the greater good of others, our organisation, or society as a whole. This bias occurs when individuals prioritise their own interests or the interests of those providing the incentives, neglecting broader ethical, moral, or social considerations. For example, a pharmaceutical company executive might push to bring a drug to market despite knowing its harmful side effects, driven solely by the lucrative financial incentives tied to its sales, without regard for the potential harm caused to patients and society. Similarly, management consultants might consistently recommend more consulting services as the solution to every problem, and real estate agents may resort to unethical practices to rake in higher commissions. Always approach advice with caution, especially when it seems to benefit the adviser, and verify the information provided.
👉 The unscrupulous diner’s dilemma arises when a group of people agrees to split the bill equally at a restaurant before ordering. Each person can choose to order either a cheap or an expensive dish. The temptation to choose an expensive option is strong because the cost will be mostly covered by the others. Experiments in real restaurants showed that splitting the bill resulted in a much higher total bill compared to when everyone paid for their own meal. That may explain why restaurants often require large groups to split the bill.
👉 Incentives can be a powerful motivator for initiating new habits. Starting behaviours like going to the gym or adopting a healthier diet can be challenging. However, with repeated practice, these actions gradually become easier. Offering incentives for engaging in these behaviours, even for a short time, can serve as a stepping stone for habit formation.
Incentives can influence behaviour in unintended ways
It is crucial to create incentives that align with the desired behaviour to guide actions toward the intended outcomes.
👉 Innovation thrives on challenging assumptions, exploring new possibilities, pushing boundaries, and taking risks. Failures are an inherent part of the innovation process and provide invaluable lessons for future success. Companies dedicated to cultivating innovation must understand that punishing failures stifles creativity. Instead, they should celebrate failures and learn from them, creating a culture where employees feel empowered to take calculated risks. By aligning incentives with this attitude of exploration and learning, companies can stimulate creativity and sustain innovation.
👉 We expect politicians and top executives to balance short-term and long-term goals. However, politicians often prioritise short-term wins to secure re-election. This makes it difficult to initiate long-term projects with upfront costs and delayed benefits, as voters may not see the results before the next election. Similarly, top executives are usually rewarded based on quarterly company performance. Investing in long-term projects with substantial future benefits can negatively impact short-term financial results. This raises the question: Why would individuals prioritise long-term investments if they harm short-term performance?
For information about our general tendency to prefer immediate rewards at the expense of future rewards, see the blog post about present bias.
Incentives can shape how people perceive a situation
Incentives signal to people being incentivised what is most important. Altering perceptions through incentives can unintentionally encourage behaviour that contradicts the intended goals of the incentive.
👉 People donate money to charities for various reasons, such as wanting to positively influence the lives of others or to signal their personal values to themselves or others. However, offering small gifts like pens as tokens of appreciation for donations can actually reduce the amount people give. This is because these gifts can change the perception of the donation, making it seem like a transaction where money is exchanged for goods. In such cases, the value of the gift often does not justify the donation. Similar dynamics apply to individuals who donate blood.
👉 Families with school-age children must plan their holidays during designated school breaks. Unfortunately, these periods are usually the least ideal for holidays, as everything is busier, more expensive, and less pleasant. To save money and enjoy a more relaxed holiday, some parents take their children out of school a week before the official breaks. Most parents refrain from doing this because they feel a moral responsibility to adhere to the school schedule. In an effort to curb this behaviour, Welsh officials introduced a £60 fine. This changed parents' perspectives, shifting the issue from a moral responsibility to a cost-benefit analysis. Because they could save a significant amount of money by going on holiday earlier, many parents opted to pay the fine and go early. Some travel agencies even offered to cover the fines for them.
👉 At daycare centres, parents typically make a strong effort to pick up their children on time out of respect for the staff. One daycare decided to implement a small fine for parents who were more than 10 minutes late. Surprisingly, this led to more parents arriving late, and the trend continued even after the fine was abolished. The small fine signalled to parents that being late was not a big deal, and once this perception was established, it was difficult to change.
A bad incentive is worse than no incentive at all. Fines must be substantial to be effective, so it is better to introduce a significant fine or none at all. As more people engage in a certain behaviour, the social proof principle kicks in: our tendency to look at the actions or beliefs of others to determine what is appropriate.
Incentives can be manipulated and exploited
People excel at manipulating and exploiting incentives.
👉 During colonial times in Vietnam, French officials in Hanoi faced a significant problem with rats. To combat the issue, they offered monetary rewards to locals for every rat tail they submitted, aiming to decrease the rat population. However, this strategy backfired. Instead of killing the rats, people would merely cut off their tails and release them, enabling them to reproduce further. Some individuals even established rat farms with the sole purpose of harvesting their tails. Additionally, people from neighbouring towns brought rats to Hanoi just to cut off their tails. Instead of fixing the rat problem, this approach made it worse.
👉 In the 19th century, a team of scientists studying fossils at an excavation site in China enlisted the help of local farmers to locate fossils. To incentivise the farmers, the scientists offered payment for every piece of fossil they turned in. Surprisingly, the team received a much larger quantity of fragments than anticipated… because the farmers deliberately smashed the fossils they discovered into pieces to maximise their earnings.
Framing is (as always) crucial
The way an incentive is framed significantly influences people’s reactions. Individuals form judgements about the incentive’s creator based on its framing, as different frames convey different signals and stories.
👉 A cinema chain introduced variable pricing, making the popular middle seats more expensive while keeping the prices for the less popular front and side seats unchanged. Many people were upset, perceiving the new pricing as unfair and greedy, believing the cinema chain was just trying to profit more from the middle seats. This perception led to negative media publicity. To avoid this reaction, the cinema chain could have reframed the price increase as a discount. They could have explained that prices were rising due to inflation, but they were offering a discount for those willing to sit in the front or on the side. This approach would have positioned the company as considerate rather than greedy.
👉 In a similar case, Coca-Cola increased the prices of their cans in vending machines on hot days. This upset people, as they felt Coca-Cola was taking advantage of them during hot weather. A better approach would have been for Coca-Cola to explain that price increases were necessary, but that they would offer discounts on cold days.
👉 During the Covid pandemic, most office workers started working from home. After the pandemic, many companies asked their employees to return to the office three days a week. Employees were unhappy, feeling this change was a punishment. A better approach would have been to initially state that everyone would need to work in the office five days a week, but due to their strong performance during the pandemic, employees were rewarded with the option to work from home two days a week.
Know who pays for the product and who benefits from the incentive
The payer for the product or service may differ from the enjoyer of the incentive.
👉 Most airlines offer frequent flyer miles to encourage customer loyalty. Passengers earn miles based on the distance they fly and can redeem them for free flights or seat upgrades. This is particularly appealing to business travellers, as they accrue miles while their employer covers the ticket cost. Consequently, these travellers are incentivised to select flights that maximize their miles rather than simply choosing the cheapest options.
Incentives can reveal preferences
Incentives have the power to reveal preferences that might otherwise remain hidden, even to ourselves. Often we only really understand our preferences when we are faced with a decision.
👉 Employers prefer to retain only employees who are genuinely committed to their work, as they tend to be more productive. To achieve this, some employers offer an annual financial incentive for employees to voluntarily leave the company (‘pay to quit’). Those dissatisfied with their work are likely to accept the offer and leave on good terms. The deliberate decision to stay strengthens the commitment of the remaining employees through the consistency principle, making them even more motivated than before.
Incentives must be balanced
Focussing too much on one aspect can lead to unintended consequences or the neglect of other important factors. For example, if incentives emphasise quantity alone, quality may suffer, as the message conveyed is that only quantity matters. Achieving the right balance ensures that incentives effectively motivates the desired behaviour without causing negative outcomes in other areas.
👉 Paying drivers per ride in ride-hailing services like Uber or Bolt can negatively impact customers. This payment structure might prioritise speed over safety, as drivers could drive recklessly to complete more rides and earn more money. Additionally, drivers might focus on quantity over quality, potentially leading to less courteous behaviour and poorly maintained vehicles. To address this, ride-hailing services use a rating system where customers rate drivers from 1 to 5 stars and leave comments. This system incentivises drivers to prioritise the quality of their service as well.
👉 In many cases, determining whether surgery is necessary for back pain is challenging. Doctors who are not paid per operation can provide an objective opinion. However, doctors who are compensated per operation have an incentive to recommend surgery, whether they realise it or not. Hospitals where doctors are paid for back surgeries tend to perform more of them compared to hospitals where they are not. This also applies to caesarean sections and chemotherapy treatments. Although hospitals won't openly admit they aim to maximise profit per patient, paying doctors per operation clearly signals that profit is a priority.
Loss aversion can enhance the effectiveness of incentives
People tend to feel the pain of losing something more intensely than the pleasure of gaining the same thing (loss aversion). They are more motivated to avoid losses than to achieve gains.
👉 Bonuses are financial rewards given to motivate individuals to perform well or reach specific goals. Typically, bonuses are paid out after the agreed target is achieved. However, studies suggest that it may be more effective to pay out bonuses in advance, with the condition that they must be repaid if the target is not met. Repaying money already received is perceived as a loss. Since people work harder to avoid losses than to achieve gains, this approach can drive them to exert more effort to meet the target.
How to design effective incentives
Incentives can fail and even backfire, discouraging desired behaviours and leading to unintended consequences. A poorly designed incentive can be more harmful than none at all. To design effective incentives, follow the key steps outlined below. These steps provide a basic framework for this complex process.
1️⃣ Define the incentive program on paper
In this initial stage, a new incentive program is designed and crafted from scratch.
👉 Clearly state the objectives you want to achieve with the incentive program. Whether it's increasing sales, enhancing customer satisfaction, boosting productivity, or lifting employee morale, establishing precise objectives will guide the design process. What specific outcomes do you want to accomplish? What behaviours or actions do you seek to encourage or reinforce? How will you measure the success of the incentive program?
👉 Understand the needs, motivations, and preferences of your target audience, whether they're customers, employees, or partners. Recognise that individuals are motivated by various factors. What motivates them? What matters most to them? What shared values do they hold? What are their primary concerns, priorities, goals, aspirations, and challenges?
👉 Define an incentive structure that aligns with your objectives and resonates with the target audience. Will you choose monetary rewards or non-monetary alternatives such as recognition, privileges, or enriching experiences? Utilise existing knowledge about incentives to define effective ones. Consider factors such as the available budget, alignment with organisational values, communication strategy, appropriate incentive size (neither too small nor too large), clear and measurable criteria for earning the incentive, the signal the incentive sends, and the story it conveys about your organisational values. Could the incentive unintentionally upset or demotivate participants? Anticipate possible ways in which individuals might attempt to manipulate the incentive structure.
2️⃣ Test the designed incentive program in the real world
The second stage involves testing the newly designed incentive program in a real-world setting. This is crucial because predicting what will work in advance is challenging. Individuals are motivated by various factors, and strategies that succeed in one environment may not produce the same results elsewhere.
👉 Experiment with the incentive scheme in a controlled environment with a small group of participants. This allows you to test assumptions, gather constructive feedback, assess the program’s effectiveness, evaluate the potential for abuse, and identify areas for improvement. Clearly communicate the incentive program’s objectives, eligibility criteria, and rewards to all participants.
👉 Continuously monitor the trial results and refine the incentive program using insights from real-world observations, ensuring it is optimally tailored for broader adoption. Consider questions such as: What happened? What were the underlying reasons? How can we strengthen the incentive scheme? What anti-abuse features are required? Continue making adjustments until the desired effectiveness is achieved.
3️⃣ Roll out the improved incentive program
In the third and final phase, implement the improved incentive program using insights from the pilot test phase.
👉 Launch the incentive program to the target audience, accompanied by comprehensive training sessions. Introduce tracking and measurement systems to monitor participants' progress toward the incentive objectives. Provide extensive training and ongoing support to all stakeholders.
👉 Continuously assess the effectiveness of the incentive program in achieving its predefined objectives. Gather feedback from participants and stakeholders to identify areas needing refinement, and make necessary adjustments for subsequent iterations. Remain flexible and open to evolving the program in response to changing organisational needs, market conditions and other factors.
👉 Celebrate the achievements of participants who meet the incentive goals. Publicly recognise their efforts and contributions to reinforce positive behaviour and inspire others to strive for similar results.
By following these steps, you can design an incentive program that effectively motivates and rewards participants, drives desired outcomes, and contributes to overall success.
References
Mixed Signals, how incentives really work, Uri Gneezy
Poor Charlie’s Almanack, Charles T. Munger
Podcasts featuring Uri Gneezy
👉 Success 2.0: Getting What You Want, Hidden Brain, by Shankar Vedantam
👉 How To Understand Psychological Incentives - Uri Gneezy, Modern Wisdom, by Chris Williamson
👉 How incentives work (and why most backfire), Nudge, by Phill Agnew
👉 Why Amazon paid staff $5k to quit, Nudge, by Phill Agnew
👉 Mixed Signals with Uri Gneezy, Thinkers & Ideas, by Martin Reeves
