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In general, incentives are anything that persuade a person to alter their behaviour in the desired manner. It is emphasised that incentives matter by the basic law of economists and the laws of behaviour, which state that higher incentives amount to greater levels of effort and therefore higher levels of performance.

Divisions

In economic terms, an incentive is a financial or non-financial reward or penalty which is often adopted by governments and businesses to enforce certain action or behaviour. Incentives can be broadly broken down into two categories: intrinsic incentives and extrinsic incentives. Both types of incentives can be powerful tools. In the context of economics, incentives are most studied in the area of personnel economics where economic analysts, such as those who take part in human resources management practices, focus on how firms make employees more motivated, through pay and career concerns, compensation and performance evaluation, to motivate employees and best achieve the firms' desired performance outcomes.

Intrinsic and extrinsic incentive

An intrinsic incentive is when a person is motivated to act in a certain way for their own personal satisfaction without seeking any external reward, nor facing any external pressure to perform the task. For instance, a singer who enjoys singing may be intrinsically motivated to spend several hours a day to improve their performance without receiving any recognition or awards from others. Often, intrinsic incentives are useful in increasing one’s empowerment, utility level, and autonomy and can reinforce employees’ work involvement and commitment.

On the other hand, an extrinsic incentive is when a person faces external pressure that compels them to act in a particular way. The external pressure could include either a reward for completing the task or could be a form of punishment or consequence if the task is not completed. For example, an employee may be motivated to complete an extra unit of work if the employee knows that they will receive a bonus at the completion of that extra unit. As such, extrinsic incentives can often be effective in helping people improve their motivation when facing different difficulties with the completion of a given task or lack interest in participating in an activity.

Intrinsic incentives and extrinsic incentives are both important and drive people's behavior. Experts believe that intrinsic incentives are stronger motivators compared to extrinsic incentives as they increase employees’ work engagement and genuine enjoyment of work. However, people's intrinsic motivation tends to decrease when they are offered too many extrinsic rewards. In order to maintain the action, constant incentives have to be provided. This is known as the Overjustification Effect.

Overall, the standard "law of behaviour" suggests that more incentives will result in higher performance and higher effort. People can take their performance to the next level by being rewarded for their efforts. As a result, extrinsic incentives are commonly used within the workforce by employers and managers. This is because employers believe that the more they encourage their employees to act in a manner which is consistent with the interests of the firm, the more likely the firm is to reach its organizational goals.

However, there are some parties who oppose the benefits of using extrinsic incentives and believe that they cause more harm than good. These opponents believe that the constant use of extrinsic incentives can lead to the crowding out of intrinsic incentives, which are also valuable performance motivators. When people are constantly being incentivised by external pressures, they neglect their intrinsic motives which could consequently be detrimental to their work ethic. Employees can become too comfortable with consistently gaining some reward for acting in a manner which is consistent with the interests of the firm. As a result, employees begin to believe that they deserve to earn rewards for doing certain things, not for the benefit of the firm but rather for their own benefit, which leads to them shirking if no extrinsic incentive is offered in return for high effort.

Nonetheless, incentives (both intrinsic and extrinsic) can be beneficial in altering a person's behavior and can be effectively used and executed within many different areas of life including in the workforce, in education and within one's personal life.

Classification

Classified by David Callahan, the types of incentives can be further broken down into three broad classes according to the different ways in which they motivate agents to take a particular course of actions:

Monetary incentives

Monetary incentives are any form of financial good given to someone to incentivize their actions and align their incentives with those of the principal who provides the monetary incentive. This is a type of extrinsic incentive and is commonly seen in the workplace. They can come in the forms of profit sharing, bonuses, stock options or even paid vacation time. Well-chosen monetary incentive programs can produce positive motivation and influence the productivity and output of individuals and firms.

A common monetary incentive system used by firms is performance-based pay where incentives are paid based on employees' productivity or output over a particular period of time. Some methods are commission-based where the employee, for example a salesperson, receives a payment directly correlated to their output level. Firms also pay additional wages or rewards for employees who work overtime and for their additional work above firm expectations. Expectancy theory implies that, provided employees place sufficient value on the monetary incentive to justify their extra effort and perceive that greater effort will result in better performance, such incentives can motivate employees to maintain high levels of effort and discourage shirking. This in turn increases the individual productivity of workers and the overall productivity of the firm.

Other monetary incentives are less direct, such as awarding periodic, discretionary bonuses to top performers, offering the possibility of a promotion to a higher-paying position or profit sharing for team projects. Alternatively, firms can also incentivize their employees to perform by threatening to demote or terminate them for poor performance. When employees feel that their careers are in jeopardy, they are more likely to increase their efforts.

The effect of monetary incentives can depend on the framing of the rewards. For example, in cadaveric organ donation, funeral aids are perceived to be more ethical (particularly in showing gratitude and honoring the deceased donor) and potentially increase donation willingness than direct cash payments of the same monetary value.

Non-monetary incentives

Non-monetary incentives can act as an impactful reward system to employees with superior performance that is independent to predetermined targets. Non-monetary incentive places focus on providing recognition to employees, which acts as a reinforcement to encourage work engagement and productivity. Some examples of these incentives include extra paid holidays, recognition, gifts, family benefits or even work-based perks such as more interesting projects or work. Rewards such as these tend to boost employees' job satisfaction as they feel more appreciated for their efforts. Compared to monetary incentives, studies have shown that employees find non-monetary incentives more memorable as they are separated from normal pay and hence are more distinguishable.

Effective use of non-monetary incentives can positively influence employees’ perception of the company’s image as well as increase the morale of firms. Compared to monetary incentives, non-monetary incentives hold a deeper and longer-lasting influence on employees’ motivation as it results in a higher utility level. Employees with higher job satisfaction and morale were found to have better overall performance, contribution and hence higher productivity.

Incentives in the economic context

The economic analysis of incentives focuses on the systems that determine the incentives needed for an agent to achieve a desired outcome dictated by the principal. Incentives can help companies link employees' rewards to their productivity. When a firm wants their employees to produce a certain amount of output, it must be prepared to offer a compensation scheme such as a monetary bonus to persuade employees to reach the target output. Compensation must achieve two goals. The first is to reduce employee turnover and retain the highest performing and most productive employees. Compensating employees can help attract workers to work harder and retain their ability. The second is to improve productivity. Compensation can not only stimulate the ability of workers to produce output, but also improve the enthusiasm of employees to work, thus promoting business development. A rise in pay variance across the firm reflects an increased demand for highly productive workers, and therefore compensation has begun shifting towards pay-for-performance. This helps employees recognize the direct relationship between their work output and their reward.

Misaligned incentives

Principals within a firm want their agents to work for the principals' best interests, but agents often have different goals than the principals. Due to this problem of misaligned incentives, firms must design compensation plans to induce workers to act in the firm's best interest and generate a level of output that maximizes the firm's profits.

The problem of asymmetric information means that the principal does not know exactly how to motivate its agents to act in the firm's best interests. Consequently, compensation plans are difficult for firms to design. The principal-agent theory is used as the guiding framework when aligning incentives with the employee's effort to obtain the efficient level of output for the firm. For example, a manager may want a certain level of output from an employee but does not know the capabilities of the employee in the presence of imperfect monitoring, and to achieve the best outcome, an optimal incentive scheme must be designed to motivate the worker to increase their productivity.

CEO incentives

The board of directors in a company plays an important role in creating incentives for CEOs so that their best interest aligns with that of the shareholders. CEOs can be given incentives in many forms, including salary, bonuses, shares, and stock options to reward spectacular performance while penalties can be imposed for unsatisfactory performance. To ensure that the CEOs are appropriately incentivized, CEOs can be made the substantial owners of the company’s stock by the board of directors. CEOs that own a portion of the company’s stock will have an incentive to work towards the common best interest of themselves and the company shareholders. Threat to dismiss the CEOs for unsatisfactory performance can also act as an incentive to reinforce the performance of the CEOs, which can in turn maximize the company’s value. The possibility of dismissal will increase CEOs’ accountability for their own actions considering that the possible dismissal would likely lead to a poor reputation for themselves. As a result, a potential increase in work engagement and performance can be seen.

Apart from monetary incentives, non-monetary incentives also play a part in increasing the work performance of CEOs. Non-monetary incentives can be introduced in the form of benefits such as power, public acknowledgement, prestige, and title. However, some argue that non-monetary incentives are less impactful.

Tournament theory

Tournament theory describes a framework of compensation based on an individual's position within a firm's hierarchy. The theory demonstrates that individuals are not promoted on the basis of their absolute performance and output, but instead based on their performance relative to other employees in the same position within the organization. Ceteris paribus, the larger the difference in compensation between one position to the next, the greater the incentive to exert more effort in order to achieve a promotion. However, that incentive is diminished as the size of the firm (and therefore the potential candidates for promotion) increases.

Firms must address the risk that a relative compensation scheme could incentivize uncooperative behavior amongst co-workers. Accordingly, firms encounter a trade-off between incentivizing workers to increase their efforts by increasing pay variance between the promoted and the unpromoted and, on the other hand, minimizing disharmony amongst co-workers by maintaining some level of pay compression.

Self-selection effects of incentives

Employees know more about their own abilities, competitiveness and risk attitudes than potential employers. Due to this asymmetric information, firms design incentives not only to enhance employees’ motivation to act in the interests of the firm and maximize their output, but also to influence the type and quality of workers that they attract. For example, empirical studies have shown that firms which implement pay-for-performance rather than fixed wage compensation schemes tend to attract more productive workers who are less risk averse. Accordingly, firms use incentives as a method of filtering out low productivity workers.

Team-based incentives

Production is increasingly organized around teams in many large firms. Teamwork may enhance company productivity for firms that encounter multidimensional, complex problems. A firm may be able to solve a complex task which requires a high level of various different skills by assigning it to expert workers with complementary skills. Due to constantly advancing technologies, seldom does an individual employee have an absolute advantage across all skills that are required to solve the complicated problems that firms face, hence team collaboration is crucial and beneficial to ensure the success of a team.

Individualized incentives are said to be dysfunctional in an interdependent working environment where individual performance is difficult to observe and so firms may opt for team-based incentives instead. Team-based incentive refers to the incentive system that rewards employees based on performance of the team. Team-based incentives are described as more beneficial to companies than individual-based incentives. By paying a straight piece rate to individual employees, they would have little to no motivation to help each other as the incentives they receive are irrespective of the result of others. On the other hand, paying team incentives based on team output can promote cohesiveness, trust, cooperation, and support within a team. Researchers found a positive relationship between team-based incentive and employees’ work efficacy, stability, and salary as well as company output.

Research shows that employees prefer individual-based incentives over team-based incentives due to a few reasons. Firstly, they believe that team-based incentives are prone to unfairness. Employees with more contributions may be discouraged from seeing employees that contributed less receiving the same level of incentive. Moreover, as a team expands and the effect of team incentives weakens, employees struggle to establish a clear link between effort given and incentives received. It is also inevitable that team incentives could induce the free-rider problem because an employee’s motivation to maximize their individual output could be diminished. Managers may need to offer a team incentive that is strong enough to ensure that each worker’s individual payoff from exerting maximum effort is greater than their individual payoff from free riding on the efforts of other team members.

Using Game theory to illustrate this, firms need to implement a team-based incentive that results in the value of ‘Y’ in Game 1 being greater than 100 and enforce a punishment for free-riding that makes the value of ‘X’ less than 40. This would ensure that both team members’ dominant strategy in Game 1 is to work hard and the Nash equilibrium is (Work Hard, Work Hard).

In contrast, some studies have shown that peer pressure and employees’ intrinsic incentive to perform well in a team environment may mitigate the free-rider problem associated with team-based incentives. Such case studies demonstrate that team incentives increase firm productivity in settings that involve complex, interdependent production where peer pressure and intrinsic incentives outweigh selfish preferences. Peer rating system can also be introduced for team members to rate each other’s contribution to a task. Research findings show that imposing a penalty on free riders is useful in decreasing the tendency of free riding.

Potential issues associated with the use of incentives in firms

Ratchet effect

Incentives are arguably beneficial in increasing productivity, however, they can also have an adverse effect on the firm. This is evident through the ratchet effect. A firm may use its observation of an employee's output level when they are first employed as a guide to set performance standard and objectives for the future. Knowing this, an employee may deliberately reduce their output level when first employed or hide their ability to produce at a higher output with the intent of exploiting being rewarded in the future when they strategically increase their output level. Best performances of employees can be limited from it. Thus, the ratchet effect can significantly diminish production levels of a firm and planned economies.

Crowding-out effect

Additionally, in the 1970s psychologists began exploring the relationship between extrinsic and intrinsic motivation whilst economists were simultaneously studying the "crowding-out" effects of monetary incentives. This came as a result of Richard Titmuss' 1970 publication, "The Gift Relationship", which explained how the constant use of extrinsic incentives can result in conflict with intrinsic motivators and lead to the desired behavior being "crowded out". In his publication, Titmuss argued that the use of monetary incentives was disrupting social norms around the idea of voluntary contribution and would ultimately have a crowding-out effect. He acknowledged that if the incentives are large enough, they are more likely to offset crowding-out effects (at least in the short run while the incentives are being offered). However, Titmuss noted that making the incentives too large could also have an adverse effect due to the possibility of negative inferences being drawn from the size of the incentives. Crowding-out effects can also occur when temporary incentives are removed in the long run. In the workplace, the complete removal of extrinsic incentives can result in employee effort levels being lower than they were when the incentives were offered, thereby hindering motivation and performance.

Stock options

Incentives are not always effective at aligning employees' incentives with those of the firm. For example, some corporate policies popular during the 1990s aimed to encourage productivity have led to failures as a result of unintended consequences. Moreover, providing stock options was intended to boost CEO productivity through offering a remunerative incentive to align the CEOs' interests with those of the shareholders to improve company performance. However, CEOs were found to either make good decisions which resulted in a reward of a long-term price increase of the stock, or were found to have fabricated the accounting information to give the illusion of economic success and to retain their incentive-based pay. Furthermore, it has been found to be extremely costly for firms to incentivize CEOs with stock options. Nevertheless, firms are forced to pay substantial amounts of money to ensure that CEOs act in the best interest of the firms.

Conflicts generated by pay variance

Incentives can have a bipolar effect on the company. On the one hand, the company's incentives to employees may create a pay gap. For example, low-paid employees may reduce their production or contribution to the company. Low-paid employees and high-paid employees may not be able to communicate and cooperate effectively, causing low-paid employees to gradually lose their enthusiasm for work. Firms should provide a fair amount of incentives for both low-paid and other employees, incentives for low-paid workers can be breaks rather than monetary incentives. Motivating employees with financial rewards may make a difference. That's because if the company is profitable in the first year, it may have plenty of bonuses to hand out to employees. However, if the company makes less money in the second year than it did in the first year, the company may not be able to give employees the same bonuses as in the first year even though they put in the same effort. This also reduces employees' motivation to work. Therefore, incentives may be counterproductive. Firm can provide other types of incentives rather than monetary incentives, such as promotion or vacation breaks for high-performing employees.

Incentives in the context of voluntary contributions

When it comes to volunteering activities, monetary incentives can bring negative effects. According to the Self-perception theory, humans constantly seek explanations for their behavior. When individuals are involved in volunteering activities, they most likely perceive themselves as prosocial and altruistic, and attach a symbolic price to the act of volunteering. When a monetary reward is attached to an otherwise prosocial activity such as volunteering, people may perceive that their originally altruistic actions are now linked to extrinsic incentives, causing their self-image benefit and prosocial motivation to decrease. A crowding-out effect leads to a decrease in individuals’ desire to volunteer and people eventually stop contributing due to the rewards attached. For example, if monetary incentives are offered for voluntary blood donation, it will have a negative effect on the amount of people donating blood.

Incentives in the educational context

Incentives can have a positive effect on education. For example, students may underestimate their own learning ability. Incentives not only make teachers or parents pay more attention to students' abilities, but also encourage students to achieve good learning outcomes. However, it is worth noting that monetary incentives may not be positive. There may be bribery education in monetary incentives, and this monetary incentive is often contrary to morality.

Conclusion

Ultimately, there is always potential for conflicts to arise, both in the short and in the long run, during the application of incentives in different areas, as incentives that seek to change behaviours can cause crowding out on intrinsic motivators. Growing evidence suggests that economists must broaden their focus when exploring the effects of incentives as the effect they have is largely dependent on how they are designed and specifically how they interact with intrinsic and social motivators in the short run and the long run.

See also

• Climate finance
• Climate Investment Funds
• Bounty (reward)
• Eco-investing
• Environmental Quality Incentives Program
• Externality
• Incentive-centered design
• Incentive payments
• Incentive program
• Incentive trust
• Incentivization
• Investment incentive
• Long-term incentive plan
• Loyalty marketing
• Loyalty program
• Motivation
• Motivational salience
• Motivations of open source programmers
• Motivations for online participation
• Performance-related pay
• Perverse incentive
• Positive-incentive value
• Profit motive
• Research and Development Tax Incentive
• Reward system
• Social Impact Incentives
• Steering tax
• Tax incentive
• Travel incentive
• Wicked problem

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