Why is it important to develop a well-structured incentive system? One of the reasons is due to the concept of moral hazard. Moral hazard is an idea that an individual or group that is protected in some way will act differently than if they did not have that same protection.
We have come across examples of moral hazard every day. For example, one a professor is tenured, does the quality of his or her lectures decrease to focus more on research? If workers go from an hourly wage to a salaried one do they take extra breaks and longer lunches? If you have car insurance are you more than likely to take risks when driving your vehicle?
Most recently, the outcome of the Great Recession represents moral hazard. Are corporations that are too big to fail more willing to take larger risks due to them being bailed by the government and main street?
A major issue with moral hazard is because you can’t always observe someone’s action or effort. You can only assume that they are being productive at work and not shirking (slacking). As a result, an incentive, let’s say a bonus payment, cannot be based on effort. This is very unfortunate since companies ultimately want more effort from their employees. For an incentive system to work, it must be based on a metric that is observable like an increase in a company’s profit.
However, incentive programs can be impacted by other factors. For example, in agricultural areas like the Central Valley of California, the recent drought contracted profits for agricultural firms. Even though farmers and workers may have put in maximum effort, profits decreased due to factors beyond their control resulting in a missed incentive payout. Ultimately, when developing incentives, you need to be cautious in penalizing workers due to bad luck (bad outcome) or rewarding them for good luck (good outcome). This is especially the case when the factor has a high probability of occurring.
Sometimes as an employer you must pay a premium for talent and to mitigate the chances of shirking and employee turnover. This is known as an efficiency wage. An efficiency wage is a wage that is higher than the market equilibrium. Incentives can be tied to efficiency wages in the form of a carrot (additional reward).
As consumers, we deal with efficiency wages all the time. For example, why do people choose to buy Apple products? One of the reasons could be the quality of the product in relation to competing products. We are willing to pay a premium for better quality (efficiency wage). Why do people choose to go to the same mechanic when they can go somewhere else and possibly pay a lower price for the same work? The answer could be due to honesty. People are willing to pay a higher premium for honesty (efficiency wage) and the honest work that the mechanic will do rather than take the risks and costs associated with a potentially dishonest mechanic.