Mind the Economy / Incentives 4

Why do we need more human organisations designed for human beings?

Incentive theory is the main tool that economists use when moving from the descriptive to the normative perspective

17 November 2024

Aggiungi Il Sole 24 Ore
ai preferiti su Google

6' min read

Incentive theory constitutes the main tool that economists use when they move from the descriptive to the normative perspective. That is, when they move from the description of economic behaviour to the design of measures aimed at shaping the choices of real people, in their multiple roles as consumers, workers, savers, etc. The compensation schemes that organisations use with their workers, for example, are a classic example.

We have seen in recent weeks how often operational practices diverge from the prescriptions derived from theory. The 'piecework' or pay-for-performance scheme, for example, seems to be used much less frequently than its theoretical formalisation would suggest. High-powered incentives (high-powered incentives), those essentially based on a market exchange, can in fact generate rather serious side effects. This is usually the case when the workers' performance is difficult to measure objectively, or when their work is multitasking, i.e. involves a plurality of tasks, or when the work is carried out in a group and in groups it is generally difficult to distinguish the individual contribution of the individual members. In all these cases, alternative incentive instruments are used, such as subjective evaluations, efficiency pay or career advancement.

The change taking place: the bias

These are all practices consistent with more traditional theoretical models. But in recent years something is changing. The validity of the two fundamental assumptions of the behaviour of economic agents, their rationality and the pursuit of self-interest, is, in fact, being questioned from many quarters. Our decision-making processes are subject to systematic errors (bias) because our brains use cognitive shortcuts, the 'heuristics', which often prove to be highly effective in leading us quickly and cheaply to the right solution, but at other times, lead us systematically astray. 'Systematically' here means that these deviations are not 'errors' but real 'biases', regular and therefore predictable distortions.

Criticism of the self-interest

The second aspect of the break with the traditional approach concerns the critique of the self-interest - 'the first principle of economics' as Francis Ysidro Edgeworth called it. The content of the self-interest principle has gradually been radicalised. Dennis Mueller, now professor emeritus at the University of Vienna, states in one of his important textbooks: 'The fundamental behavioural principle of economics is that human beings are selfish and rational maximisers of their own utility' (1989). Even more extreme is the position expressed by Paul Milgrom and John Roberts in their handbook on the economics of organisations in which human beings are described as 'fundamentally amoral', individuals who 'break rules, ignore agreements, use fraud, manipulation and deception if they find personal advantage in doing so'.

To question the fundamental assumptions of the economic approach to human behaviour is not to claim that these axioms are factually false. That is a given. But that in itself would not be a problem. All scientific theories adopt models built on simplifying assumptions. Milton Friedman, in his methodological works, advocated so-called 'instrumentalism'. He went so far as to state that a theory based on unrealistic assumptions is in many cases better than another based on more complex and realistic assumptions, because the former paradoxically explains much from little.

Conclusions and implications

The problem, then, is not so much the assumptions as the conclusions and implications that these assumptions produce. It is a position that in the context of optimal contracts is well summarised by Robert Gibbons, when he writes: "One possibility is that economic models that ignore psychological and social aspects may be incomplete descriptions of how incentives work in organisations. A second, more alarming possibility is that management practices based on such models may damage (and even destroy) important non-economic realities such as intrinsic motivations and social relations" ('Incentives in Organisations. Journal of Economic Perspectives, 12(4), pp. 115-132, 1998).

What exactly is Gibbons telling us? Not only and not so much that the use of unrealistic assumptions such as that of self-interested behaviour or Olympic rationality may produce incomplete and misleading descriptions. This would not, then, be a big problem. What he adds next, however, is a more alarming possibility and, that is, that when these theories become managerial practices then they can operate in such a way as to transform the reality on which they intervene, producing those hidden costs associated with the destruction of important realities such as intrinsic motivation and distorting the very nature of labour relations.

A complex motivational structure

The main reason lies in the fact that human beings have a complex motivational structure, fundamentally influenced by social relationships. We like to give, we are eager to reciprocate the benefits we receive and to punish those who behave badly towards us. We have a genuine aversion to inequality and injustice. We are willing to trust and are generally much more trustworthy than rational choice theory predicts.

These behaviours are driven by so-called 'pro-social motivations' or, as economists say, 'social preferences'. They serve to regulate our interpersonal relationships, reduce conflict, generate cohesion and facilitate cooperation. Acknowledging the existence of this complex motivational structure and understanding its logic can help us not to destroy them but rather to enhance them, as Elinor Ostrom suggests, "by developing institutions capable of bringing out the best in every human being" ("Beyond Markets and States: Polycentric Governance of Complex Economic Systems". American Economic Review 100(39), pp. 641-72, 2010).

Already Adam Smith wrote on the first page of his The Theory of Moral Sentiments (1759) that 'However selfish [man] may be supposed to be, there are evidently certain principles in his nature which induce him to take an interest in the lot of others, and make it necessary for him to be happy with others, though he derives nothing from it except the pleasure of seeing it. Behavioural economics has greatly contributed to our knowledge of these 'principles' of our nature that make other people's happiness necessary to us. We have learned to look for the root of it in the workings of our brains. Bill Harbaugh is a neuroeconomist, a scholar who uses the tools of neuroscience to analyse what goes on in our heads when we make certain decisions.

The experiment

A few years ago, together with colleagues Ulrich Mayr and Daniel Burghart, he conducted a series of experiments in which he could observe what happened in the brains of participants while they were confronted with a certain choice. Each subject was given a certain amount of money that he could use to fund a charity organisation. He could donate 0, 15, 30 or 45 dollars to the charity at a variable personal cost. He received offers each time that he could accept or refuse and while this series of decisions took place his brain was scanned inside a functional MRI machine. A machine capable of detecting the activation of the different areas of the brain involved in the action. Harbaugh and colleagues' experiment highlights a number of very interesting results. For example, no one refuses to donate $45 to the association when this can be done at no cost to the subject. 75% agree to give $45 to the association even if it costs them $15. A somewhat lower percentage is observed if the cost increases to $30. Finally, still one third of the subjects are willing to send all $45 to the charity without any personal gain.

A known 'social preference'

This result, although difficult to explain in terms of standard theory, is not particularly surprising. It has, in fact, been replicated thousands of times and represents a well-known regularity in the study of 'social preferences'. What is really interesting about the study by Harbaugh and colleagues is the discovery of what goes on inside our cranial box when we make these decisions. Adam Smith, we have seen, was convinced that other people's happiness was necessary to us even though we derived nothing from it 'except the pleasure of noticing it'.

What Harbaugh's scans brought to light, however, is that 'noticing' is not the only pleasure that other people's happiness brings us. Indeed, when the experimental subjects freely decided to donate their money, certain brain areas such as the nucleus accumbens, the insula and the caudate nucleus were activated in their brains. All areas generally involved in circuits that process rewards (Harbaugh, W., et al. "Neural Responses to Taxation and Voluntary Giving Reveal Motives for Charitable Donations". Science, 316 no. 5831 pp. 1622-1625, 2007).

Moving from the model of homo economicus to the reality of homo sapiens, even in economic theory, would help us to understand realities that would otherwise remain mysterious as well as to develop more effective policies of action and to design organisations that are more respectful of our human nature. It is a goal that Matthew Rabin ("Incorporating Fairness into Game Theory and Economics". American Economic Review 83, pp. 1281-1302) pointed to it as fundamental to the transformation of economic science, which he hoped would begin to be "concerned not only with the efficient allocation of material goods, but also with the design of institutions in which subjects are happy to interact with each other".