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 in 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 and not through short term incentives. And so, let's look at some examples. If we think about like nurses, or we think about perhaps office workers, salaried office workers, and 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 a 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 it 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. And so we might see this in examples like gaming, gaming an incentive plan. There's a famous example from a company called Lincoln Electric, and in that company, they used to pay typists by the key stroke. And what they 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. A 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 you want those key strokes to be high quality, but at the same time we can't really measure easily what it is that makes a key stroke high quality. A 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 targeting 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 onto 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 we're able to solve these problems, then that job that you're looking at might be a good candidate for a pay mix that is heavily weighted towards 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'd 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 tests, 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 might 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 that are good scores or poor scores, because we don't have an experience using that particular exam. And 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, on that case, even though 60% reading at grade level isn't what the teacher had 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 have the control problem, where that 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 might not be able to keep track of the numbers that workers produce, and it also might 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 the liner problem. Now we get to metering and control. Our metering problem might be that first 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 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 workers' 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 to the pay mix. And 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 a 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 workers actually 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 Safelight Autoglass. When they introduced an incentive to their workers for installing and repairing auto glass, they found that there are some things that seem to be outside of the workers' control. So, for example, whether a customer was actually present after they'd called in the representative from Safelight Autoglass. 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 we are introducing incentives, we want to enable workers to fix problems as they arise themselves. And again, this is in itself a very productive activity. So next up, we're going to be talking about how to design incentive plans. See you next time. [BLANK AUDIO]
