The Power of Incentives

I just finished to read a new book called "Freakonomics" by Steven Levitt & Stephen Dubner. Levitt is not the typical economist, he looks at the world in a different way; he uses economics to explain human behavior. The book was written based on few fundamental ideas, I would mentioned two:

a) Incentives are the cornerstone of modern life

b) The conventional wisdom is often wrong (But not always!)

He goes to mention that understanding incentives is the key to understanding about any riddle.

In chapter one, he examines an example of late pick ups from a daycare center. According to Levitt there are three types of incentives: social, moral & economics. The moral pressure to pick up children by the scheduled time was proving inadequate, and late pickups were becoming a business problem for the daycare center. To encourage better promptness, the administrator introduced a small fine for tardy pick ups. If parents were 10 min late they would pay $3USD per child for each incident. The fee would be added to the parents monthly fee.

After the fee was enacted the number of late pick ups went up! double the original number. According to Levitt, this incentive substituted an economic incentive ($3 penalty charge) for a moral incentive, the guilt that parents were supposed to feel when they came late. For a few dollars each day , parents could buy off their guilt... Furthermore, the small fine send a signal to the parents that weren't such a big a problem.

After couple weeks the daycare administration decided to take away the penalty fee, but the number of late pick ups did not went down. Now they could arrive late, pay no fine and feel no guilt.

By now you may have already guess that the solution was a larger penalty fine... large enough that parents really wanted to avoid the payment of the fee.

In October 2003, Charlie Munger gave a speech to the undergraduate students of University of California, Santa Barbara, he posed a problem to the students where a tire store chain in the Northwest has succeeded over fifty years (Les Schwab tire store chain)... Les Schwab started competing first with Goodyear, then competition was with the great discounter's such as Costco and Sam's Club... and Schwab still remains. (Note, the owner has no education at all)

Charlie answered on how Les Shwab accomplished it's success by mentioning that they must have done a lot's of things right, but among the best things was that the company harnessed what Mankiw calls the "superpower of incentives". He must have a very clever incentives structure driving his people.

Just give it a second thought on this concept... and you will find that everything that we do in life is based on some sort of incentive. That's the way that we learned since we were children... if you get A's you get a prize, if you disobey your parents you get grounded.

Isn't it possible then that what Levitt saids about incentives "understanding incentives is the key to understanding about any riddle." can helped us to understand the world that we live?