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An incentive is something that motivates an individual to perform an action. The study of incentive structures is central to the study of all economic activities (both in terms of individual decision-making and in terms of co-operation and competition within a larger institutional structure). Therefore, economic analysis of the differences between societies (and between organizations within a society) amounts to characterizing the differences in incentive structures faced by individuals involved in these collective efforts. Incentives aim to provide value for money and contribute to organizational success.
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 taxonomy divides incentives into four broad classes:
|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.|
|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, 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, 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 serfdom, where work is motivated by the threat or use of violence, pain and/or deprivation. 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.
The categories mentioned above do not 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.
One and the same situation may, in its different aspects, carry incentives that come under multiple categories. In modern American 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).
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 science and sociology. A classic example of the economic analysis of incentive structures is the famous Walrasian 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.
In cases with asymmetric information where one user knows some relevant fact about another, principal-agent theory is the guiding framework in optimizing incentive of choice. The classic example for a situation for asymmetric information can be that of a manager and worker, where manager may want a certain level of output from the worker. The manager does not know the capabilities of the worker, and to achieve the best outcome, an optimal scheme of incentive may be chosen to motivate the worker to give their best performance.
An optimal incentive is one that accomplishes the stated goal. If the goal is to maximize profits, then an optimal incentive will be one that encourages workers to balance the risk imposed by the employee for poor performance and the marginal disutility of effort. A weak incentive is any incentive below this level.
Regulation in the utilities 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.
Incentive structures, however, are notoriously more tricky than they might appear to people who set them up. Incentives do not only increase motivation, they also contribute to the self-selection of individuals, as different people are attracted by different incentive schemes depending on their attitudes towards risk, uncertainty, competitiveness. 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 perverse incentives.
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 failures as a result of unintended consequences. For example, stock options were intended to boost CEO productivity by offering a remunerative incentive (profits from rising stock prices) for CEOs to improve company performance. But CEOs could get profits from rising 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 incentives 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.
Also there is the tradeoff of short term gains at the expense of long term gains or even long term company survival. It is easy to plunder the assets of a previously successful company and show spectacular short term gains only to have the enterprise collapse after those responsible have gotten their incentives and left the organization or industry. Although long term incentives could be part of the incentive system, they have been abandoned in the past 20 years. An example of an organization that used long term incentive programs was Hughes Aircraft and was highly successful until the government forced its divestiture from the Howard Hughes Medical Institute. Recently there has been movement on adopting the benefit corporation or B-Corporation as a way to change the trend away from short term financial incentives to long term financial and non financial incentives.
Not all for profit companies used short term financial incentives at levels below the president or very top executive levels. The trend to move financial incentives down the organization hierarchy started in the 1980s as a way to boost what was considered low productivity. Prior to that time the incentives were associated more with customer satisfaction and producing high quality products. Moving financial incentives down the corporate chain had the unintended consequences of subverting internal processes to save short term costs, forcing obsolescence at the lower levels as investment was deferred or abandoned, and lowering quality. Some of these issues are explored in the British documentary The Trap. This idea of financial incentives and pushing them to the lowest level common denominator has led to a new company structure or organizational ecology where essentially everything is a standalone profit center with the only incentive being short term financial incentives.
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.
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