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Newsletter: Incentives and its limits

(Volume 1, Issue 26)

Quote of the week

"The key is to keep company only with people who uplift you, whose presence calls forth your best." — Epictetus


Three recent articles

1. Zack Kanter discusses the exponential growth of Wal-Mart and Amazon by comparing and contrasting the algorithms Sam Walton and Jeff Bezos designed. Walton's success was due to a centrally controlled algorithm to provide customers a wide selection in stores at lowest prices. However, Amazon's success is due to a decentralized algorithm to provide customers a wide selection unbounded by four walls of a store, and to kill bureaucracy by converting internal cost-centers into external profit centers. How will Amazon control quality as it exponentially grows?

2. In the Foothills of Cold War, Vitaliy Kastelnelson takes an objective view of the potential outcomes of the US-China relationship, and asks what role defense companies have to play in the future.

3. Recently contemplating Nassim Taleb's Black Swan philosophy, the message in Frank Martin's article Will They Sow The Wind Reap The Whirlwind? is that the U.S. fate is a black swan outcome. With employment participation low, debt to GDP levels increasing, monetary policy increasingly ineffective, an unthinkable outcomes of the fiat currency could be in the winds ahead.


Topic of the week: Incentives and its limits

The "Reward and Punishment Superresponse Tendency" is the first stop in the journey we kicked-off several weeks ago to study biases (see Busting Biases newsletter).

Reward and Punishment Superresponse Tendency is about the power of incentives. Ben Franklin said, "If you would persuade, appeal to interests and not to reason." This applies in the workplace, with animals, in hiring agents, at home. To encourage employees to grow profit, pay them bonuses when profit grows. To encourage a pet dog to sit, reward it with a tasty treat when it sits. To encourage young student to develop strong study habits, reward her with a trip to the toy store for demonstrating strong study habits.

Get the incentives right and the job will get done...most of the time. The qualification "most of the time" is important. Taking incentives to its extreme can cause terrible behavior. For example, perfectly rational pursuit of incentives may cause bad conduct. Think of the accountant skewing the numbers to maximize profit to in turn maximize a bonus. So, as with anything, checks and balances are important, such as:

  • Internal audit systems

  • Punishment for bad conduct

  • Prevention techniques (education, training, controls, culture, etc.)

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