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Incentives, Incentives, Incentives

Allen R. Sanderson*

"If incentives work so well, maybe there are ways to improve public sector outcomes through the application of these same 'incentives matter' principles."
In real estate, the oft-stated mantra for what determines a property's value is the familiar "location, location and location." In economics, the equivalent mantra is that "incentives matter." Individual households, private firms, and public office respond purposefully and predictably to incentives. (Or, in Adam Smith's language, "It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest.")

Thus, if we're dissatisfied with a particular activity or outcome, or want to modify some behavior, seeing the underlying incentives and finding a way to change them can often produce a more desirable result. And this might entail understanding who profits most, or suffers the consequences most directly, from one's actions, and how to (re)align the incentive structures.

For example, given that the Chicago Bears can sell out Soldier Field constantly, and the National Football League (NFL) shares its television revenues equally across members of the cartel, it is not surprising that the owner of the Bears is willing to do without a costly high-quality quarterback—payroll would rise but any effect on revenues would be shared with all the other teams. On the other side of town, as long as the Cubs can continue to pack Wrigley Field on a regular basis, the financial incentives to end their 100-year World Series drought are relatively modest.

Universities face similar situations: Once a faculty member has tenure, what exactly is his or her incentive to teach well, to be a good institutional citizen, and to remain on the cutting research edge of the discipline? Shame, conscience, peer pressure, and the love of one's field will ensure some modicum of productivity, but the threat of dismissal would likely be a stronger motivation to continue to perform well. Backed by a strong union that provides job security and resists merit pay, this is perhaps an even more pronounced problem with regard to K-12 public education and educators.

Restaurants are heavily dependent upon repeat business (and positive word of mouth) to remain solvent. Thus it's not surprising that by and large they go out of their way to satisfy and enlarge their customer base. This clientele is, after all, their principal source of revenue. Having servers' earning be somewhat dependent upon customer satisfaction, as reflected in the amount of tips, is one way to ensure that the objectives of the restaurant owner, diners, and wait-staff are in sync. (Non-profit organizations are less dependent upon "repeat business" or turnstile traffic for revenue, and thus they are more apt to serve other constituencies—wealthy donors or political special interests—instead. Thus one is more likely to observe programs and activities that cater to the whims of this elite clientele rather than what the typical visitor to a museum or the average supporter of a cause might prefer.)

Employee theft is a constant problem for many businesses, and they must go to some lengths to discourage and contain it. When monitoring is difficult or costly, incentive pay and group responsibility and rewards are two common methods employed. When firing workers is relatively easy, this is an effective third option. Being paid above and beyond what one could earn in another job and/or the risk of being fired for malfeasance are basically just two points along the incentive-disincentive spectrum.

In light of recent scandals involving steroids, Major League Baseball might want to think about instituting penalties for entire teams—and owners—when a player is convicted of violating the league's substance abuse policies, or when a team member commits a felony. It would give them an incentive to monitor more closely and to nip problems in the bud. The National Collegiate Athletic Association (NCAA) punishes universities by withholding financial streams or imposing constraints on intercollegiate activities, such as bowl or tournament eligibility, for infractions—falsifying transcripts, under-the-table payments to athletes—of its governing statutes. If they really wanted to fix the problem, perhaps our professional leagues could learn something from these eggheads.

In recent years, the Catholic Church has paid out billions of dollars to settle sexual abuse claims against priests. At least in this situation, parishioners have to pay in one way or another—the opportunity cost of these payouts and legal costs that could have gone toward worthier causes—for the sins of their spiritual advisers and employees, and thus presumably they have a personal stake in curtailing such activities in the future. However, Methodists and Mormons don't have to chip in from their own collection plates to transfer monies to Catholics for the costs of these claims against other members of the religion industry. If they did, one would expect more whistle-blowing and finger-pointing.

In other private, competitive markets, there are easy ways to punish "offenders": poor quality merchandise or service at Macy's can turn me into a Nordstrom's shopper; high-priced beverages at Starbucks and I sniff for the aroma of my local McDonald's or Dunkin' Donuts. If United doesn't treat me well in Terminal One at O'Hare, I can try American in Terminal Three—or Southwest at Midway airport.

The entry of Netflix into the home DVD rental market led almost immediately to lower prices and reduced (or zero) dollar penalties for late returns at Blockbuster, which then led to lower monthly subscription fees for Netflix customers. Ceteris paribus, airfares are lower for flyers using airports served by multiple carriers, and even United customers benefit from the presence of Southwest at the terminals even if personally they don't fly such discount carriers.

To the extent that Wal-Mart is able to enter a small-town or suburban market and bring more competitive prices and wages, this is all to the good. To the extent that it replaces one spatial monopoly with another, then neither shoppers nor workers are better off.

If incentives work so well, maybe there are ways to improve public sector outcomes through the application of these same "incentives matter" principles.

Law-enforcement officials obviously believe that disincentives affect citizens' behavior when it comes to where one leaves a car or how fast he or she drives it; fines are higher for more egregious parking or more serious traffic violations. But what if the shoe is on the other foot? How do we, as taxpayers, escape paying for incompetence and poor service in public spheres? How can we protect ourselves against cost-overruns in public projects, abuses by public officials, inattentive clerks in city, county and state offices, or poor quality (and maybe even dangerous) service in public transportation?

Periodic elections to remove scoundrels and change bad policies are undoubtedly inefficient and a poor substitute for being able to vote with our feet, and even the latter takes time to bring change on a large scale. Recall petitions—even just the threat of being able to exercise such an option—may offer one promising avenue to effect change. But how exactly does one find an alternative when it comes to first-class mail delivery, poor cable reception or connections from government-supported monopolies, or local public bus and train service? (USPS has undoubtedly had to improve its customer service to compete with FedEx, UPS and DHL for packages and express mail; the same could hold true for the last bastion of the mail monopoly—prohibitions against carrying regular letters.)

More generally, is there a way to think about these situations, including the recent, high-profile multi-million-dollar claims for police torture, shootings, and corruption in Chicago and other major metropolitan areas? Perhaps these court settlements should be paid for by docking the police pension funds instead of taxpayers' wallets. This is not a perfect scheme because an individual officer would still only pay a fraction of the cost of his or her behavior—the rest would be borne by fellow officers—but it would be a start. The larger issue is why taxpayers should foot the bill in the form of higher taxes or other public services that have to be postponed or downsized to pay for these illegal excesses?

What if jurors in our infamous Alabama, Mississippi and Illinois counties so well known to trial lawyers had to cover some—or all—of their proposed gargantuan settlements in class-action suits from their own and neighborhoods' pockets? They might be less inclined to treat these awards as "play money", and pay a little more attention to the law and less time trying to engage in vigilante attacks on major corporations.

At the Federal level, if Treasury Secretary Henry Paulson and Fed chairman Ben Bernanke were required to hold their entire wealth portfolios in the form of U.S. savings bonds, perhaps we'd see more balanced budgets and less inflation.

Not exactly an incentive per se, but implementing "truth in advertising" for proposed legislation in the public arenas might serve as a good complement to other methods. Far too often the electorate has no way to gauge the indirect costs or alternatives of public polices. Two contemporary cases, one micro and one macro, illustrate these defects and offer possible emendations.

With respect to the attempts to encourage the use of biofuels, the goals of reducing global warming and making us less-dependent upon foreign petroleum for our energy were certainly touted by officials and endorsed by the general public. But what if that legislation—akin to the warning labels on cigarettes or signs discouraging pregnant women from consuming alcohol—also had to carry an explicit warning label: "Enactment of this ethanol subsidy will very likely result in substantially higher prices for milk, eggs, cheese, beef, and tortillas." A "bread and butter" issue if there ever was one!

Or what if the recently enacted proposal to provide an economic stimulus (by doling out $168 billion in tax rebates) had attached to it: "Note: passage of this act will increase the government deficit by $168 billion, ultimately raise the national debt by the same amount, and will be financed by borrowing money from China and assorted other nations."

All citizens now in favor of increasing the price of foodstuffs and the federal government's budget deficit please raise your hands.

After that, we could find ways to garnish the wages, budgets or pension funds of public officials who are negligent and profligate with our tax dollars. Then we could move to presidential candidates who propose prosperity and progress without sacrifice or costs with outrageous schemes that would even make Santa Claus, the Easter Bunny, or the tooth fairy blush.


For more on incentives, see "Incentives Matter," by Russ Roberts, and more links at Incentives. On Econlib.

In sum, the challenge is not so much in "reinventing government" but in applying the same scrutiny and analyses—calculating marginal benefits and marginal costs, seeing the incentive structure, weighing the tradeoffs, and understanding the possible unintended consequences—in the public arenas as we do inside families and firms. Stockholders, who have a direct, personal stake in the financial performance of the business, and even Las Vegas bookies, who are intensely vigilant when it comes to spotting betting irregularities that point to a contest that may be rigged, serve societal interests well. The challenge is to find ways to translate these private-sector detection devices to the public sector. Or quite possibly we actually know how to do it but those in government can thwart us because, as the twist on the Golden Rule frames it, they who have the gold and want to keep it make the rules.

* Mr. Sanderson teaches economics at the University of Chicago.

For more articles by Allen R. Sanderson, see the Archive.
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