Behavioral finance FAQ / Glossary (Incentive)

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Dates of related message(s) in the
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Year/month, d: developed / discussed,
i: incidental

(perverse) Incentive


04/11i + see perverse effect /
incentive,
moral hazard,

unintended consequence,
principal-agent, signal

Sticks and carrots. Are they always efficient?

Definition:

Incentives are key factors of behavior, are usually a
system
of rewards / penalties
, carrots and sticks (yes, greed and
fear
, see those words, play a part).

For example, specific incentives linked to performance are given to
people to  motivate them to strive to reach some results.

It can be just a direct cut they are paid when reaching those results,
for example :

* a direct percentage of sales, of profits...

* or an amount linked to the difference between those results and
   predetermined standards or objectives.

It is then one of the tools of the "management by objectives".

Economic incentives


Obviously, money enters largely in the package of goodies (and sometimes
punitions) used as incentives.

This makes incentives an important field of behavioral economics.
In some cases they even raise crucial issues:

For example, bank traders bonuses are much debated as they are often
seen  to have been a factor in the "subprime crisis" by inciting those
traders to make highly risky operations in a massive way.

= >With this exemple we enter the field of "perverse incentives"

  In what incentives are useful

Candies for angel-like behavior?


Generally, incentives are seen as necessary to reach
individual and collective goals
.

Governments offer some tax incentives (targeted deductions) to
    foster some economic, cultural or humanitarian goals

They are a tool in human resource management as stimuli for the
    staff..

Also they are used to monitor executives as a way to limit the
    "principal-agent problem
"
(see that phrase).

Are there drawbacks?

Weapons for devil-like behavior?

Those incentives can have perverse effects (see the related glossary article)
in the form of unintended and counterproductive results or side effects, as:

They can verge on manipulation, even deception,

They can be based on the wrong goals, even on destructive ones

(for example they could entice to take wild risks, or to put the
chase for fast results before the needed attention to long term
outcomes, which are essential for the organisation's survival).

Therefore they might give the wrong signals, thus make
people neglect other crucial goals or risks
.

Also they can create loopholes and moral hazards .

("cooking the books" or using other opportunist / cheating tricks
that boost the figures...)

They are not always effective in reaching the objective which
    is set. An excessive stress can even be counterproductive.

Also if they are reached it can be a matter of chance not related  
    to the efforts fostered by those incentives.

More insidiously, their relevancy can dwindle as people

start to manipulate statistics (see Goodhart law) or even
cook the accounts
.

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This page last update: 07/09/15  

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