An incentive is something that motivates or drives one to do something or behave in a certain way.
There are two type of incentives that affect human decision making. These are: intrinsic and extrinsic incentives. Intrinsic incentives are those that motivate a person to do something out of their own self interest or desires, without any outside pressure or promised reward.
However, extrinsic incentives are motivated by rewards such as an increase in pay for achieving a certain result; or avoiding punishments such as disciplinary action or criticism as a result of not doing something.
Some examples of extrinsic incentives are letter grades
in the formal school system, monetary bonuses
for increased productivity or withholding of pay for underperforming in the workplace.
Examples of intrinsic incentives include wanting to learn a new language to be able to speak to locals in a foreign country or learning how to paint for self enjoyment.
In the context of economics, incentives are most studied in the area of personnel economics
where human resources management practices focus on how firms manage employee incentives such as pay and career concerns, compensation
and performance evaluation.
Classified by David Callahan
, the types of incentives can be further broken down into three broad classes according to the different ways in which they motivate agents to take a particular course of actions:
Incentives in economic context
The economic analysis of incentives focuses on the systems that dictate the incentives needed for an agent to achieve a desired outcome.
When a firm wants their employees to produce a certain amount of output, it must be prepared a offer a compensation scheme such as a monetary bonus to influence the employees to reach the target output.
Compensation must achieve two goals. The first is its ability to attract workers to the jobs and be able to retain them.
The second is its ability to incentives workers to produce an output as workers who do not produce do not generate any profit for the firm.
A rise in pay variance across occupations reflects an increased demand for highly productive workers thus, influencing compensation to shift towards pay-for-performance
. Firms use a variety of methods to implement productive behavior. Some methods are commission based where the employee, for examples a salesperson receives a payment directly correlated to their output level. Other methods are less direct, for example awarding periodic bonuses to top performers, offering a possibility of a promotion to higher-paying position or profit sharing
for team projects.
Alternatively, firms can also incentives their employees to perform by threatening to demote or terminate them.
Firms must design the compensation plan to induce workers to operate in the firms best interest and put forth a certain level of output that maximizes the firms profits.
However, since the interest of workers and their employer do not always align and asymmetric information
, where one (worker/ employer) does not know some relevant facts about the other, make the compensation plan difficult to establish.
Here, the principal-agent theory
is used as the guiding framework when aligning incentives with the employees effort to obtain the efficient level of output for the firm.
For example, a manager may want a certain level of output from an employee but does not know the capabilities of the employee in the presence of imperfect monitoring, and to achieve the best outcome, an optimal scheme of incentive may be set to motivate the worker to increase their productivity.
The Tournament theory
also provide a framework of compensation but at different levels of the firms hierarchy.
The theory demonstrates that individuals are not promoted on the bases of their performance and output , instead on the relative position in the organization.
The theory also explains that the compensation does not necessarily motivate the employee currently working at that level but instead motivates the employees below that level who aim at getting promoted.
Incentives are arguably beneficial in increasing productivity, however, they can also have an adverse effect on the firm.
This is evident through the ratchet effect
. A firm may use its observation of the employees output level when they first get employed as a guide to set performance standard and objectives for the future.
Knowing this, an employee may purposely reduce their output level when first employed or hide their ability to produce at a higher output with the intent of exploiting being rewarded in the future when they strategically increase their output level.
Thus, the ratchet effect can significantly diminish production levels of a firm and planned economies.
Neither do incentives not always increase motivation as they can contribute to the self-selection of individuals, as different people are attracted by different incentive schemes depending on their attitudes towards risk, uncertainty, competitiveness.
For example, some corporate
policies popular during the 1990s aimed to encourage productivity have led to failures as a result of unintended consequences.
For example, providing stock option
s were intended to boost CEO
productivity through offering a remunerative incentive to aligning the CEOs interests with those of the shareholders to improve company performance.
However, CEOs were found to either make good decisions which resulted in a reward of a long-term price increase of the stock, or were found to have fabricated the accounting information to give the illusion of economic success and to retain their incentive based pay.
Furthermore, it has been found to be extremely costly for the firms to incentivize the CEOs with stock options, nevertheless, firms are forced to pay substantial amounts of money for the provision that the CEO acts in the best interest of the firms and profit maximization.
* Bounty (reward)
* Incentive program
* Incentive salience
* Loyalty marketing
* Loyalty program
* Motivations of open source programmers
* Motivations for online participation
* Performance-related pay
* Profit motive
* Reward system
* Travel incentive