Incentives matter

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Much of what we see in the business and political worlds can be explained by incentives. When companies, politicians, and governments create the wrong incentives, bad things happen. Consider the following example at Uber as reported in Tuesday’s Wall Street Journal:

Unlike taxis, ride-hauling services like Uber charge fixed fares to passengers based primarily on the projected distance they will travel, not the actual distance they ride. Uber encourages drivers to take the most direct route, but they are compensated based on actual mileage, incentivizing them to take longer routes at company expense. Out-of-town passengers usually have no incentive to pay attention. The practice, known as longhauling, is clearly unethical. Nonetheless, company policy encourages it, creating what economists call a “perverse incentive.” We should not be surprised when this happens.

Of course, there is a logical reason for compensating drivers based on actual mileage. They know the conditions on the ground and should be free to select the best routes for their customers even if it means deviating from the route recommended by navigation. But this post is not about Uber’s policy; it’s about the role of incentives.

This type of incentive problem is not unique to Uber. When a company reimburses travel expenses without tight controls, employees are more likely to stay at expensive hotels and eat well while on the road. When a government employs a voluntary income tax, individuals are more likely to fudge on the numbers. When EMPTALA guarantees emergency room treatment regardless of one’s ability to pay, some Americans will not pass on health insurance, take their chances, and just ignore the bills if they get sick. The list of examples in business and government is endless. Empirical evidence helps us understand the scope of these problems after the fact, but many of them could have been minimized or avoided altogether by considering the incentives in advance.

Many of these incentive problems occur because policymakers assume that people will overlook a perverse incentive and “do the right thing.” I’m not a cynical person, but this is usually folly. Consider the 2008 financial crisis. Politicians blamed lenders for issuing questionable loans—which some did—but they were simply gaming the system government created.

When it comes to economic policy, bad incentives usually come from government intervention. Free markets promote their own incentives, usually healthy ones, with limited or no government oversight. Companies that deliver better products at lower prices are more likely to succeed, while those that do not serve their customers well will eventually fail. Well-intentioned government schemes designed to aid the poor, clean up the environment, or promote other social objectives usually limit customer choice and favor large companies that can afford the compliance costs.

Incentives matter.

3 Comments

3 Comments

  1. xman  •  Aug 15, 2018 @8:16 PM

    incentives are all that matter

  2. Chuckie  •  Aug 17, 2018 @11:03 AM

    Incentives matter but what can’t people just do the right thing. The USA was founded on individual freedom and responsibility. Be honest, help your neighbor, etc. even if you don’t have to..

  3. xman  •  Aug 17, 2018 @11:25 PM

    Hey Chuckie, it’s nice when it happens, but it usually doesn’t. Don’t give people an incentive to cheat the system.