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The paradox of incentives

27 January 2012

9:21 AM

27 January 2012

9:21 AM

Banker bashing has become something of a national pastime, and politicians have been quick to join in. But rather than devoting their energy to avenging past sins, our political leaders might be
better off learning the lessons of Dan Ariely’s book, The Upside of Irrationality.

In this valuable work, Ariely shows that the incentive of big bonuses can actually damage performance, not improve it.

He cites a century-old experiment in which rats were placed in a cage with two pathways. One led to a reward, the other to a device which gave the rats an electric shock. The aim of the experiment
was to see how quickly the rats learned which path to take.

As an added twist, the scientists varied the size of the electric shock. Some rats who took the wrong pathway received a low level shock, which produced a tickling sensation. Others received a
medium shock, while a third group received a high level shock, which was almost fatal.

The results seem eminently predictable.  The higher the electric shock received, the greater the motivation there is for the rat to learn the rules of the cage, and therefore those rats who
receive the strongest shock are the quickest to learn which pathway to take out of the cage.  It is obvious.
But wrong.

The rats which received the biggest shock — in effect the most severe punishment for making a poor decision — were slower to figure out which pathway was right than all the other rats.
In other words, the group with the biggest incentive to succeed were the least successful. 


Perhaps I’m being uncharitable by drawing parallels between rats and bankers, but Ariely’s own work suggests that humans react in the same way as rats do when it comes to motivators.

In a different experiment, this time conducted in India, Ariely offered volunteers bonuses for winning games which tested their reasoning skills and cognitive ability. The volunteers were divided
into three groups. For the first group, the bonus on offer was equivalent to a day’s pay for the average local worker. Winners in the second group received a bonus worth two weeks’ pay,
and in the third group, 5 months’ pay.

The results would make bankers quiver.

You would expect those with the most to gain to be the most motivated and perform best. In fact, those in line for the biggest bonus performed more slowly and less successfully than those chasing
more modest windfalls.

Instinctively we think large monetary incentives must encourage individuals to go the extra mile. But Ariely draws our attention to the psychology of bonuses and the dangers huge rewards can
create. The frantic pursuit of riches can heighten feelings of workplace stress and encourage recklessness and poor decision making.

Unsurprisingly the banks don’t want to hear this.

After presenting his findings to leading banking executives, Ariely describes how they agreed that large bonuses may have a negative effect for others but certainly not for them! It is unfortunate
that they refused an opportunity to take part in a study themselves.

The promise of vast rewards has led many bankers to take enormous risks with people’s money. Banks like Goldman Sachs and Barclays have been fined for their poor practices. At the very least
they behaved imprudently and took unjustified risks. At worst, their behaviour triggered the financial crash of 2008 from which the Western world will take years to recover.

Most of us Tories view with equanimity people who make large sums of money in pursuit of wealth and job creation. That’s an entirely virtuous outcome, and one which benefits society as a
whole. But we should distinguish a little more between wealth creation and the activities of some of our bankers, which amount to wealth extraction, and wealth extraction in their own interests at
that.

David Davis is the Conservative MP for Haltemprice and Howden


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