Incentive
Encyclopedia
In economics
and sociology
, an incentive is any factor (financial or non-financial) that enables or motivates a particular course of action, or counts as a reason for preferring one choice to the alternatives. It is an expectation that encourages people to behave in a certain way. Since human beings are purposeful creatures, the study of incentive structures is central to the study of all economic activity (both in terms of individual decision-making and in terms of co-operation and competition
within a larger institutional structure). Economic analysis, then, of the differences between societies (and between different organizations within a society) largely amounts to characterizing the differences in incentive structures faced by individuals involved in these collective efforts. Ultimately, incentives aim to provide value for money and contribute to organizational success.
divides incentives into four broad classes:
(There is another common usage in which incentive is contrasted with coercion
, as when economic moralists contrast incentive-driven work—such as entrepreneurship
, employment
, or volunteering motivated by remunerative, moral, or personal incentives—with coerced work—such as slavery
or serf
dom, where work is motivated by the threat or use of violence. In this usage, the category of "coercive incentives" is excluded. For the purposes of this article, however, "incentive" is used in the broader sense defined above.)
society, for example, economic prosperity and social esteem are often closely intertwined; and when the people in a culture tend to admire those who are economically successful, or to view those who are not with a certain amount of contempt (see also: classism
, Protestant work ethic
), the prospect of (for example) getting or losing a job carries not only the obvious remunerative incentives (in terms of the effect on the pocketbook) but also substantial moral incentives (such as honor and respect from others for those who hold down steady work, and disapproval or even humiliation for those who don't or can't).
and sociology
. A classic example of the economic analysis of incentive structures is the famous Walras
ian chart of supply and demand
curves: economic theory predicts that the market will tend to move towards the equilibrium
price because everyone in the market has a remunerative incentive to do so: by lowering a price formerly set above the equilibrium a firm can attract more customers and make more money; by raising a price formerly set below the equilibrium a customer is more able to obtain the good or service that she wants in the quantity she desires.
A strong incentive is one that accomplishes the stated goal. If the goal is to maximize production, then a strong incentive will be one that encourages workers to produce goods at full capacity. A weak incentive is any incentive below this level.
Incentives help people to make the right decision, or the one one would like them to make. To accomplish things you want done in economics you must give the consumer or the producer incentives, with out them they would have no reason to do what you ask.
Incentives can be used in several contexts. For example, policymakers in the United States used a quid pro quo incentive when some of the U.S. incumbent local telephone companies were allowed to enter long distance markets only if they first cooperated in opening their local markets to competition.
Incentive regulation is often used to regulate the overall price level of utilities. There are four primary approaches to regulating the overall price level: rate of return (or cost of service) regulation, price cap regulation, revenue cap regulation, and benchmarking (or yardstick) regulation.
With benchmarking, for example, the operator's performance is compared to other operators' performance and penalties or awards are assessed based on the operator's relative performance. For instance, the regulator might identify a number of comparable operators and compare their cost efficiency. The most efficient operators would be rewarded with extra profits and the least efficient operators would be penalized. Because the operators are actually in different markets, it is important to make sure that the operators' situations are similar so that the comparison is valid, and to use statistical techniques to adjust for any quantifiable differences the operators have no control over.
Generally regulators use a combination of these basic forms of regulation. Combining forms of regulation is called hybrid regulation. For example, U.K. regulators (e.g. Ofgem) combine elements of rate of return regulation and price cap regulation to create their form of RPI - X regulation.
Incentive Rates are also prevalent in the utility sector, under any of the utility regulatory frameworks noted. Incentive rates are a vehicle for the utility to induce large commercial or industrial customers to locate or maintain a facility in the utility service territory. The incentive is provided in the form of a discount from the utility's standard tariff rates, terms or conditions. In the U.S., incentive rates (also known as Economic Development Rates and/or Load Retention Rates) are a common component of the utility strategy for supporting the economic development efforts of a particular geographic region or political entity.
s can often make incentives much more complex than the people offering them originally expected, and can lead either to unexpected windfall
s or to disasters produced by unintentionally perverse incentive
s.
For example, decision-makers in for-profit firms often must decide what incentives they will offer to employees and managers to encourage them to act in ways beneficial to the firm. But many corporate
policies — especially of the "extreme incentive" variant popular during the 1990s — that aimed to encourage productivity have, in some cases, led to spectacular failures as a result of unintended consequences. For example, stock options were intended to boost CEO productivity by offering a remunerative incentive (profits from soaring stock prices) for CEOs to improve company performance. But CEOs could get profits from soaring stock prices either (1) by making sound decisions and reaping the rewards of a long-term price increase, or (2) by fudging or fabricating accounting information to give the illusion of economic success, and reaping profits from the short-term price increase by selling before the truth came out and prices tanked. The perverse incentive
s created by the availability of option (2) have been blamed for many of the falsified earnings reports and public statements in the late 1990s and early 2000s.
is an obvious example of how refused normal bonus incentives have become after the capital market meltdown.
A possible solution against the criticism of overpaying executives in boom times and underpaying them in recession times is by linking bonus targets to an Operating Index. By doing so external effects (economic cycles) can be excluded from performance measurement. This makes incentive pay more fair or likely not certain as bonuses are based on performance relative to other companies in the peer universe.
While the notion of a fair system seems to be an equal deal, those who are outperforming by a large margin will feel slighted by this approach; Thus, a system based on individual company performance has been the standard.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
and sociology
Sociology
Sociology is the study of society. It is a social science—a term with which it is sometimes synonymous—which uses various methods of empirical investigation and critical analysis to develop a body of knowledge about human social activity...
, an incentive is any factor (financial or non-financial) that enables or motivates a particular course of action, or counts as a reason for preferring one choice to the alternatives. It is an expectation that encourages people to behave in a certain way. Since human beings are purposeful creatures, the study of incentive structures is central to the study of all economic activity (both in terms of individual decision-making and in terms of co-operation and competition
Competition
Competition is a contest between individuals, groups, animals, etc. for territory, a niche, or a location of resources. It arises whenever two and only two strive for a goal which cannot be shared. Competition occurs naturally between living organisms which co-exist in the same environment. For...
within a larger institutional structure). Economic analysis, then, of the differences between societies (and between different organizations within a society) largely amounts to characterizing the differences in incentive structures faced by individuals involved in these collective efforts. Ultimately, incentives aim to provide value for money and contribute to organizational success.
Categories
Incentives can be classified according to the different ways in which they motivate agents to take a particular course of action. One common and useful taxonomyTaxonomy
Taxonomy is the science of identifying and naming species, and arranging them into a classification. The field of taxonomy, sometimes referred to as "biological taxonomy", revolves around the description and use of taxonomic units, known as taxa...
divides incentives into four broad classes:
| Class | Definition |
|---|---|
| Remunerative incentives | are said to exist where an agent can expect some form of material reward — especially money — in exchange for acting in a particular way. |
| financial incentives | |
| Moral incentives | are said to exist where a particular choice is widely regarded as the right thing to do, or as particularly admirable, or where the failure to act in a certain way is condemned as indecent. A person acting on a moral incentive can expect a sense of self-esteem, and approval or even admiration from his community; a person acting against a moral incentive can expect a sense of guilt, and condemnation or even ostracism from the community. |
| Coercive incentives | are said to exist where a person can expect that the failure to act in a particular way will result in physical force being used against them (or their loved ones) by others in the community — for example, by inflicting pain in punishment, or by imprisonment, or by confiscating or destroying their possessions. |
| Natural Incentives | such as curiosity, imagination, mental or physical exercise, admiration, fear, anger, pain, joy, or the pursuit of truth, or the control over things in the world or people or oneself. |
(There is another common usage in which incentive is contrasted with coercion
Coercion
Coercion is the practice of forcing another party to behave in an involuntary manner by use of threats or intimidation or some other form of pressure or force. In law, coercion is codified as the duress crime. Such actions are used as leverage, to force the victim to act in the desired way...
, as when economic moralists contrast incentive-driven work—such as entrepreneurship
Entrepreneurship
Entrepreneurship is the act of being an entrepreneur, which can be defined as "one who undertakes innovations, finance and business acumen in an effort to transform innovations into economic goods". This may result in new organizations or may be part of revitalizing mature organizations in response...
, employment
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
, or volunteering motivated by remunerative, moral, or personal incentives—with coerced work—such as slavery
Slavery
Slavery is a system under which people are treated as property to be bought and sold, and are forced to work. Slaves can be held against their will from the time of their capture, purchase or birth, and deprived of the right to leave, to refuse to work, or to demand compensation...
or serf
SERF
A spin exchange relaxation-free magnetometer is a type of magnetometer developed at Princeton University in the early 2000s. SERF magnetometers measure magnetic fields by using lasers to detect the interaction between alkali metal atoms in a vapor and the magnetic field.The name for the technique...
dom, where work is motivated by the threat or use of violence. In this usage, the category of "coercive incentives" is excluded. For the purposes of this article, however, "incentive" is used in the broader sense defined above.)
Other forms
These categories do not, by any means, exhaust every possible form of incentive that an individual person may have. In particular, they do not encompass the many other forms of incentive—which may be roughly grouped together under the heading of personal incentives—which motivate an individual person through their tastes, desires, sense of duty, pride, personal drives to artistic creation or to achieve remarkable feats, and so on. The reason for setting these sorts of incentives to one side is not that they are less important to understanding human action—after all, social incentive structures can only exist in virtue of the effect that social arrangements have on the motives and actions of individual people. Rather, personal incentives are set apart from these other forms of incentive because the distinction above was made for the purpose of understanding and contrasting the social incentive structures established by different forms of social interaction. Personal incentives are essential to understanding why a specific person acts the way they do, but social analysis has to take into account the situation faced by any individual in a given position within a given society—which means mainly examining the practices, rules, and norms established at a social, rather than a personal, level.Social pressure
It's also worth noting that these categories are not necessarily exclusive; one and the same situation may, in its different aspects, carry incentives that come under any or all of these categories. In modern AmericanUnited States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
society, for example, economic prosperity and social esteem are often closely intertwined; and when the people in a culture tend to admire those who are economically successful, or to view those who are not with a certain amount of contempt (see also: classism
Classism
Classism is prejudice or discrimination on the basis of social class. It includes individual attitudes and behaviors, systems of policies and practices that are set up to benefit the upper classes at the expense of the lower classes...
, Protestant work ethic
Protestant work ethic
The Protestant work ethic is a concept in sociology, economics and history, attributable to the work of Max Weber...
), the prospect of (for example) getting or losing a job carries not only the obvious remunerative incentives (in terms of the effect on the pocketbook) but also substantial moral incentives (such as honor and respect from others for those who hold down steady work, and disapproval or even humiliation for those who don't or can't).
| Type | Definition |
|---|---|
| Straight piece rate | In the straight piece rate system, a worker is paid straight for the number of pieces he produces per day. In this plan, quality may suffer. |
| Straight piece rate with a guaranteed base wage | A worker is paid straight for output set by management even if worker produces less than the target level output. If worker exceeds this target output, he is given wage in direct proportion to the number of pieces produced by him at the straight piece rate. |
| Halsey Plan | W = R.T + (P/100) (S-T).R where W: wage of worker, R : wage rate, T : actual time taken to complete job, P : percentage of profit shared with worker, S : std. time allowed. Output standards are based upon previous production records available. Here management also shares a percentage of bonus. |
| Rowan Plan | W=R.T + ((S-T)/S).R.T Unlike Halsey Plan gives bonus on (S-T)/S , thus it can be employed even if the output standard is not very accurate. |
Economics
The study of economics in modern societies is mostly concerned with remunerative incentives rather than moral or coercive incentives — not because the latter two are unimportant, but rather because remunerative incentives are the main form of incentives employed in the world of business, whereas moral and coercive incentives are more characteristic of the sorts of decisions studied by political sciencePolitical science
Political Science is a social science discipline concerned with the study of the state, government and politics. Aristotle defined it as the study of the state. It deals extensively with the theory and practice of politics, and the analysis of political systems and political behavior...
and sociology
Sociology
Sociology is the study of society. It is a social science—a term with which it is sometimes synonymous—which uses various methods of empirical investigation and critical analysis to develop a body of knowledge about human social activity...
. A classic example of the economic analysis of incentive structures is the famous Walras
Walras
Walras is surname of:* Auguste Walras , French school administrator and economist* Léon Walras * Walras' law...
ian chart of supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
curves: economic theory predicts that the market will tend to move towards the equilibrium
Economic equilibrium
In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...
price because everyone in the market has a remunerative incentive to do so: by lowering a price formerly set above the equilibrium a firm can attract more customers and make more money; by raising a price formerly set below the equilibrium a customer is more able to obtain the good or service that she wants in the quantity she desires.
A strong incentive is one that accomplishes the stated goal. If the goal is to maximize production, then a strong incentive will be one that encourages workers to produce goods at full capacity. A weak incentive is any incentive below this level.
Incentives help people to make the right decision, or the one one would like them to make. To accomplish things you want done in economics you must give the consumer or the producer incentives, with out them they would have no reason to do what you ask.
Regulation in the Utility Sector
Incentive-based regulation can be defined as the conscious use of rewards and penalties to encourage good performance in the utility sector.Incentives can be used in several contexts. For example, policymakers in the United States used a quid pro quo incentive when some of the U.S. incumbent local telephone companies were allowed to enter long distance markets only if they first cooperated in opening their local markets to competition.
Incentive regulation is often used to regulate the overall price level of utilities. There are four primary approaches to regulating the overall price level: rate of return (or cost of service) regulation, price cap regulation, revenue cap regulation, and benchmarking (or yardstick) regulation.
With benchmarking, for example, the operator's performance is compared to other operators' performance and penalties or awards are assessed based on the operator's relative performance. For instance, the regulator might identify a number of comparable operators and compare their cost efficiency. The most efficient operators would be rewarded with extra profits and the least efficient operators would be penalized. Because the operators are actually in different markets, it is important to make sure that the operators' situations are similar so that the comparison is valid, and to use statistical techniques to adjust for any quantifiable differences the operators have no control over.
Generally regulators use a combination of these basic forms of regulation. Combining forms of regulation is called hybrid regulation. For example, U.K. regulators (e.g. Ofgem) combine elements of rate of return regulation and price cap regulation to create their form of RPI - X regulation.
Incentive Rates are also prevalent in the utility sector, under any of the utility regulatory frameworks noted. Incentive rates are a vehicle for the utility to induce large commercial or industrial customers to locate or maintain a facility in the utility service territory. The incentive is provided in the form of a discount from the utility's standard tariff rates, terms or conditions. In the U.S., incentive rates (also known as Economic Development Rates and/or Load Retention Rates) are a common component of the utility strategy for supporting the economic development efforts of a particular geographic region or political entity.
Problems
Incentive structures, however, are notoriously more tricky than they might appear to people who set them up. Human beings are both finite and creative; that means that the people offering incentives are often unable to predict all of the ways that people will respond to them. Thus, imperfect knowledge and unintended consequenceUnintended consequence
In the social sciences, unintended consequences are outcomes that are not the outcomes intended by a purposeful action. The concept has long existed but was named and popularised in the 20th century by American sociologist Robert K. Merton...
s can often make incentives much more complex than the people offering them originally expected, and can lead either to unexpected windfall
Windfall
Windfall is a serial drama television series about a group of people in an unnamed small city who win almost $400 000 000 in a lottery. The series premiered Thursday, June 8, 2006 on NBC, taking the time slot occupied by ER during the rest of the year.On August 31, 2006, NBC announced the show's...
s or to disasters produced by unintentionally perverse incentive
Perverse incentive
A perverse incentive is an incentive that has an unintended and undesirable result which is contrary to the interests of the incentive makers. Perverse incentives are a type of unintended consequences.- Examples :...
s.
For example, decision-makers in for-profit firms often must decide what incentives they will offer to employees and managers to encourage them to act in ways beneficial to the firm. But many corporate
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
policies — especially of the "extreme incentive" variant popular during the 1990s — that aimed to encourage productivity have, in some cases, led to spectacular failures as a result of unintended consequences. For example, stock options were intended to boost CEO productivity by offering a remunerative incentive (profits from soaring stock prices) for CEOs to improve company performance. But CEOs could get profits from soaring stock prices either (1) by making sound decisions and reaping the rewards of a long-term price increase, or (2) by fudging or fabricating accounting information to give the illusion of economic success, and reaping profits from the short-term price increase by selling before the truth came out and prices tanked. The perverse incentive
Perverse incentive
A perverse incentive is an incentive that has an unintended and undesirable result which is contrary to the interests of the incentive makers. Perverse incentives are a type of unintended consequences.- Examples :...
s created by the availability of option (2) have been blamed for many of the falsified earnings reports and public statements in the late 1990s and early 2000s.
Recession Times
Though bonuses make an integral component of free market practices on human beings, continuing to pay them to executives by companies benefiting from US Government financial help as planned and as contracted is facing great criticism and opposition from politicians and media. The case of American Insurance GroupAIG
AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
is an obvious example of how refused normal bonus incentives have become after the capital market meltdown.
A possible solution against the criticism of overpaying executives in boom times and underpaying them in recession times is by linking bonus targets to an Operating Index. By doing so external effects (economic cycles) can be excluded from performance measurement. This makes incentive pay more fair or likely not certain as bonuses are based on performance relative to other companies in the peer universe.
While the notion of a fair system seems to be an equal deal, those who are outperforming by a large margin will feel slighted by this approach; Thus, a system based on individual company performance has been the standard.
See also
- Event planning and production
- Incentive programIncentive programAn incentive program is a formal scheme used to promote or encourage specific actions or behavior by a specific group of people during a defined period of time. Incentive programs are particularly used in business management to motivate employees, and in sales to attract and retain customers...
- Travel incentiveTravel incentiveTravel incentives are a reward subset of an incentive, recognition or a loyalty program, which is a business tool used to change behavior to improve profit, cash flow, employee engagement and customer engagement....
- Loyalty programLoyalty programLoyalty programs are structured marketing efforts that reward, and therefore encourage, loyal buying behavior — behavior which is potentially beneficial to the firm....
- Loyalty marketingLoyalty marketingLoyalty marketing is an approach to marketing, based on strategic management, in which a company focuses on growing and retaining existing customers through incentives...
- Performance-related payPerformance-related payPerformance-related pay is money paid to someone relating to how well one works. Car salesmen, production line workers, for example, may be paid in this way, or through commission....