Welcome back.

In this video we're asking whether a job should use short-term incentives.

And before we ask this question, we should point out that n most jobs,

short-term incentives are not a big part of total compensation.

Rather, if we're looking at the pay mix as a whole, most people are getting

the majority of their pay through base pay, not through short-term incentives.

And so let's look at some examples.

If you think about nurses, or we think about perhaps office workers,

salaried office workers, these are jobs where

most people aren't getting the majority of their pay through short-term incentives.

But on the other hand, short-term incentives are prominent pieces

of total compensation package in some other jobs.

So for example, in a factory, a worker might be paid a piece rate

that is a certain commission for every unit that they produce.

Or in agricultural work,

people might be paid per basket or bushel of produce that they pick.

And in some jobs, we might see incentives, but

their use is relatively controversial, such as for teachers.

And so what makes these jobs that use short-term incentives

different from jobs that don't?

Or in other words, what is it that seems to make a job a good candidate for

short-term incentives?

And what is it that makes a job seemingly a bad candidate for short-term incentives?

And to answer those questions,

we want to look at kind of the typical problems of short-term incentives.

That is, these are the typical reasons why a job

might not actually be paid with using short-term incentives, and

instead might be paid more in terms of a base salary.

So the first problem is the alignment problem.

So what's the alignment problem?

The alignment problem is that the performance measures aren't very well

aligned to what it is that we want to get out of our workers.

And so kind of our lesson is, don't pay for A while expecting B.

So we might see this in examples like gaming, gaming an incentive plan.

There is a famous example from a company called Lincoln Electric.

And in that company, they used to pay typists by the keystroke.

What the found were that some of the most productive typists

were just spamming one key on their keyboard over their lunch break.

Actually, this wasn't a very productive activity.

The second problem is the measurement problem.

That is, you can't measure what it is that we want to measure.

And the lesson here is that you shouldn't pay

short-term incentives for things you can't easily measure.

And kind of the example from Lincoln Electric, again,

would be, we want those keystrokes to be high quality.

But at the same time,

we can't really measure easily what it is that makes a keystroke high quality.

The third problem is the metering problem, and that is that you can't define success.

Perhaps this is a job that you haven't had before in the past.

And so you can't tell the difference between a good output and a poor output.

In other words, we find it hard,

difficult to benchmark these jobs and to find success.

Kind of our lesson here is that we want to benchmark low short-term incentives, or

low target incentives for low performance, and high short-term incentives for

high performance.

And to do that, of course, we need to be able to define what low performance is.

And we need to be able to define what high performance is.

A fourth problem is the control problem.

So what's the control problem?

Well, that's where your success depends on factors that are outside of your control.

And our big lesson here is, don't use incentives for

measures that workers can't control.

Workers tend to be more risk averse than their firms.

And so when you're paying them incentives for

things that are outside of their control, you're pushing more risk on those workers.

And it's also potentially very demotivating

to get a cut in pay because of things that you never really had control over.

And so if you're able to solve there problems,

then that job that you're looking at might be a good candidate for

a pay mix that is heavily weighted toward short-term incentives.

And so let's try to look at some more examples.

So the first example I want to get back to are paying teachers for

the test scores of their students.

So here, the alignment problem could be that we want teachers to teach both

technical skills and also soft skills like creativity and cooperativeness, and so on.

And that goes along with our measurement problem which is,

technical skills are easy to measure.

We can give, for example, a test at the end of the year to see,

to gauge students' learning on those technical skills.

But it would be very hard to administer a test that actually measures the students'

creativity or their ability to cooperate with others.

And so since it's difficult to measure those other things that we also want

teachers to be imparting to their students,

we end up having an alignment problem when we design these tests.

And that leads to things such as teachers teaching to the test, as opposed to

teaching both the skills that are on the test and also those other things,

those values that we want teachers to be imparting to their students.

We also have metering control problems as well.

So for example,

when we're giving an exam, we may not know what scores are grade appropriate.

So for example, if we have a new exam, and

it's being rolled out to perhaps a very small population,

then we might not know whether those scores are good scores or

poor scores, because we don't have any experience using that particular exam.

It also could be difficult to meter an exam because of the control problem.

That is, the teachers don't have control over what students know when they enter

their class.

So for example, if the students have their teacher and

they have their teacher for a full year and

at the end of the year only 60% were reading at grade level, it could look bad.

But if I told you that before, when the students

had come into that person's class, 0% of them were reading at grade level.

Well in that case, even though 60% reading at grade level isn't what

the teacher wanted, it's still a very big improvement.

And so by that measure, according to the metering problem, well, maybe

the teacher actually did do a good job by helping some of those students catch up.

But then you also had the control problem, where the teacher never really had control

over the quality of the students when they came into that class.

Let's take another example from factory piece rates.

So in a factory, if you're paying a piece rate, that is, a dollar value for

every unit that they produce, then quality might suffer.

That's because you're paying for quantity, but you're expecting both quantity and

also quality.

And so if we look at the measurement problem, we're saying that we can't, and

so kind of related is the measurement problem.

We may not be able to keep track of the numbers that workers produce.

And it might also be very difficult to measure the quality of the items that they

produce as well.

That's why, to solve the measurement problem,

we also might have to have some sort of a way of using serial numbers or

something to track the quality of the items as they come down the assembly line.

That way we can solve that alignment problem.

Now we get to metering control.

Our metering problem might be that for a specific task,

we can't define good performance.

So let's say that a worker perhaps gets a new piece of technology a new piece

of equipment, and

we find out that there's a 2% defect rate on the items that they're producing.

Now is that a good performance?

Well, we don't necessarily know, because we don't have experience with that item.

We don't have experience with that new piece of capital.

It could be the case that that 2% defect rate is very high or very low.

But we just don't know, because we don't have good data on that yet.

Also, we have the question of control.

Again, the control problem here would be that employees don't necessarily have

control over the workmanship of their inputs.

So for example, if we're paying workers for the quantity that they produce and

also for the quality of the items that they produce, it could be challenging.

Because perhaps the materials,

perhaps the steel that they're getting is defective or of low quality.

Or if they are assembling cars,

it could be that the suppliers are giving them poor engines to put into their cars,

and that's leading a lot of these cars to be returned to the manufacturer.

And again, these are for things that are outside of the worker's control,

because they're only getting those poor inputs from somewhere else.

And so kind of the big idea here is,

again, short-term incentives are only one element of the pay mix.

And is also, we can include multiple different short-term

incentives as part of our whole short-term incentive package.

So for example, a piece rate where we're just paying workers per unit they produce

might have quality concerns,

as workers allocate their effort more toward quantity of production.

And so one thing we can do is,

we can incorporate piece rates into a plan that also includes bonuses for quality.

Another big idea is that if we're introducing an incentive,

we also want to give workers the ability to fix their own problems.

So for example, in some cases,

there could be a problem that seems to be outside of a worker's control.

But after the incentive is introduced, it's discovered that worker could have

at least some ways of actually managing some of that risk.

So for example, there's a famous example of a company called Safelite Auto Glass.

When they introduced an incentive to their workers for

installing and repairing auto glass, they found that there

are some things that seemed to be outside of the worker's control.

So for example, whether the customer was actually present

after they called in the representative from Safelite Auto Glass.

But after the introduction of the incentive,

some of the most savvy workers began to phone ahead to make sure that the customer

was ready to have their car serviced.

And so this is just an example of how when introducing incentives,

you want to enable workers to fix problems as they arise themselves.

And again, this is,

in itself, a very productive, potentially very productive activity.

So next up we're going to be talking about how to design incentive plans.

See you next time.

2.2.2 Should Jobs Use Short Term Incentives?

Managing Employee Compensation

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