We human beings we are self centered. Our own interests come first; this is just how we are. We respond to incentives especially if they appeal to our self interest. And if the incentives don’t appeal, there would be unintended consequences. That is why Charlie Munger said:

Show me the incentives and I will show you the outcome.

I came across a few interesting cases over the years of how incentives either got the job done or led to some unintended consequences. Here they are.

Scenario 1: Self interest prevails over rational reasoning

According to this article on Bloomberg, India has 1.5 M Electric Rickshaws (or eRickshaws). This is more than all the Electric Vehicles (EVs) sold in China, since 2011. The Chinese get government subsidies for buying EVs whereas Indians don’t. China has probably the largest charging infrastructure needed for EVs. On the other hand, in India policy makers only recently announced a policy on charging infrastructure. And mind you, most cycle rickshaw drivers in India are poor and uneducated. Given all these handicaps in India, how did eRickshaws outsell the EVs in China?

I don’t have all the answers, but I am guessing self interest has something to do with it. You may go to a Cycle Rickshaw driver and tell him that eRickshaws are better because they are quieter or more fuel efficient or environment friendly. All valid reasons backed by data, but it is unlikely he will buy.

But, if you went to him and told him that with eRickshaws he can earn more money with lesser physical effort, he would suddenly be interested in them! How, he asks incredulously? You say: eRickshaws are faster than cycle rickshaws and therefore his trips will be shorter thereby saving him time during peak time and with the saved time he make more trips per day and earn more money each day. Since he doesn’t have to pedal anymore, he will be less tired. So you see, you must appeal to interest and not to reason.

Scenario 2: People will game systems according to their self interest.

Matt Levine, a Bloomberg columnist, in this article on Wells Fargo says (emphasis mine):

Two basic principles of management, and regulation, and life, are:

1. You get what you measure.
2. The thing that you measure will get gamed.

Really that’s just one principle: You get what you measure, but only exactly what you measure. There’s no guarantee that you’ll get the more general good thing that you thought you were approximately measuring. If you want hard workers and measure hours worked, you’ll get a lot of workers surfing the internet until midnight. If you want low banking bonuses and measure bonus-to-base-salary ratios, you’ll get high base salaries. Measurement is sort of an evil genie: It grants your wishes, but it takes them just a bit too literally. 

Matt Levine’s words were too beautiful to not quote them. People everywhere tend to game the system to serve their own self interests. For example, in one of India’s IT Services companies, they introduced a rule that all employees must work a minimum of 9 hours 15 minutes everyday. It was going to be calculated based on the first swipe in and last swipe out of the building.

There were valid reasons for the company to mandate this; the company earned nearly 65% of its revenue by billing its clients by employee-hours. To avoid a potentially embarrassing situation such as the company billing the client for say X number of employee-hours and later on an audit finding that in reality its employees worked less than X. And the company made efforts to convey such rationale in town hall after town hall. So after the rule was implemented, did the employees work 9 hrs 15 mins? Yes. Were they more productive? No.

For a while the employees complied. But they soon realized ways in which they could ‘game’ the system in small ways. They would swipe into the building nearest to the gate and swipe out of it in the evening instead of the building in which they work, which would add say 15 minutes to a workday. To make up for shortfalls, they would take longer lunch breaks, tea breaks or hit the office gym before swiping out in the evening. So net, net- the company probably got what it wanted but productivity just remained at the same level.

Here is another example. The City of Philadelphia introduced a sin tax which raised the price of sugared drinks like colas. There may have been good reasons as well. For one-Sugar kills. So do you think consumption of sugared drinks went down in Philly? Yes. Did people drink colas less? No.

The stores in Philadelphia reported a drop of sales of sugared drinks by 42%! Wow! But, guess what- stores just outside Philadelphia reported a rise in sales of cola bottles of much more! What was happening? The people of Philadelphia did not reduce their consumption as the law intended; instead of getting their fix in Philly, they got their fix outside Philly.

A third example. In the state of Tamil Nadu in India, during the election of 2016, one of the political parties promised electric grinders (a coveted product in households) to voters if they came to power. And as luck would have it, they did come to power and kept their promise to the voters. So, were the people happy with the freebies? Yes. Did they use it? No.

Soon after the distribution, the free grinders were sold in neighboring states through middlemen. It’s not that they voters coveted the grinders less; they valued the liquidity of money more. Also, the fact that they got it for free, may have something to do with valuing it less.

A fourth example. Karnataka charges 18% road tax on luxury cars. Why? To earn higher taxes for the state. About 350 Kms away is Pondicherry, where registering a similar car is way cheaper. I have a friend that owns a S Class and he said that he paid a flat Rs 200,000 in Pondicherry whereas registering in Karnataka would have costed him 12X that amount! No wonder then, that a majority of high end cars plying in Bangalore have a Pondicherry registration.  Now think about this too: The seller -the Mercedes dealer is motivated (because on selling he/she pockets the margin), the buyer is motivated (because he/she saves money) and the local authorities in Pondicherry are motivated too (because they earn through registration fees). Maybe the government of Karanataka can do with a course on mental models.

A fifth example. In our apartment complex, we implemented waste management procedures and mandated it for all the 500 residents. We trained residents in October and November and set a deadline of 1st December to stop using plastic bags. Guess what? Even after training, some residents were okay to use plastic bags until 30 November. We appealed to reason (good environmental practices) and not sufficiently to interest (convenience), therefore it backfired a bit.

A final sixth example. Remember the episode from Seinfeld where Kramer and Newman collect soda bottles from New York and go to a different state to sell and pocket the difference?

So…it pays to know that we may design policies, rules etc. But people are wired to game the system.

The image below summarizes this section.

Now, think about policies designed to encourage women to not give up their career, like longer paid maternity leaves. Would these help women or make hiring women less viable?

Scenario 3: Due to self interest, even good people will rationalize themselves out of moral responsibility.

Lawyers, doctors, Consultants, financial products sales people are all incentivized to sell products and services.  Even if the client doesn’t need them. And guess what products or services get sold the most?  The ones with the highest margins, of course. It’s not that the people selling them are bad. No- it’s just that when self interest comes into play, even good people rationalize their way through. “Oh, he was going to need a root canal in the next 6 months anyway!” or “One more insurance policy won’t hurt him” or “Yeah, I built an application for him that he doesn’t need today but he may do so in the future”.

So what does all of the above mean to you and me?

1. More regulation is not the answer to problems. If you want to improve compliance, appeal to interest and not to reason. Don’t assume that people will be moved by your reasons. Always add a “so what does this mean to you” to every reason. eRickshaws may be faster but you need to tell the driver, that would mean more revenue to him.
2. Beware of salespeople, middlemen and advisers especially if the advise that they give is good for them. A confession: I made a million power point presentations and not one of them ended up saying you don’t need more IT services or consulting. Therefore if possible, it’s best to avoid all salespeople. Don’t go to a bank and ask if you need another savings product. My wife and my mother, on two different occasions did this and guess what they ended up with – more investment products.
3. Take alternate opinions. If an orthopedic surgeon recommends surgery, consult a physiotherapist whose job is to help you recover through exercise and not necessarily surgery.  If you hire investment bankers for acquisitions, hire another just to tell you why the acquisition isn’t a good idea.
4. Know that people will try to game the system to avoid inconvenience. Therefore if you design systems or processes, seek feedback. Be humble and be willing to change the system based on feedback. People can be ingenious and will go to quite an extent to avoid inconvenience.
5. Know that people will respond to positive incentives better than negative. Be creative in how you design them. Instead of levying fines on citizens for littering, can you design a system where you reward them for not littering? And can that system be gamed too?

Let me finish with another of Charlie Munger’s quotes. He says:

“Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”

A couple of years back, I started collecting examples of mental models from everyday life. As a result, my own appreciation for incentive caused bias and other mental models has gone up.

Thanks for reading!

A few of us recently contributed to our friend- Nitin Goyal’s blog on Incentive caused bias. In the process, I got the idea for this blog. There is nothing new or different that I have to add in this blog than what Charlie Munger, Morgan Housel, Anshul Khare or Nitin Goyal have already said.