Incentives: The Failure & The Fix
Curiosity Chronicle
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The McNamara Fallacy and the Six Pillars of Incentive Design
Cobra heads, nail-quantifier weight, employee turnover and new account openings were all victims of the McNamara fallacy. The reliance on vanity metrics that will impress superiors or the public is a recipe for disaster in incentive design. So with these in mind, let's craft a better framework for incentives. Incentives involves six key pillars: Objectives, Metrics, Anti-metrics, Stakes and effects, clarity and fluidity.
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Today at a Glance:
Incentives are everything—an uber-powerful force governing our interactions, organizations, and society.
Unfortunately, humans are astonishingly bad at establishing incentives—we consistently create systems that invite manipulation and unintended consequences.
The framework for better incentives involves six key pillars: Objectives, Metrics, Anti-Metrics, Stakes & Effects, Skin in the Game, and Clarity & Fluidity.
Incentives: The Failure & The Fix
“Show me the incentive and I will show you the outcome.” — Charlie Munger
Incentives are everything—an uber-powerful force governing our interactions, organizations, and society.
Well-designed incentives have the power to create great outcomes; poorly-designed incentives have the power to…well…create terrible outcomes.
Unfortunately, humans are astonishingly bad at establishing incentives—we consistently create systems that invite manipulation and unintended consequences. More often than not, we wind up in the poorly-designed camp scrambling for answers and quick fixes.
Let’s change that…
In today’s piece, I will share a framework for establishing incentives (that actually create desired outcomes).
Incentives: The Failure
Let’s start with a basic definition of incentives:
Incentives are anything that motivates, inspires, or drives an individual to act in a specific manner. They come in two forms: intrinsic and extrinsic.
Intrinsic incentives are internal—created by self-interest or desire. Extrinsic incentives are external—created by outside factors, typically a reward (positive incentive) or punishment (negative incentive).
For today, we'll be focusing on extrinsic incentives…
In a (very) simple model, extrinsic incentives involve two key components:
Measure: The metric that the individual or group will be judged upon. The measure can be quantitative (KPIs, metrics, etc.) or qualitative.
Target: The level of the measure at which a reward or punishment will be initiated. The target can be specific (you receive your incentive if the KPI hits X level) or general (you receive your incentive if your manager is satisfied with your work).
But there is a real problem here. This simple model of incentives—which will feel familiar if you have ever worked in the government, a large organization, or anywhere really—often leads to undesirable outcomes and unintended consequences.
Goodhart’s Law
Goodhart’s Law is quite simple: When a measure becomes a target, it ceases to be a good measure. If a measure of performance becomes a stated goal, humans tend to optimize for it, regardless of any associated consequences. The measure loses its value as a measure!
Goodhart’s Law is named after British economist Charles Goodhart, who referenced the concept in a 1975 article on British monetary policy.
“Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” — Charles Goodhart
But the concept was popularized by anthropologist Marilyn Strathern. In a 1997 paper, she generalized the thinking and called it Goodhart’s Law.
“When a measure becomes a target, it ceases to be a good measure.” — Marilyn Strathern
It became a mental model with considerable practical relevance—a phenomenon that has been observed time and again throughout history.
Let's look at a few examples and use them to build a mental model for where incentives go awry.
The Cobra Effect
There were too many cobras in India. The British colonists—worried about the impact of these deadly creatures—started offering bounties for cobra heads.
Locals excitedly began breeding cobras, chopping off their heads, and turning them in to earn the bounties. When the breeding got out of hand, some of the breeders were forced to release the cobras onto the streets, thereby increasing the population of cobras.
Clearly not what the British had in mind…
The British viewed cobra heads as a simple way to measure cobra elimination, so it gave the population an incentive to deliver cobra heads. The result? Locals gamed the system, breeding cobras to earn the bounties.
An incentive designed to reduce the cobra population actually increased it!
Soviet Nails
In order to meet their ambitious goals, the Soviets needed to produce more nails to fuel their industrial complex.
First, Soviet factories established incentives based on the number of nails produced. What happened? The workers produced thousands of tiny nails.
Nevertheless, they persisted, adjusting the incentives to be based on the weight of nails produced. That should fix the tiny nails problem! What happened? The workers produced a few massive nails.
In both cases, the nails were useless.
The Soviet factory managers had viewed nail quantity and nail weight as easy ways to measure production, so they gave their workers incentives based on these measures. The result? A bunch of useless nails.
Amazon's "Hire-to-Fire" Issue
Amazon believed employee turnover was healthy—from the early days, they had created a culture where the bottom 10% should be scrubbed annually in order to continue to upgrade the talent level of the organization.
To incentivize healthy employee turnover rates, it gave its managers a target rate for annual turnover.
The result? Media articles about a “hire-to-fire” practice emerged. Managers had allegedly hired employees they planned to fire in order to meet their turnover targets.
Clearly not what Jeff Bezos had in mind...
Wells Fargo Account Openings
Wells Fargo is a new inductee of the Unintended Consequences Hall of Fame. An instant classic.
Senior leadership of the bank viewed new account openings as an easy way to track business growth, so it gave its junior employees target account opening goals. Employees would be pushed to hit these goals or risk punishment.
The result? Employees opened millions of fake accounts to hit their targets and Wells Fargo was fined billions for the fraud.
Today’s newsletter is brought to you by Tegus!
Tegus has been a complete game changer for my research and learning process. Tegus is the leading platform for primary research—it offers a searchable database of thousands of instantly-available, investor-led interviews with experts on a wide range of industries, companies, and topics. It’s fast and cost-effective, enabling you to do great primary research without breaking the bank.
Special Offer: Tegus is offering a free 2-week trial to all Curiosity Chronicle subscribers—sign up below to level up your research game today!
Today at a Glance:
Incentives are everything—an uber-powerful force governing our interactions, organizations, and society.
Unfortunately, humans are astonishingly bad at establishing incentives—we consistently create systems that invite manipulation and unintended consequences.
The framework for better incentives involves six key pillars: Objectives, Metrics, Anti-Metrics, Stakes & Effects, Skin in the Game, and Clarity & Fluidity.
Incentives: The Failure & The Fix
“Show me the incentive and I will show you the outcome.” — Charlie Munger
Incentives are everything—an uber-powerful force governing our interactions, organizations, and society.
Well-designed incentives have the power to create great outcomes; poorly-designed incentives have the power to…well…create terrible outcomes.
Unfortunately, humans are astonishingly bad at establishing incentives—we consistently create systems that invite manipulation and unintended consequences. More often than not, we wind up in the poorly-designed camp scrambling for answers and quick fixes.
Let’s change that…
In today’s piece, I will share a framework for establishing incentives (that actually create desired outcomes).
Incentives: The Failure
Let’s start with a basic definition of incentives:
Incentives are anything that motivates, inspires, or drives an individual to act in a specific manner. They come in two forms: intrinsic and extrinsic.
Intrinsic incentives are internal—created by self-interest or desire. Extrinsic incentives are external—created by outside factors, typically a reward (positive incentive) or punishment (negative incentive).
For today, we'll be focusing on extrinsic incentives…
In a (very) simple model, extrinsic incentives involve two key components:
Measure: The metric that the individual or group will be judged upon. The measure can be quantitative (KPIs, metrics, etc.) or qualitative.
Target: The level of the measure at which a reward or punishment will be initiated. The target can be specific (you receive your incentive if the KPI hits X level) or general (you receive your incentive if your manager is satisfied with your work).
But there is a real problem here. This simple model of incentives—which will feel familiar if you have ever worked in the government, a large organization, or anywhere really—often leads to undesirable outcomes and unintended consequences.
Goodhart’s Law
Goodhart’s Law is quite simple: When a measure becomes a target, it ceases to be a good measure. If a measure of performance becomes a stated goal, humans tend to optimize for it, regardless of any associated consequences. The measure loses its value as a measure!
Goodhart’s Law is named after British economist Charles Goodhart, who referenced the concept in a 1975 article on British monetary policy.
“Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” — Charles Goodhart
But the concept was popularized by anthropologist Marilyn Strathern. In a 1997 paper, she generalized the thinking and called it Goodhart’s Law.
“When a measure becomes a target, it ceases to be a good measure.” — Marilyn Strathern
It became a mental model with considerable practical relevance—a phenomenon that has been observed time and again throughout history.
Let's look at a few examples and use them to build a mental model for where incentives go awry.
The Cobra Effect
There were too many cobras in India. The British colonists—worried about the impact of these deadly creatures—started offering bounties for cobra heads.
Locals excitedly began breeding cobras, chopping off their heads, and turning them in to earn the bounties. When the breeding got out of hand, some of the breeders were forced to release the cobras onto the streets, thereby increasing the population of cobras.
Clearly not what the British had in mind…
The British viewed cobra heads as a simple way to measure cobra elimination, so it gave the population an incentive to deliver cobra heads. The result? Locals gamed the system, breeding cobras to earn the bounties.
An incentive designed to reduce the cobra population actually increased it!
Soviet Nails
In order to meet their ambitious goals, the Soviets needed to produce more nails to fuel their industrial complex.
First, Soviet factories established incentives based on the number of nails produced. What happened? The workers produced thousands of tiny nails.
Nevertheless, they persisted, adjusting the incentives to be based on the weight of nails produced. That should fix the tiny nails problem! What happened? The workers produced a few massive nails.
In both cases, the nails were useless.
The Soviet factory managers had viewed nail quantity and nail weight as easy ways to measure production, so they gave their workers incentives based on these measures. The result? A bunch of useless nails.
Amazon's "Hire-to-Fire" Issue
Amazon believed employee turnover was healthy—from the early days, they had created a culture where the bottom 10% should be scrubbed annually in order to continue to upgrade the talent level of the organization.
To incentivize healthy employee turnover rates, it gave its managers a target rate for annual turnover.
The result? Media articles about a “hire-to-fire” practice emerged. Managers had allegedly hired employees they planned to fire in order to meet their turnover targets.
Clearly not what Jeff Bezos had in mind...
Wells Fargo Account Openings
Wells Fargo is a new inductee of the Unintended Consequences Hall of Fame. An instant classic.
Senior leadership of the bank viewed new account openings as an easy way to track business growth, so it gave its junior employees target account opening goals. Employees would be pushed to hit these goals or risk punishment.
The result? Employees opened millions of fake accounts to hit their targets and Wells Fargo was fined billions for the fraud.
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