Incentives and Mental Accounting

As part of my current research, I am thinking about how firms could utilize what behavioral economists have learned in order to design better incentive systems. The following passage is often at the forefront of my mind for some reason:

"Another violation of fungibility introduced by the budgeting system occurs because some budgets are intentionally set 'too low' in order to help deal with particularly insidious self-control problems. For example, consider the dilemma of a couple who enjoy drinking a bottle of wine with dinner. The might decide that they can afford to spend only $10 a night on wine and so limit their purchases to wines that cost $10 a bottle on average, with no bottle costing more than $20. This policy might not be optimal in the sense that an occasional $30 bottle of champagne would be worth more than $30 to them, but they don't trust themselves to resist the temptation to increase their wine budget unreasonably if they break the $20 barrier. An implication is that this couple would greatly enjoy gifts of wine that are above their usual budget constraint. This analysis is precisely the opposite of the usual economic advice (which says that a gift in kind can be at best as good as a gift of cash, and then only if it were something that the recipient would have bought anyway). Instead the mental accounting analysis suggests that the best gifts are somewhat more luxurious than the recipient normally buys, consistent with the conentional advice (of non-economists), which is to buy people something they wouldn't buy for themselves.

The idea that luxurious gifts can be better than cash is well known to those who design sales compensation schemes. When sales contests are run, the prize is usually a trip or luxury durable rather than cash. Perhaps the most vivid example of this practice is the experience of the National Football League in getting players to show up at the annual Pro Bowl. This all-star game is held the week after the Super Bowl and for years the league had trouble getting all of the superstar players to come. Monetary incentives were little inducement to players with seven-figure salaries. This problem was largely solved by moving the game to Hawaii and and including two frst-class tickets (one for the player's wife or girlfriend) and accommodations for all the players."

--Richard Thaler, "Mental Accounting Matters"

The Pro Bowl example really is one of my favorites, but I wonder how it could be translated into a more commonplace setting- after all, I don't think that professional football players count as the representative employee. Rather than give every employee a large reward, the sales managers have usually taken the tactic of giving a single large reward to the winner of a sales competition. While I agree that this can be a stronger incentive than giving a cash prize to the winner, I am not convinced that this sort of a compensation scheme is motivating for everyone. In order for this system to work as (likely) intended, everyone would have to believe throughout the entire touranment period that they have a chance of winning if they try hard enough. I find it more realistic that the lower-performing people don't even try to win at all, or that the lower-ranked employees stop trying after they realize that they are out of contention. My hypothesis is even more unfortunate if the goal of the competition in the first place is to get the low performers' rear ends in gear.

Now that I've thought about what probably is less than optimal, I need to spend some time thinking about what could be better...and then of course try to establish empirically that my option is better. My thinking leads me to a paper by Karla Hoff and Priyanka Pandey that shows that individuals' reponses to incentives depend on their beliefs about themselves and others, and also that this performance can be affected by introducing a random component in reward payoff. (This point about the random draw is not the main focus of the paper, but it is what got my attention for future work. The paper itself is very interesting and has implications for other issues, such as forced integration of schools, which the Supreme Court made a hot button issue in the last few days.)

My hypothesis is that the following incentive scheme would dominate the alternatives discussed: the ultimate reward for the tournament will be a non-cash luxury gift that could be (reasonably) easily traded for cash if one so desired. However, the workers will receive a piece rate in the form of raffle tickets for the reward. Obviously, this runs into problems if workers are overly risk-averse, but I think the benefits of the scheme would outweigh the risk-aversion drawback. Why do I believe this? My simple answer is to look at how well state lotteries do in terms of revenue, all for an outcome with a negative expected value and roughly 50% tax rate.

I couldn't resist...

I know all about the sterotype of the acedemic holed away in the ivory tower, but I thought for a long time that academics at professional schools did not fit this model. I am no longer convinced of this (no judgment), so I found the following cartoon in the WSJ pretty amusing:

But I thought economists were against price floors...

Today the U.S. Supreme Court blocked a 96-year-old ban on price floors. To be specific, these price floors are not imposed by the government, but rather by manufacturers and distributors. These organizations are now not automatically excluded from being able to set minimum prices to retailers.

I am puzzled by this on several levels. First, weren't manufacturers just getting around this anyway by requiring retailers to abide by a "minimum advertised price"? (Anyone that has shopped on a web site that said "Price too low to display" or "We'll show you the price when you put the item in the cart" knows what I'm talking about.) Second, don't price price floors generally lead to allocative and technical inefficiency and deadweight loss? I thought for a bit that I was just being a silly economist when I read this part of the article:

"The Bush administration, along with economists of the Chicago school, had argued that the blanket prohibition against resale price maintenance agreements was archaic and counterproductive because, they said, some resale price agreements actually promote competition.

For example, they said, such agreements can make it easier for a new producer by assuring retailers that they will be able to recoup their investments in helping to market the product. And they said some distributors could be unfairly harmed by others — like Internet-based retailers — that could offer discounts because they would not be incurring the expenses of providing product demonstrations and other specialized consumer services."

Um...okay. (Clearly I don't sound convinced, but I'm also not one that gets a lot of value from product demonstrations and sales pitches.) I'm trying to get my head around this argument...I'll keep you posted...

Can You Say Externality?

Further proof that economics is everywhere...an article in today's WSJ (available for 7 days) entitled "Prosperity's Pitfall: Why Indian Lions Are Dying in Wells" explains that:

"India's Asiatic lions, an important tourist draw and a powerful symbol of the nation, keep falling into open wells as more lions and more farmers compete for the same small patch of land."

Now, as one who likes lions, I find this to be a bit sad. As an economist, I see the lions as a positive externality that should be internalized. I find it interesting that even a Wall Street Journal article doesn't use this terminology and stays at the level of "dead lions are bad, since lions are valuable" without speaking to any potential policy implications.

Blog Updates

Hi all,

So I have made a few changes to the blog. I don't remember all of them, but here are the highlights:

1. New title- suggested by a friend who is cooler than I am, so I figured I should take his advice
2. Anonymous comments now allowed
3. Ping sending now enabled

Happy reading!

Jodi

Those tall smart people could really get screwed...

Greg Mankiw notes in his research that taxing height is not such a bad idea from an economic perspective. After all, tall people are given an unearned advantage in life, right? (For those of you that aren't convinced, a friend of mine told me about a study where, in a mating sense, the compensating differential needed for 6 inches of lost height was found to be about $140,000 in income. Sheesh.)

A NYT article last week discussed findings that first-born children have, on average, IQs about 3 points higher than other people. (For those of you that are curious, the difference is atributed to nurture rather than nature, which is weird since I didn't think that IQ was sensitive to environment.) Does this mean that taxing first-born children would also make sense economically? I think the excerpt from the article, reprinted below, helps make the case:

Three points on an I.Q. test may not sound like much. But experts say it can be a tipping point for some people — the difference between a high B average and a low A, for instance. That, in turn, can have a cumulative effect that could mean the difference between admission to an elite private liberal-arts college and a less exclusive public one.

The OR People Win Again...

When I was a Masters student at MIT, I studied Operations Research...you know, queueing theory and the shortest paths problem and such. Around this time, I started to get annoyed (mainly on principle) at the people running the checkouts at the CVS in Porter Square. (Perhaps this indicates a pathological condition on my part, but hear me out.) One day I went into this CVS and saw a sign above the checkouts asking people to form separate lines in front of each register. In addition, this sign specifically pointed out that the goal of the proposed system was to provide faster service. As one who has though a lot about these types of problems, I knew that the stated goal couldn't possibly be achieved. Apparently Whole Foods got my telepathic memo.

Whole Foods has decided to implement a single-line policy in its Manhattan stores, which is in contrast to the typical one line per register setup. This has, not surprisingly to me, resulted in shorter wait times for customers and greater equity. (Wow, a time where efficiency and equity are not at odds, at least not for customers.) Think about it- with one line, you never have to worry about whether you picked a "good" line, you wouldn't be held up by the guy in front of you with 100 coupons, and you would never get upset that the guy that entered the line next to yours 2 minutes after you got in line is now happily walking away with his groceries while you are still standing in line.

Theoretically, this is great- why didn't companies think to do this sooner? My guess is that they probably did but were afraid that they would upset customers. Why? There is a tendency for people to believe that a wait is longer than it actually is when they see a very long line. This psychological phenomenon would lead people in the single long line to either perceive the store experience to be more unpleasant or to balk altogether and leave without a purchase. This congitive bias leads to the persistence of an inefficient setup, since consumers are largely incorrect in this case about what will make them happiest...in other words, a Pareto improvement could be achieved if the consumers' biases could be reduced or eliminated.

Update: Apprently I'm not the only one that finds this interesting...Tyler Cowan has a post on his web site about the economic relevance of supermarket lines as well (on which I made an ass of myself trying to post a comment, but that is another story). Economists are already looking at supermarkets- Alex Mas and Enrico Moretti, for example, have a paper that gives evidence in the supermarket realm that workers are positively impacted in terms of speed and productivity by having more productive co-workers around. I am curious as to whether there is also a productivity impact of seeing more people in line. That said, I am not going to try to guess whether a cashier would work faster if she saw a long line or just get frustrated and register a productivity decrease.

Libertarian Paternalism???!! What the...

A very astute-seeming reader of this blog asked me, as a behavioral economist, about my take on libertarian paternalism. Now, I taught an economics tutorial entitled "Sex, Drugs and Rock & Roll", where we discussed risky behaviors and various takes on the libertarian viewpoint. Nonetheless, this concept is (was) foreign to me, and in literal terms doesn't even seem to make sense. The nice people who contribute to Wikipedia, however, inform me that "soft paternalism, also referred to as libertarian paternalism, is a political philosophy that believes the state can 'help you make the choices you would make for yourself—if only you had the strength of will and the sharpness of mind'". Okay, so far so good, though I'm not convinced that the state knows how a perfectly rational me would behave.

Now, for my take on the matter. Let's take a person that smokes crack as an example. This person may be
a. Behaving perfectly rationally, but his discounting of future happiness is so large that he is willing to sacrifice a lot of long-term happiness for the immediate high
b. Behaving in a time-inconsistent (or state-inconsistent) way such that after he smokes some crack he's going to look back and really wish that he had made a different choice
c. Be unaware of the true costs and benefits of smoking crack (note that this can apply to both rational and time-inconsistent people)
d. Not considering costs and benefits at all, since some hard drugs can actually suppress the areas of the brain that analyze those tradeoffs

Now, consider that the aim of policy in general is to maximize social welfare. I would then argue that situations b and d could warrant some paternalistic intervention, since those crack smokers will almost certainly be thankful later. Choice c seems to call for some sort of education initiative. And choice a...well, that guy is just somebody that I can't relate to, but he seems to be doing okay for himself. A policy gets very tricky here because an outside observer, and perhaps the people themselves, cannot distinguish between possibilities a-d, so there would have to be a blanket rule that raises some people's long-run utility (b,d) through limiting choices and lowers that of others (a and potentially c). Do the benefits to the winners outweigh the costs to the losers? I at least think that this is the relevant question to consider.

I found the paternalism argument curious in general, since it is often a hard sell, and much of the justification for intervention can be made through an externalities argument as well. For example, I would be much more behind the government outlawing crack because of what it can do to children, both before and after birth, since children cannot choose who their parents are and presumably are not in the market for crack themselves.

Addendum: I added a comment to the Marginal Revolution post that initially started this discussion. Basically, one of the arguments being made was regarding paternalism for poor people since they are more prone to "irrational" choices. A colleague of mine did experiments on this very topic (paper source is given in the comment), and he finds that it is cognitve ability that drives biases, not specifically level of wealth. So even if somebody was into peternalism for those that can't help themselves, targeting poor people isn't the way to go. Also, when behavioral economists hear about increased choice being utility-decreasing, they usually think of bounded rationality issues rather than self-control ones.

Addendum #2: Apparently the Australian government doesn't have qualms about being selectively paternalistic.

I Blame Freakonomics...

An article from today's WSJ: (available for 7 days)

The Baby-Name Business
Parents are feeling intense pressure to pick names that set their kids apart. Some are even hiring consultants. Alexandra Alter on the art of 'branding' your newborn.

Scary. I'm all for my (hypotheical) kids not getting beat up on the playground, but this is ridiculous.

An Economist's Dream Nowadays...

...is often to find clever instrumental variables in order to take advantage of what the social sciences like to call "natural experiments". The basic rationale is that an economist (or other social scientist) doesn't always have the luxury of running a controlled experiment in the real world as, say, a physicist would in the laboratory. However, in order to reach a valid conclusion, the economist must be able to identify a control and a treatment group, or have some form of exogenous (meaning coming from outside the system in question) variation in order to be able to identify cause and effect rather than just correlation.

The best general interest description of this topic (in my opinion) has come on February 27 in the Wall Street Journal in an article titled "Is an Economist Qualified To Solve Puzzle of Autism?". (Apologies that the link will only be functional for 7 days.) The article mentions several examples of natural experiments, and I will go through the autism one here. Researchers have found that children that watch more television have higher rates of autism. Many people would jump to the conclusion that television watching in fact causes autism, which is not only incorrect logically but also runs counter to biological knowledge. The general problem in evaluating this cause and effect is that television watching is generally a choice variable, and it could be the case that either autistic children just like watching TV more or there is an outside force that results in both autism and desire for TV watching. A scientist could tease out cause and effect here by doing a large-scale study where children in the control group got no television and children in the experimental group had to watch TV all day. In addition to being potentially prohibitively expensive, this plan also suffers from various ethical issues. This is where economists come in. The economist basically says "gee, it would be really nice if there was an outside factor that randomly placed children into low TV and high TV groups so that I could measure the difference in outcomes that result." This is exactly what an instrumental variable is. In the autism case, the instrument used is rainfall. The amount of rainfall within a region is fairly difficult to predict ahead of time, so families are not likely to be making decisions of where to live based on this information. That said, children in areas that turn out to be rainer are likely to be inside more, and thus likely to be watching more television. If the economist can show this link, and he can also show that kids in rainer areas have higher rates of autism, then there is fairly convincing evidence that there is a causal link between TV watching and autism. (Full disclosure: biologists are very up in arms over this conclusion, since autism is considered to be a hereditary rather than an environmental condition. The burden is also on the economist to rule out other potential explanations- for example, as pointed out in the article, one could also reach the probably erroneous conclusion that carrying an umbrella causes autism.)

So why am I bringing this up now? An article in today's NYT talks about variation in medical treatment by ZIP code. Since people likely don't choose the specific ZIP code to live in based on the potential medical care available (especially since an earlier article argued that high cost did not correlate with high quality), it seems like there is potential for ZIP code to be used as an instrument for...something. (It is also important to note here that the authors are careful to point out that cost is not correlated with rates of illness or cost of living.) For what? I'm not sure yet, but it's interesting to think about. Suggestions welcome.

I will follow up with another post relating to the economics of specific points in the article.

Moral vs. Monetary Incentives

A few people that (thankfully) actually read what I write have asked why I specifically mention the potential effects of "insultingly small" monetary incentives. In general, I make the point that a small monetary incentive can crowd out an intrinsic moral incentive. I am careful to limit this assertion to small incentives, since economic research has shown this to be empirically true only on a small scale. This doesn't mean that there is evidence that a large monetary incentive doesn't crowd out a moral incentive, it just means that the large incentives haven't been tested, probably due to resource (or fairness) constraints. Consider the following example:

Gneezy and Rustichini (2000, JLS) performed a field experiment with 10 day care centers in Haifa, Israel. These day care centers were having problems with parents picking up their children late, which (to me at least) is not surprising since there was no specific penalty for doing so. In order to combat this problem, the day care centers instituted a fine of 10 Shekels per child if a parent arrived more than 10 minutes late. Economic theory would obviously suggest that, since the price of picking up a child late has increased, there would be less of that activity. However, what the researchers saw was that more, rather than fewer, parents started picking up their children late. It is also important to note that this higher level of tardiness persisted even after the fine was taken away (at least for the period that the researchers observed.) The authors of the study make the claim that this evidence is consistent with the crowding-out of the original moral incentive.

The authors of this study are careful to point out that the fine is "relatively small but not insignificant". They go on to mention, for example, that an illegal parking fine is 75 Shekels, and the failure to pick up dog droppings results in a fine of 360 Shekels. (I know, I know, I just coldn't resist adding that one in.) Furthermore, a baby-sitter earns between 15 and 20 Shekels per hour. My hypothesis is that the economically expected behavior would have been observed had the fine been larger. The parents likely took the fine as an approximation of the inconvenience to the teachers, and may have realized that they were previously overestimating the inconvenience to others.

As a side note, I really like the signs in Vermont that say "DUI: You Can't Afford It". Most states post signs giving specific dollar amounts for various offenses, but I think that the fear of the unknown is a much better incentive, if for no other reason than it prevents people from making an explicit cost/benefit comparison.

For a more thorough treatment of the crowding out effect, see here. (Note that the authors of this site describe a "significant monetary fine" in the day care example, which I feel implies the fine to be larger than it actually is.)

Another Blog Shout Out...

Dan Gilbert is a psychology professor at Harvard and the author of Stumbling on Happiness. As a behavioral economist, I found this book to be very interesting- economists generally take for granted that people know what will make them happy (or give them utility, in econ speak), and this is the very notion that Gilbert is trying to dispel. I've included a link to his blog, which is generally on topics (loosely) related to the book, in the list to the right. Happy reading!

A surprisingly entertaining time sink...

http://implicit.harvard.edu

This site has tests of subconscious racial and cultural association...apparently I have a predisposition to associate Asian-Americans more strongly with being American than European-Americans...overall, what I take from this is that Stephen Colbert would not be impressed with my patriotism.

(Side note: this actually is economically relevant- discrimination, whether explicit or implicit, is an important topic in the field.)

Sour Grapes?

An article today in the NYT states that a number of (for the most part) liberal arts colleges are no longer going to participate in U.S. News and World Report's annual college rankings. Furthermore, the consortium of these schools has plans in the works to come up with their own ranking system.

At first, I applauded the desire to not be subjected to arbitrary outside judgment. For example, I once taught two sections of Principles of Microeconomics (not at Harvard) with exactly 49 students each. I thought this was a little bizarre, and when I inquired I was told that things were done this way because U.S. News and World Report has a category for the number of classes with fewer than 50 students. (As a sidenote, I doubt the students would have had a less positive educational experience had there been 98 students in one class. I do believe that there are some subjects and courses in which a smaller class with a discussion format is specifically desirable, but introductory microeconomics is not one of those courses.) Therefore, at least in some cases, the rankings result in inefficiency due to the fact that they cause nonproductive effort to be exerted on things like arbitrarily reducing class size. I would have to guess that this is not the only area that results in inefficient use of resources, and I am trying to think of a way to analyze rigorously the degree to which the rankings alter the priorities of schools and whether the changes are productive or unproductive.

However, the more I thought about this, the less positive I was toward the decision. First, wouldn't any ranking system that was designed by schools that, for whatever reason, found it not optimal to participate in the current system be inherently biased in favor of these schools? U.S. News can at least say that it is an independent entity with little incentive to favor any school or set of schools. I would certainly take the results of any in-house ranking system with a grain of salt. Second, isn't all publicity good publicity? Maybe I am not representative, but if I were using the U.S. News rankings as a guide, I would either fail to realize that a non-mentioned school existed at all or conclude (being on the losing side of asymmetric information) that the school refused to participate because it wouldn't have ranked well anyway. (So much for "no news is good news".) My assumption regarding a non-mentioned school's quality would likely be worse than what an actual ranking would have indicated. If potential students are like me, then refusal to participate doesn't appear to be optimal, though it may give the school administrators some utility from being able to issue a "so there".

Apparently (but not shockingly) I am not representative. Alex Brown, Colin Camerer and Dan Lovallo have done research that shows that "cold opening" a movie (i.e. not showing it to critics before it is released) can, for some types of movies, increase box office revenue (compared to a counterfactual of a reviewed movie with similar attributes). Economic theory would suggest that if a movie is not reviewed prior to opening, there must be a reason, since the review generates publicity for the movie if nothing else. Therefore, iterated thinking would lead an individual to believe that any cold-opened movie was a lemon and would stay away. However, this type of iterated thinking doesn't seem to always happen in the real world, and it seems that in some cases providing no information can be preferable to providing negative information. I suppose we'll have to see how those liberal arts colleges do in coming years.

The Principal-(Principal-Agent) Problem

Standard incentive theory talks a lot about the principal-agent problem. The general idea is that you have a manager (principal) and an employee (agent). The principal wants the agent to exert the "correct" level of effort, but the principal can only observe the output of the agent and cannot see directly the level of effort exerted. Furthermore, there is some noise in the process such that the level of effort cannot be recovered from the output. The solution to the problem is generally to offer an incentive scheme that is a function of the agent's output. This serves to better align the objectives of the principal and the agent.

None of this is anything new. BUT, coming back to the teacher incentives issue, there seems to be something other than the standard principal-agent problem at hand. School boards, principals and presumably society want students to perform well. Clearly, students would be the agents in this situation. However, there is not (currently) a direct link between the aforementioned principals and the students. Instead, there are teachers in the middle. Therefore, Greg Mankiw's question about who should be given incentives within this framework is an interesting one. In other words, are teachers agents, principals, or both? Are school boards principals for only the teachers or also directly to students? I believe that it is important to answer these questions before even addressing what teacher outcomes should be rewarded.

In standard incentive theory, an incentive in place is designed to induce effort, not quality, at least in the short-run. (One could argue that in the long-run the incentive would induce quality as well due to employee sorting.) Clearly, effort is what needs to be induced from students. (Even if students need to build human capital/quality, effort is the defining component here since there is no sorting of students.) With teachers, however, is it effort or quality that needs to be induced? In other words, do teachers simply need to try harder, or do they specifically need to build their human capital? This distinction is important when trying to design the appropriate incentive scheme. Furthermore, a reward based on student performance is a largely useless incentive unless teachers know specifically what they can do in order to generate more successful students.

My hunch is that Greg is onto something with the suggestion that both teachers and students should be given incentives. Anecdotally, a lot of the failures in the current academic system are in situations with high-quality teachers and unmotivated students or motivated students with less than hard-working and/or unqualified teachers. If this is true, then neither teacher nor student motivation is sufficient in itself, and there are large complementarities at play. (Full disclosure: it is my strong belief that educators should be exactly that and should not be expected to take on roles of social worker, motivational speaker and the like. There should be a division of labor where other employees perform these more motivational tasks, and the teacher's motivational responsibility is to make the material clear and interesting.) Offering incentives to students (theoretically) will induce effort, especially if this is augmented with non-teacher motivational help. (More on this later.) Offering incentives to teachers will...do something, though no one seems to be sure what. If I were a teacher that was to be compensated on student outcomes, I would offer to share some of my surplus with my students. That said, it's easy to see why these issues are still open to debate.

Listen up ladies...

Back in my undergraduate days, I studied theoretical computer science...you know, algorithms and such. I have to admit that I don't use most of what I learned, and much of it is in fact very fuzzy by now. That said, there are random concepts that come forth as still being relevant. For example, market design has become an increasingly popular topic in economics, and what better market to study than the dating market? Consider the following algorithm:

First, a definition...a stable match is an assignment where there are no rogue couples, i.e. that no individual has another person that they like better than their current mate that also likes them better than the person they are with. Intuitively, we could say that there isn't going to be any adultery or something like that.
Now, the process:
1. Each male and female comes up with a rank ordering of all of the members of the opposite sex. (This matching becomes more complicated if we consider same sex couples.)
2. Each day, the girls go out and stand on the balconies of their apartments. Each guy goes and stands beneath the balcony of the girl that he likes best that hasn't rejected him yet. (In other words, the guys work progressively down their lists until they don't get rejected any more.)
3. The girls take a look at the guys below their balconies, and each picks the highest ranked one and tells him to come back the next day (which by construction he will). She rejects all of the other guys.
4. This process repeats. If there are an equal number of men and women, the process will repeat until each girl has exactly one guy at her balcony, and she will marry that guy.

This process results in a stable matching of partners. Now, this seems great for the girls, right? Not quite...
Another definiton: a person's realm of possibility is the set of people that the person could be paired with in a stable matching.
Not surprisingly, each guy gets matched with the highest ranked girl in his realm of possibility, since he just works his way down the list in order. In technical terms, the resulting matching is optimal for guys. However, the matching is also pessimal for girls! Furthermore, girls (but not guys) could do better by lying about their preferences. So the algorithm is also not strategy-proof for the girls.

Clearly, the context of this algorithm could be extended to college admissions, medical resident matches, etc. Nevertheless, it is an important less to you ladies out there to not just sit there and wait for guys to come to your balcony!

For a more rigorous treatment, see here.

I find it interesting that this algorithm assumes that men and women have perfect information about all the members of the opposite sex and that their preferences don't change over time. What would happen if these assumptions were relaxed? Stay tuned, perhaps...

Why all the fuss about teacher incentives?

There is yet another article about merit-based pay for teachers in today's NYT (Titled "Long Reviled, Merit Pay Gains Among Teachers" if you are so interested). As an economist who likes to read about incentives, I really don't understand why people are so opposed to these ideas. (Full disclosure: both of my parents are high school teachers.) Okay, maybe I do understand, I just don't agree with those people. It seems to me that there are two different types of incentives being considered- the first being a traditional merit-based pay system, and the second being a form of compensation for doing a job that others don't want to do. From an economic perspective, the latter type of incentive promotes labor force sorting and efficiency (the technical term is compensating differentials, and explains for example why garbage men make more money than others with comparable levels of education and skill).

Think about the following situation: there is an overall pool of teachers of varying abilities and subject knowledge. If we consider these teachers to all be part of the same supply of labor (and hence with the same wage for a given level of tenure and education), then basically what will happen is that the most able teachers will be able to get the cushiest jobs in the easiest subjects in the best schools, since they will likely be the ones with the best resumes and the most impressive interviews. This of course assumes that all teachers want these "best" jobs- there may be some quite good teachers that are specfically looking for a challenge, but I would bet that that is the exception, not the rule. Therefore, what ends up happening is that the less appealing schools and subjects get lower quality teachers, since they get what is left over once the better teachers have accepted positions. This problem is even worsened when the "better" school districts can afford to pay more money for teachers (think Scarsdale, NY and their $90K teachers). Presumably this is not what policy makers want to have happen. If they instead want the mix of teachers to be roughly equivalent across schools and subjects (and perhaps even have the "worse" schools and subjects have better educators), then they have to provide a mechanism for shifting the preferences of teachers. The most straightforward mechanism is a monetary incentive scheme, and it is easy to see why this works. While teachers would likely agree about which schools (and perhaps even subjects) are better, they likely differ in their assessments of "how much better". In other words, the teachers differ in how much they must be compensated to go to a worse school or teach a worse subject. Now let's consider an incentive of $10K per year to go teach drafting in an inner-city school. (This could be accomplished either by raising the drafting wage, lowering the non-drafting wage, or a combination fo the two.) Those good teachers that place a high value on teaching English Lit at a grade-A school would not consider this incentive enough to change their preferences, but the incentive would change the preferences of those who were less insensitive to subject or location- they would gladly take the money in exchange for the more difficult school and subject. Now we have at least some good teachers at both types of school in different subjects, which is what we were looking for. (I am not ignoring the point that an English Lit teacher can't just go and teach drafting, but the incentives not only work to alter the choices of current teachers, they also serve to influence the choice to become qualified to teach drafting in the first place. This is a concept often overlooked with incentives.)

Hopefully the argument makes sense up to this point. So why is there all the fuss, even on this issue? One explanation is that this sort of incentive is socially unacceptable. Teaching has long been seen as a "calling", and thus it is considered a bit uncouth to care about monetary compensation too much. Furthermore, well-meaning programs like Teach for America have served to strengthen this idea, almost likening the teaching profession to a volunteer position with the Peace Corps or something. I think this is a mistake that needs to be corrected- teachers are educated professionals with a specific job to do and they should be treated as such, both in terms of compensation and working conditions. The "teaching as a calling" argument largely serves to justify low wages for a very skilled group of people and potentially makes people feel guilty about leaving the profession, or guilts them into entering the profession in the first place. That said, there is a moral incentive at play here, and economists have shown in some cases that a small monetary incentive actually decreases performance due to the crowding out of the moral incentive. My solution? Don't make the monetary incentive insultingly small. :)

I will come back later and talk about the Pay for Performance issue, since I think that there is much to be said on that front as well.

If you are bored with me...(aka a shameless shout out)

...you should check out Greg Mankiw's blog. Greg is an economics professor at Harvard, and he posts on a lot of topics related to introductory economics (he also teaches the intro course). It's a very interesting collection of blurbs and usually gets good comments as well.

http://gregmankiw.blogspot.com

Long time no see...

As you can see, I had good intentions for this blog but never really got it off the ground. However, I am now going to try for real, and hopefully you will stay with me. One of the reasons this blog got ignored was that I was publishing content on more targeted blogs- for different courses, for students that work for me, etc. These individual blogs are listed below if you are so interested:

• Ec10 Helpful Hints (Note: this is useful for all students studying introductory economics)
  
• Organizations, Management Behavior and Economics
  
• International Corporate Governance
  

Enjoy!