Incentives: The Hidden Forces That Shape Behavior

Incentives are anything that persuades a person to change their behaviour.

In English we know incentives as “the carrot and the stick,” but it’s such a proven and time-tested system that every culture has a version of this in its own language.

It’s a force that exists throughout nature. Plants, animals and humans are constantly looking for feedback to figure out the actions and behaviour that work and increase their chance of survival.

Because incentives are closely tied to our survival mechanism, they often work on us subconsciously. When it is in our own interest to do so, incentives can distort our thinking and override our conscious behaviour. However, humans are complicated in that their incentives can be hidden or intangible. 

Charlie Munger summarized it best: “Show me the incentives and I will show you the outcome.”

Incentives can be categorized into

• Intrinsic: the motivation of people’s behaviour comes from within.
  • Example: the open-source movement in programming where programmers create code for free and which can be used or built upon by others. Some of the possible intrinsic incentives explaining this behaviour:
    • Altruism
    • Community sharing and improvement
    • Recognition
    • Ego
    • Creative expression
• Extrinsic: external pressure persuades people to act in a particular way. This can be a reward for completing a task or a form of punishment if a task is not completed.
  • Example: companies’ loyalty programmes or bounty programmes where people receive financial or non-financial rewards for taking a specific action.

Both intrinsic and extrinsic incentives are important and drive people’s behaviour. Knowing that, the question becomes: how?

Here we borrow from behavioural psychology – especially from B.F. Skinner and his Operant Conditioning – which refer to incentives as reinforcement and have identified four types:

• Positive reinforcement: certain behaviour leads to a positive outcome. For example, a teacher praising a student when he receives good grades.
• Negative reinforcement: certain behaviour reduces a negative outcome. A child cleaning his/her room to stop his/her parent’s nagging, for example.
• Extinction: undesired behaviour is ignored. A worker has done more than expected but receives no recognition. He’ll be less likely to work as hard in the future.
• Punishment: undesired behaviour leads to a negative outcome. For example, removing a benefit following poor performance. Or spanking a child if he breaks a window.

Favour incentives over punishment as punishment is more limited:

• The undesirable behaviour returns when the threat of punishment is gone.
• Punishment triggers a fight-or-flight response and makes us more aggressive.
• We learn what we shouldn’t do, but not what we should do.
• It’s often applied unequally as we are ruled by bias. And one thing humans don’t like is unfair treatment, so you’ll likely create hate and animosity unnecessarily.

In short, modify the rewards or punishment and the strength of the behaviour changes. Punishment works best to prevent actions whereas incentives work best to encourage them.

Survival is propelled by our need for food and water. However, most of us don’t live in conditions of extreme scarcity, so the types of reinforcement appealing to us will differ.

Culture – national and corporate – plays an important role in determining effective reinforcers. And what’s reinforced shapes culture. Offering tickets to a cricket match might serve as a powerful reward for someone in a country where cricket is a big deal, but would be meaningless to most Americans. 

Change the incentives to change the behaviour. The simpler, the better, as Munger shows in this FedEx example: 

“The heart and soul of the integrity of the system is that all the packages have to be shifted rapidly in one central location each night. And the system has no integrity if the whole shift can’t be done fast. And Federal Express had one hell of a time getting the thing to work.

And they tried moral suasion, they tried everything in the world, and finally somebody got the happy thought that they were paying the night shift by the hour, and that maybe if they paid them by the shift, the system would work better. And lo and behold, that solution worked.”

Incentives drive our behaviour. Understanding them is the key to understanding yourself and other humans. Failing to recognize their importance often leads us to make major errors.

“Never, ever, think about something else when you should be thinking about the power of incentives.” – Charlie Munger

How to use Incentives

In business, you get what you reward for.

Have you created an environment or vision that people want to work for and that motivates them intrinsically? Or do you have to keep them interested with extrinsic incentives, such as higher pay or better secondary benefits?

When working with an external agency, how do you compensate them? Is their compensation aligned with the performance of your business? Or do they get compensated regardless of your performance?

Instead of paying a YouTube Ad agency for maximizing impressions or views, it makes more sense to pay them for maximizing the number of new customers. Even if they don’t influence your entire funnel, collaboration can resolve this. 

Aligning incentives is always the right choice.

In investing, always ask yourself: what are the incentives of the other stakeholders? Are they aligned with mine?

Is management compensated to produce the best returns for themselves, for the company or for the shareholders?

Do these people do or say this to make a profit for themselves or do they have another motivation? Does their profit come at my expense?

In sales, reward your salespeople for the right behaviour. 

Are they compensated to sell the newest model or an older one?

Are they compensated to sell as many as possible or to foster deeper relationships?

Are they compensated immediately and to sell without regard for returned products or do they get paid later, knowing the customer is not going to return the product?

The commission arrangement makes all the difference.

In life, you apply this to changing your own behaviour or the behaviour of your children.

For yourself, ask:

• What is the behaviour I want to exhibit? (exercising, reading more, doing something less)
• What incentivizes my current behaviour?
• How can I change the incentives to favour my desired behaviour?
• How can I make the incentive and the desired action so simple that starting it takes me no effort?

To stimulate academic performance in children:

• Give them an intrinsic reward by complimenting them for good grades.
• Give them an extrinsic reward, like candy or money, for performing well.
• Stop nagging about academic performance when they get good grades (negative reinforcement).
• Spank the child or take away something enjoyable in the case of bad grades (punishment).

Or…stimulate the child’s curiosity and joy in the process of learning by asking them in a supportive manner how the test went and what could be improved next time.

The best way is encourage long-term behaviour formation is to make the reward (1) intrinsic and (2) something the child can experience by himself, such as the satisfaction of learning something new or improving himself.