Thursday, June 28, 2007

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.

No comments: