Behavioral Science

Are Perverse Incentives Affecting Your Small Business?

by . May 17th, 2013

During the early days of fossil hunting back in the Nineteenth Century, paleontologists realized that many of the “dragon bones” that were sold in Chinese markets were actually mineralized dinosaur bones. In a rush to gather as many of these bones as possible, paleontologists started paying Chinese peasants for every fragment they could gather.

Dinosaur Bones by e_walk via photopin cc

To their dismay they found that peasants were actually digging up the bones and smashing them into pieces to get the most profit from them, severely diminishing their scientific value. This incident has become a classic case study on perverse incentives, a phenomenon that has far-reaching consequences in all social interactions, including business.

You don’t need to be a psychologist to know that when anyone does something, there is usually a reason behind it, especially when it comes to sales and management. As entrepreneurs and managers, we try to figure out what incentives we’ll need to give customers and employees to get results we actually want. Problem is, we can’t always predict how people will react.

Missing The Bigger Picture

We’re always looking for ways to improve the performance of every aspect of our business, and for that we turn to metrics and quantifiable data as a way to measure performance. However, there are plenty of limitations to purely metrics-based assessments.  Data won’t always tell you the whole picture, as we discussed in a post we did for VentureBeat.

If you base decisions purely on metrics you’d come to think of as “good”, then you might be working towards results that won’t be of use to anyone – worse still if you reward efforts aimed at getting those results.

Data by r h via photopin cc

In the former USSR, managers and employees of glass plants were at one point given incentives based on tons of sheet glass produced per period. Naturally, almost all these plants produced sheet glass so thick you could barely see through them. Funnier still was what happened next – the incentives were changed so managers were rewarded by the square meter. Predictably, factories produced glass so thin the sheets couldn’t be used for anything.

Ask your social media team to focus on getting bigger jumps traffic, and you might be getting that traffic at the expense of actual conversions. Focus too much on acquiring new customers, and you might be alienating old customers who would have provided more value over their lifetimes. Focus too much on increasing times on site and you might find you’re producing  overly-lengthy types of content that isn’t actually useful to most visitors.

Here’s a more familiar example. Say you have multiple employees given the same task and the same amount of time to complete it. Let’s say someone finishes well ahead of time – and you immediately reward them with a bunch of other stuff to do. If this becomes a pattern, it’s very likely you’ll see that employee’s productivity taper off to closely match their coworkers.

Fixating on just individual metrics – be they dinosaur bone fragments, sales, site traffic, or whatever – without looking at the big picture and understanding how people will react, is a great way to get nowhere fast.

Self-interest 

Greedy Squirrel by CaptPiper via photopin cc

While there are numerous examples of altruism out there, your customers and employees will always be mostly acting out of self-interest. Customers and clients want to get something out of you. And while esprit de corps still counts for a lot, employees generally want to get paid. And just imagine how many people would get murdered or robbed if it weren’t illegal.

You’ve probably tried to game “the system” at some point in your life. For example, customers and a few unethical employees share exclusive coupon codes with people they aren’t intended for all the time, negatively impacting profit margins – even ruining some smaller companies.  We fully expect this and still give out coupons – in a controlled manner -because we’ve taken this into account in as much as we know how.

Just Following Orders

Milgram Experiment via commons.wikimedia.org

Maybe you want your employees to take the initiative and tell you if something’s up. But as the Milgram and Asch Conformity experiments tell us, the leadership still sets the tempo for whatever actions take place. As soon as someone takes else takes responsibility for your actions, you’re less likely to question anything and be more focused at the tasks at hand.

The diffusion of responsibility in business likely deserves its own post, but to sum it up, people in large groups will always tend to act differently from how individuals would alone, because no one will feel personally responsible for anything. This makes it much easier for unintended consequences to come about. No one thinks it’s their problem.

Milgram Experiment Will Lion via photopin cc

In the events leading up to the Subprime Mortgage Crisis of 2008, lending practices had deteriorated to the point that loans were being given out on the basis of nothing more than a credit score.

It would be hard to blame mortgage sales agents for anything that happened, but at the same time, it defies belief that they all didn’t think anything was at all screwy with what was happening even as they did what they did.

The same thing can even be argued about the victims of the crisis. It’s also doubtful that everyone who instigated the policies that caused this serious economic collapse would have willfully robbed someone at gunpoint, even though what they did had a likely worse effect on millions of families.

Hive by Chiswick Chap via commons.wikimedia.org

The sheer scale of the multitude of policies that created several perverse incentives at each and every single step of the Subprime Crisis. In any case, we could only say this thanks to the benefit of hindsight, and this might be rather dramatic compared to what can happen to your small business.

But these things do happen, and while we might think it’s all because of malice or some greater evil at work, it may very well mostly a function of sociology and group dynamics gone out of control.

What can be done?

Group by Éole via photopin cc

While you can’t always predict what people will do,  Here are a couple of things you might want to try:

  • Empathize! Familiarize yourself with the kind of work your employees or team members do. Doesn’t have to be in-depth, but you have to understand what the work involves not just professionally, but on a personal and mental level as well. Also detach yourself emotionally from your business and try to see how customers see you.
  • Keep teams small. Smaller, more intimate teams are more likely to take responsibility for their own actions
  • Create a culture of openness and curiosity. Easier said than done, but try to have an atmosphere where you are respected, not feared to encourage employees to give their honest feedback.
  • Trust people, but prepare for the worst. Be realistic about what kinds of weaknesses your employees and customers give in to, but try to be discreet about it. Showing you don’t trust anyone is good way to turn off everyone that matters.
Understanding the sometimes dramatic differences in group and individual human motivation is important when figuring out how things can go wrong. As managers and entrepreneurs, we should never forget that being a great leader likely relies less on technical aptitude, and more on knowing what people want.

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