Saturday, January 24, 2009

Incentives are dangerous?

Incentives are dangerous, and not just because people game them. They often yield collateral damage. Remember the tale of the Darwin Award winner who strapped a jet engine to his car, dreaming of a joyride for the ages, and then met his sorry end as a human flapjack on the side of a mountain? Incentives are like that jet engine. There's no question the engine will take you somewhere, fast, but it's not always clear where. Or what you're going to mow down on the way. Yet incentives are still the first resort of most managers, perhaps because they all think they're smart enough to create the perfect carrot.

Take Merrill Lynch. In the book Riding the Bull, author Paul Stiles describes his experience as a new trader at the venerable investment bank. Merrill wanted Stiles, then 29, to trade complex international bonds in volatile markets. He tried asking advice of the seasoned traders, but they ignored him -- a minute spent helping Stiles was a minute spent not adding to their monthly bonuses. They kept barking into their phones for hours at a time and yelled at Stiles every time his shadow fell across their computer screens. Eventually, Stiles was reduced to silently observing their behavior from a distance, like a rogue MBA anthropologist. It surely never dawned on the person who set up Merrill Lynch's incentive system that the traders' bonuses would make training new employees impossible.

Why are we so bad at anticipating the effects of our well-intentioned incentive plans? The answer has to do with something that psychologists call a "focusing illusion." Behavioral economist Daniel Kahneman and management professor David Schkade surveyed Midwestern students and asked them to predict the satisfaction of students in California on several dimensions, such as "job prospects," "climate," "personal safety," and overall life satisfaction. They also asked the Midwesterners to rate their own satisfaction. The professors then posed the same questions to actual California students and compared the answers. The Midwest students correctly predicted that the Californians would be happier about their weather.

But the Midwestern students wrongly predicted that California students would be happier with their lives in general than Midwestern students. The overall scores are identical. Schkade and Kahneman showed that, in essence, the Midwestern students erred by focusing too much on a single variable. When you're a Midwesterner contemplating a long, cold winter, you can't help but think that Californians must be happier. But you're ignoring the larger happiness portfolio, in which weather recedes to insignificance among the other things that may influence a Californian's satisfaction -- good friends, terrible traffic, career opportunities, laundry, and a governor who compulsively repeats Terminator jokes.

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