Sunday, April 4, 2010

Freakonomics: Chapter 1

Charlie Munger says the most important rule in management is "Get the incentives right". Munger argues that the power of incentives is constantly underestimated. In Freakonomics, Steven Levitt shows us how pervasive incentives are in society, and what we can learn from that. Value investors who can grasp the power of incentives put themselves in a position to understand which companies are utilizing the full potential of their managements.

It is not easy to design incentive schemes, because the underlying behaviour such schemes encourage are more complex than they originally appear. Levitt argues that there are three types of incentives: economic, social, and moral. A scheme designed to provide an economic incentive can often cause havoc with the social and moral incentives, resulting in a surprising outcome.

Consider an experiment done at a daycare where parents would often pick up their children late. A small fine was instituted in order to discourage late pick-ups. The daycare expected on-time pickups to rise, but instead, the opposite happened, and late pick-ups soared! Levitt argues that this is because the economic incentive did not compare to the counteracting moral incentive that was now removed: with the fine, parents were implicitly told that it was okay to pick up their children late, as long as they paid the fine. When the fine was removed, late pick-ups did not drop back to their original levels. Now, parents no longer felt guilty about late pick-ups, as the moral incentive had been removed.

Would a larger fine have caused the economic incentive to be larger than the moral one it failed to substitute? Perhaps, but economic incentives that are too strong often have other unintended effects.

Cheating is an economic act: getting more for less. Levitt discusses a few examples where cheating has occurred because the economic incentives were so strong. He discusses data grabbed from school boards that appears to show teachers were actually changing student responses on standardized tests, as teachers whose students performed well were often awarded large bonuses.

Would massive option and bonus payments cause Wall Street executives to cheat? Obviously, we all respond to incentives, both negative and positive. If you touch a hot stove, you get burned. If you speed, you receive a fine. These are just two examples of every day occurrences that shape our behaviour as a result of the pain or rewards we receive in response to an act we commit. But sometimes incentives are so complex that they can result in unintended behaviour (including cheating, and a removal of other incentives) that can offset the intended benefits!

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