Incentives are a double-edged sword. When aligned with the social interest, incentives can be powerful forces for good but misaligned incentives can be equally powerful forces for bad. One of the goals of economics is to understand what institutions generate good incentives.

On a less grand level, getting the incentives right is an important goal of managers who want to motivate employees, stockholders who want to motivate managers, parents who want to motivate children, and consumers who want to motivate real estate agents, physicians, or lawyers among many others.

In this chapter, we discussed four lessons to help get the incentives right. Lesson one is: You get what you pay for, but what you pay for is not always what you want. Sometimes the gap between what you pay for and what you want arises because the incentive plan is badly designed. More often the gap arises because measuring exactly what you want is difficult, so you must pay for something that is more easily measurable but is not exactly what you want. When the gap between what you pay for and what you want is large, strong incentives can be worse than weak incentives. As it becomes easier to measure things like quality, however, strong incentive plans are becoming more common.

Lesson two is: Tie pay to performance to reduce risk. Strong incentives put more risk on agents from factors beyond their control, and to bear this risk, the agents will demand greater compensation. Sales agents on commission, for example, bear the risk that the economy goes into a downturn or that the product they sell is of low quality. As a result of this increased financial risk, sales agents on commission must be paid higher average wages than sales agents on salary. A firm must ask whether the strong incentives created by commissions increase sales enough to justify the higher average wages.

A good incentive plan will reduce unnecessary risk by tying rewards to actions that an agent controls and that are effective in increasing output. Different incentive plans like commissions, bonuses, and tournaments impose different types of risks on agents. Which incentive plan is best will depend on which risks are most important.

Lesson three is: Money isn’t everything. In addition to earning money, workers want to enjoy their work, identify with a team, and be respected. Successful corporations provide these rewards, as well as monetary rewards. Monetary rewards can be paid only for what is measurable, but a successful corporate culture can help firms incentivize what is difficult to measure. Monetary rewards are most effective when they are supported by intrinsic motivation and measures of social status.

Lesson four is: Nudges can work. Sometimes small differences in how a choice is presented or framed can make surprisingly large differences in what people choose. Time, effort, and attention are all scarce so if a choice can be presented in a way that is quick, easy, and obvious, people are more likely to make that choice.

Successful leaders will draw on all four lessons of this chapter to design and frame incentives that align the interests of their employees, agents, and followers with their own interests.

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