Incentive Systems

Incentive Systems

The study of incentives is one of the central topics in microeconomics – incentives to work hard, to produce quality products, to study, to invest, to save, etc. How to design institutions that provide good incentives for economic agents has become a central question of economics. Behind this though is the idea of motivation, that is to say, what motives do economic agents operate under.1 Here we can identify two very different frameworks for understanding agents’ motives and associated incentive systems. On the one hand the model of incentive theory that is central to standard economics and on the other the more complex model of intrinsic motives and choice architecture that is emerging out of behavioral economics.2

Hierarchy of needs

The motivations of economic agents derive from the needs, desires and aspirations that they are trying to fulfill. These different types of needs are typically structured through the use of a model called Maslow’s hierarchy that fundamentally divides them into primary needs and secondary needs. Primary needs are physiological in nature. They include such things as food, water, shelter and sleep. Secondary needs are internal states like the desire for power, achievement, belonging, opportunities for advancement, relations with work collogues, input into decision making, etc. People’s and societies’ needs can change over time as agents move on to new ones that become more intensified and important to them.


Motives are the reason or reasons one has for acting or behaving in a particular way. It accounts for the direction, level and persistence of a person’s resource expenditure in performing an activity or trying to achieve some end. Motives are divided into two different kinds: intrinsic and extrinsic. Extrinsic motives always have an end, a locus of desire, and the process is just a means for getting there. Intrinsic motives do not necessary have a final point of design but are more process orientated. The end value is in the process.

Incentive system

A central question then within economics is how to create systems for aligning agents’ behavior with those of the organization or society. From driving too fast, to smoking, to work apathy, to lack of heath insurance, economics, business management and policy makers spend a lot of their time thinking about this question. And there are really just two ways to do this; either we use direct incentives or we alter the context within which agents are acting. Behavioral economics focuses on this later solution while standard economics focuses on the former, what is called incentives theory.

Incentive Theory

A basic premise of standard economics is that people respond to incentives.3 The theory of incentives is one of the major theories of motivation and suggests that behavior is motivated by a desire for reinforcement or incentives. Thus, in contrast with other theories that might suggest we are pushed into action by internal drives, incentive theory instead suggests that we are pulled into action by outside incentives. According to this view, people are pulled toward behaviors that offer positive incentives and pushed away from behaviors associated with negative incentives. In other words, differences in behavior from one person to another or from one situation to another can be traced back to the incentives available and the value a person places on those incentives.


The most common incentive would be a reward. Rewards can be tangible or intangible, and is presented generally after the occurrence of the action or behavior that one is trying to correct or cause to happen again. This is done by associating positive meaning to the behavior and or action. Studies show that if the person receives the reward immediately, the effect is greater, and decreases as delay lengthens. A combination repetitive action and rewards can cause the action to become a habit. This model has both its achievements and limitations. Incentive theory will give us a nice closed form model with direct linear cause and effect relations. They are very well suited to a top-down form of management because extrinsic incentives are designed to give compliance. They are explicitly and directly trying to alter agents’ behaviors according to the instructions of some managing body.

Incentive Design

Incentive systems have to be well designed, aligned with the interest of the agents in the system and the desired outcomes. 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 consequences can often make incentives much more complex than the people offering them originally expected, and can lead either to unexpected windfalls or to disasters produced by unintentionally distorted incentives. Added to this, direct incentives may have a crowding out effect. If we only take into account one form of value, we may try to optimize it at the expense of others with the overall throughput becoming suboptimal.4 Extrinsic incentive systems work well when there is a clear set of steps and clear well-defined expected outcome or goal. But they only really work for analytical processes as they narrow our focus and concentrate the mind. Extrinsic incentives only really work as long as the task involves only rudimentary mechanic tasks, simple algorithmic operations. Research has shown that when tasks become more complex, that is, as soon as the task involves some form of cognitive skills, creative skills or conceptual capabilities, extrinsic incentives were no longer effective and actually led to poorer performance.

New Context

This theory to management has been the default since the industrial age. This system has been the motivational structure for making people work throughout the 19th and 20th century and it is a core part of the whole industrial age capitalist model and the dichotomy between work and leisure. But the post-industrial economic environment we are moving into requires a new skill set involving entrepreneurship, cognitive capabilities, innovation and self-engagement. In this economy, people’s needs and motivation structure are more complex. It is an economy where people are connected and feel motivated by forming part of networks that give them different value through social media, collaborative consumption, peer production, creative commons, open sources. All of these go beyond our traditional understanding of why people render professional services and this necessitates a more complex nonlinear model that looks at the whole context within which agents are embedded in making their decisions.


By incorporating a wider spectrum of motives and values, behavioral economics has developed a very different model. Within this paradigm we are thinking about how the broader context affects the choices that agents are making. We are looking at the physical, social and cultural networks of connections that the agents make choices within and how these different networks can add or subtract from the motives of the agents in order to alter them. For example, in a purely physical context, behavioral economics looks at how choices are arranged within space such as the layout to a city where plentiful open spaces make walking a more desirable mode of transportation than other options, or in a canteen restaurant where there is a choice where we place items, we put the healthy food at the entrance making it more accessible than other options. These choices that are the easiest options due to their spatial location are examples of attractor state. Being the easiest option, they are a default, attracting users to adopt that choice. This is an example of what is called a nudge, any small influence within the environment that attracts our attention and influences the behavior that we make. Of course, marketing has been using nudge theory for a long time in the layout of shops or the placement of product in catalogs, but because marketing is largely about creating a context for influencing people’s choices it never really fitted into standard economics theory.5

Social Context

The social context within which choices are made is just as important as the physical. With the advent of social networking, the social dimension has become much more important within economics both in work and consumption. By simply connecting people and making social information available, this can strongly influence peoples’ choices and provide motivation through a social context. Intrinsic motivators are self-directional. They can be best fostered by simply giving them space to develop, not crowding them out with incentive system. We see some companies like Google, who instead of offering an incentive to employees for coming up with new innovations, they simply give the employee a day off every week to explore their interest as directed by intrinsic motivation. In so doing, they are simply non-crowding out the intrinsic motives.

Choice Architecture

Choice architecture is another outgrowth from behavioral economics, which deals with the design of different ways in which choices can be presented to consumers and the impact of that presentation on consumer decision-making – for example, the number of choices presented, how we arrange those choices or which one is the default option. An important question here is, how do we frame those choices? When we sell a car, do we tell prospective buyers the amount of fuel to run the car or the amount of money to run the car? Although they both relate to the same underlying piece of information, it has been shown that people often make different decisions based on the different ways that the information has been framed. Choice architecture is built on our understanding of people as non-rational actors and how they use all sorts of shortcuts to cope when making decisions.6

Systems Innovation

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