Step-by-Step: Analyzing Incentive Structures
There is a famous story, possibly apocryphal but pedagogically useful, about a colonial government that offered a bounty for dead cobras in an effort to reduce the cobra population in a city. Initially, the bounty worked: people killed cobras and brought them in for payment. But soon, enterprising citizens began breeding cobras specifically to collect the bounty. When the government discovered this and cancelled the bounty program, the breeders released their now-worthless cobras into the streets, and the cobra population ended up larger than before the program started. The program's designers asked "How do we get people to kill cobras?" when they should have asked "What behaviors will this incentive actually produce?"
This story illustrates the central challenge of incentive analysis: the behaviors that incentives produce are often different from, and sometimes opposite to, the behaviors that incentive designers intend. Incentives are among the most powerful forces shaping human behavior in organizations, markets, and societies. They determine what people do with their time, how they allocate their effort, which risks they take, which information they share, and which goals they pursue. When incentives are well-designed, they align individual behavior with collective goals and create systems that are self-correcting and self-improving. When incentives are poorly designed, they create gaming, dysfunction, and perverse outcomes that undermine the very goals they were supposed to advance.
Analyzing incentive structures is the skill of looking beneath the surface of any system, whether an organization, a market, a policy, or a team, to understand what behaviors are actually being rewarded, what behaviors are being punished, and what behaviors are being ignored. This analysis frequently reveals that the system's stated goals and its actual incentives are misaligned in ways that explain otherwise puzzling behavior. When you understand the incentives, the behavior stops being puzzling and starts being predictable.
This guide provides a systematic process for analyzing incentive structures, from mapping the obvious, formal incentives through uncovering the hidden, informal incentives that often have more influence than the official ones. It is designed for anyone who needs to understand why people in a system behave the way they do, whether you are a manager trying to improve team performance, a policy analyst evaluating a government program, an organizational consultant diagnosing dysfunction, or simply a curious person who wants to understand why systems so often produce outcomes that nobody wants.
What Should I Look for When Analyzing Incentives?
The first step in any incentive analysis is to develop a comprehensive inventory of the incentives that operate within the system. Most people, when asked about incentives, immediately think of financial rewards: salaries, bonuses, commissions, profit-sharing. These are important, but they represent only a fraction of the incentive landscape. A thorough analysis considers the full spectrum of incentives that influence behavior.
Formal Financial Incentives
These are the explicit monetary rewards and penalties that the system imposes. They include base compensation (salary, hourly wages), variable compensation (bonuses, commissions, stock options, profit-sharing), and penalties (fines, pay docking, loss of benefits). Financial incentives are the most visible and most studied category, and they are often the first lever that organizations pull when they want to change behavior.
But financial incentives are also the most frequently overestimated in their influence. Research by Edward Deci and Richard Ryan on self-determination theory has demonstrated that financial incentives are most effective for simple, routine, well-defined tasks and least effective, sometimes even counterproductive, for complex, creative, judgment-intensive tasks. For a factory worker on an assembly line, piece-rate pay is a clear, effective incentive. For a software engineer designing an architecture, a research scientist pursuing a hypothesis, or a teacher trying to inspire students, financial incentives can actually reduce performance by crowding out the intrinsic motivation that drives deep engagement with complex work.
Map every formal financial incentive in the system: Who gets paid what? How is variable compensation determined? What metrics trigger bonuses? What behaviors trigger financial penalties? Document the formulas, the thresholds, the timing, and the eligibility criteria. This documentation forms the foundation of your analysis.
Social and Status Incentives
Humans are profoundly social animals, and social incentives often exert more influence on behavior than financial ones. Social incentives include: recognition (public praise, awards, being mentioned in meetings or communications), reputation (being known as an expert, a leader, a reliable person), belonging (being included in important projects, invited to high-status meetings, considered part of the "inner circle"), and social approval (having colleagues, managers, and subordinates think well of you).
Social incentives also include social punishments: being excluded from decisions, not being invited to important meetings, receiving public criticism, being the subject of gossip, or losing the respect of peers. These social punishments are often more feared than financial penalties because they affect the person's daily experience and sense of identity in ways that a reduced bonus does not.
To map social incentives, observe: Who gets recognized and for what? What behaviors earn respect from peers? What behaviors earn respect from leadership? What behaviors result in social exclusion or criticism? Who is included in high-status activities (important projects, executive meetings, key decisions) and what did they do to earn that inclusion?
Career Incentives
For many professionals, career advancement is the most powerful incentive operating in their work lives, more powerful than this year's bonus and more powerful than social recognition. Career incentives include: promotion decisions (what behaviors and outcomes determine who gets promoted?), assignment decisions (what determines who gets the most interesting, most visible, most career-building projects?), development opportunities (who gets access to training, mentoring, and stretch assignments?), and exit pressures (what causes people to leave, and what signals that their career trajectory is stalling?).
Career incentives are particularly important to analyze because they operate on a longer time horizon than financial or social incentives, and they shape behavior in ways that are less visible but more pervasive. A manager who knows that promotions in their organization go to people who deliver projects on time, regardless of quality or sustainability, will optimize for on-time delivery even if it means cutting corners, burning out the team, or accumulating technical debt. The promotion incentive is shaping their behavior every day, in every decision, in ways that are invisible unless you explicitly map the connection between current behavior and career outcomes.
Intrinsic Incentives
Intrinsic incentives arise from the nature of the work itself rather than from external rewards or punishments. They include: the satisfaction of solving a challenging problem, the pleasure of learning something new, the fulfillment of doing work that aligns with personal values, the flow state of deep engagement with a meaningful task, and the sense of autonomy that comes from having control over how you do your work.
Daniel Pink, synthesizing decades of research on motivation, identified three core intrinsic motivators: autonomy (the desire to direct your own work), mastery (the desire to improve and develop skills), and purpose (the desire to do work that matters, that contributes to something larger than yourself). When these intrinsic motivators are present, people are capable of sustained, high-quality effort that no external incentive system can reliably produce. When they are absent, even generous financial incentives fail to generate genuine engagement.
To map intrinsic incentives, observe: Do people in the system have meaningful autonomy over how they do their work? Is there genuine opportunity for skill development and mastery? Does the work connect to a purpose that people find meaningful? Where intrinsic motivation is high, you will see people working with energy and creativity that exceeds what the formal incentive system would predict. Where intrinsic motivation is low, you will see people doing the minimum required by the formal incentives and no more.
Negative Incentives and Punishments
Finally, map the punishments and negative consequences that discourage certain behaviors. These include formal punishments (disciplinary action, termination, demotion) and informal punishments (criticism, exclusion, loss of interesting work, being labeled as "difficult" or "not a team player"). Negative incentives are important because they define the boundaries of acceptable behavior: they tell people not just what to do but what not to do.
Pay particular attention to what happens when people take risks that don't work out, when they raise uncomfortable concerns, when they disagree with leadership, and when they fail at ambitious goals. The system's response to these behaviors reveals its actual incentives far more clearly than its stated values. An organization that claims to value innovation but punishes failed experiments actually incentivizes caution and conformity. An organization that claims to value transparency but ostracizes people who share bad news actually incentivizes information hiding.
How Do I Identify Misaligned Incentives?
Misaligned incentives are the single most common cause of organizational dysfunction, policy failure, and market pathology. They exist when the behaviors that the system actually rewards are different from the behaviors that the system's designers or leaders intend to reward. Identifying misalignments is the core analytical skill of incentive analysis.
The Stated-Versus-Actual Test
The simplest and most powerful diagnostic is to compare what the system says it values with what the system actually rewards. Every organization has stated values (innovation, collaboration, customer focus, quality, integrity) that appear in mission statements, corporate communications, and performance review templates. And every organization has actual incentives that drive day-to-day behavior. The gap between stated values and actual incentives is where misalignment lives.
To apply this test, ask: "If someone in this system fully optimized for the stated goals, would they be rewarded or punished by the actual incentive system?" In many organizations, the answer is disturbing. A software company that states it values code quality but measures developers by lines of code or features shipped actually incentivizes quantity over quality. A hospital that states it values patient outcomes but measures physicians by patient throughput actually incentivizes speed over care. A school that states it values learning but measures teachers by standardized test scores actually incentivizes teaching to the test.
The person who fully optimizes for the stated goal (quality, outcomes, learning) will often underperform by the metrics that actually determine rewards. This gap between stated values and actual incentives creates a painful dilemma for conscientious workers and a cynicism-breeding environment for everyone.
The "Who Benefits?" Test
Another powerful diagnostic is to ask: "Who benefits from the status quo?" When a dysfunctional pattern persists despite widespread recognition that it is dysfunctional, there is almost always someone, some group, or some institutional interest that benefits from keeping things the way they are. Identifying who benefits reveals the hidden incentives that maintain the dysfunction.
For example, if a company's procurement process is widely recognized as slow, bureaucratic, and frustrating, but it persists despite years of complaints and multiple "reform" initiatives, ask: Who benefits from the current process? Often, the answer reveals that the procurement department's budget, headcount, and organizational status depend on processing a large volume of purchase requests. Simplifying the process would reduce their volume, which would reduce their justification for current staffing levels. The people responsible for "reforming" the process have a career incentive to keep it complex.
The "What Happens When?" Test
Observe what actually happens when specific behaviors occur:
- What happens when someone raises a problem early? If they are thanked and the problem is addressed, the system incentivizes early problem identification. If they are blamed for "being negative" or "not being a team player," the system incentivizes problem hiding.
- What happens when someone takes a risk and fails? If the failure is treated as a learning opportunity, the system incentivizes intelligent risk-taking. If the failure is punished, the system incentivizes caution and CYA (cover-your-ass) behavior.
- What happens when someone succeeds by cutting corners? If the shortcut is discovered and corrected, the system incentivizes doing things properly. If the shortcut is celebrated as "efficiency" or simply goes unnoticed, the system incentivizes corner-cutting.
- What happens when someone helps a colleague at the expense of their own metrics? If the helping behavior is recognized and valued, the system incentivizes collaboration. If only individual metrics matter, the system incentivizes selfishness.
These behavioral observations reveal the system's actual incentives far more accurately than any document, policy, or stated value can.
Steven Kerr's "Folly" Framework
One of the most influential papers in incentive analysis is Steven Kerr's 1975 article "On the Folly of Rewarding A, While Hoping for B," which catalogued systematic misalignments between desired behaviors and actual rewards across multiple domains. Kerr's framework remains remarkably relevant because the patterns he identified, rewarding individual achievement while hoping for teamwork, rewarding short-term results while hoping for long-term thinking, rewarding visible activity while hoping for difficult-to-measure outcomes, appear with depressing regularity in organizations across every sector and every era.
Kerr's central insight is that organizations do not have incentive problems because they lack good intentions. They have incentive problems because measuring the behaviors they actually want is difficult, so they default to measuring behaviors that are easy to measure, which are often different from the behaviors they want. The organization wants innovation but measures compliance. It wants collaboration but measures individual output. It wants quality but measures speed. In each case, the measurement system creates incentives that work against the stated goal.
What Are Common Unintended Consequences of Incentives?
Understanding common unintended consequences helps you anticipate them when designing incentives and recognize them when analyzing existing systems.
Short-Term Thinking
When incentives reward near-term results (quarterly revenue, annual performance metrics, election-cycle outcomes), they systematically discourage long-term investment. Managers cut R&D to boost this quarter's earnings. Teachers sacrifice deep understanding for test preparation. Politicians favor popular but short-sighted policies over unpopular but necessary reforms. The incentive structure makes short-term optimization rational for the individual even when it is irrational for the system.
Metric Gaming
Goodhart's Law states: "When a measure becomes a target, it ceases to be a good measure." This is one of the most important principles in incentive analysis. When people are rewarded based on a metric, they will optimize the metric, but optimizing the metric is not the same as achieving the underlying goal the metric was supposed to represent.
A call center measured on "average call handling time" incentivizes agents to rush calls and transfer difficult customers rather than resolving their problems. A hospital measured on "30-day mortality rate" incentivizes keeping dying patients alive for exactly 31 days, or reclassifying admissions to exclude high-risk patients from the measured population. A police department measured on "crime rates" incentivizes reclassifying crimes to less serious categories or discouraging victims from filing reports. In each case, the metric improves while the underlying reality the metric was supposed to represent either stays the same or gets worse.
Cooperation Breakdown
Incentives that reward individual performance in contexts that require teamwork systematically undermine cooperation. When salespeople are ranked against each other for bonuses, they hoard information and steal leads rather than collaborating. When academic departments are funded based on individual research output, professors avoid committee work and teaching that benefits the department but doesn't count toward their metrics. When divisions are measured as independent profit centers, they refuse to share resources, duplicate efforts, and sometimes actively sabotage each other's performance.
Crowding Out Intrinsic Motivation
One of the most counterintuitive findings in motivation research is that external rewards can undermine internal motivation, a phenomenon known as the overjustification effect. When people who are intrinsically motivated to do something (they find it interesting, meaningful, or enjoyable) begin receiving external rewards for doing it, their intrinsic motivation often decreases. The external reward changes their self-perception: they shift from "I do this because I find it meaningful" to "I do this because I get paid for it." When the external reward is later removed or reduced, their motivation drops below its original level because the intrinsic motivation has been eroded.
This effect has been documented in numerous studies and has profound implications for incentive design. Offering financial bonuses for creative work can reduce creativity. Paying students for reading can reduce their interest in reading. Rewarding blood donation with payment can reduce donation rates (because it changes the act from an altruistic gift to a commercial transaction). The implication is not that external incentives should never be used but that they should be applied with awareness of their potential to undermine the internal drive that often produces the best work.
Risk Aversion and Safety Seeking
When the penalties for failure are much larger than the rewards for success, people become excessively risk-averse. They avoid ambitious projects, decline challenging assignments, and stick to proven methods even when innovation is needed. In organizations where a single failure can end a career but a dozen successes are expected as baseline performance, rational actors will always choose the safe option. This is why many large organizations struggle with innovation despite genuinely wanting it: their incentive structures punish failure more severely than they reward success, creating a rational calculus that favors caution.
Focus on the Measurable at the Expense of the Important
Not everything important is measurable, and not everything measurable is important. But incentive systems, by their nature, must attach rewards to something, and that something must be observable and quantifiable. This creates a systematic bias toward rewarding measurable activities (lines of code written, calls answered, reports filed, widgets produced) at the expense of immeasurable but important activities (mentoring junior colleagues, building organizational trust, thinking deeply about strategy, maintaining relationships with key stakeholders).
The result is that the measurable activities crowd out the important ones. People spend their time on what gets measured because that is what gets rewarded, and the unmeasured activities, which may be more valuable, gradually atrophy.
How Do Intrinsic and Extrinsic Incentives Interact?
The interaction between intrinsic and extrinsic motivation is one of the most important and most misunderstood dynamics in incentive design. Getting this interaction wrong can turn a well-intentioned incentive program into a motivation-destroying disaster.
Self-Determination Theory
Deci and Ryan's self-determination theory provides the most comprehensive framework for understanding the intrinsic-extrinsic interaction. The theory proposes that humans have three basic psychological needs: competence (the need to feel effective and capable), autonomy (the need to feel in control of one's own behavior), and relatedness (the need to feel connected to others). When these needs are satisfied, intrinsic motivation flourishes. When they are thwarted, intrinsic motivation withers.
External incentives interact with these basic needs in predictable ways. Controlling incentives, those that are experienced as coercive or manipulative, that make people feel they are working for the reward rather than for the satisfaction of the work, undermine autonomy and reduce intrinsic motivation. "If you hit your target, you get a bonus" can be experienced as controlling, particularly if the target is imposed rather than chosen and the bonus represents a significant portion of total compensation.
Informational incentives, those that are experienced as feedback about competence, that provide useful information about how well one is performing, can actually enhance intrinsic motivation by satisfying the need for competence. "Your work this quarter was among the best in the department" provides competence feedback that increases motivation, even though it is technically an external evaluation.
The practical implication is that the design of the incentive matters as much as its magnitude. The same amount of money delivered as a controlling incentive ("Do X and I'll pay you Y") and as an informational incentive ("Your excellent work earned you a Y bonus this quarter") will have very different effects on intrinsic motivation. The first undermines autonomy; the second supports competence.
When Extrinsic Incentives Work Well
Extrinsic incentives are most effective and least damaging to intrinsic motivation under specific conditions:
- The task is routine and well-defined. For tasks that are not inherently interesting, where intrinsic motivation is minimal to begin with, extrinsic incentives can effectively motivate effort without crowding out anything important.
- The incentive is unexpected. Unexpected bonuses ("We were so impressed with your work that we're giving you an extra week of vacation") provide competence feedback without creating a controlling expectation.
- The incentive provides informational feedback. Incentives that tell people they are performing well enhance competence without undermining autonomy.
- The incentive preserves autonomy. Incentives that reward outcomes while leaving the method to the individual preserve the sense of control that sustains intrinsic motivation.
When Extrinsic Incentives Backfire
Extrinsic incentives are most damaging under the opposite conditions:
- The task is inherently interesting or meaningful. Adding financial incentives to work that people already find rewarding can transform their experience from "I do this because I love it" to "I do this because I'm paid to."
- The incentive is expected and contingent. "If you do X, you will receive Y" creates a transactional frame that undermines intrinsic engagement.
- The incentive is controlling. Incentives that micromanage behavior, dictating not just what to achieve but how to achieve it, thwart autonomy and reduce motivation.
- The incentive is competitive. Ranking people against each other for limited rewards creates anxiety, undermines relatedness, and shifts focus from the work itself to the competition.
What Questions Reveal Hidden Incentives?
The most important incentives in any system are often hidden, operating below the surface of formal policies and explicit reward systems. Uncovering these hidden incentives requires asking questions that probe beneath stated values and official policies.
"What Actually Determines Promotions, Raises, and Status?"
Forget the official promotion criteria. Observe who actually gets promoted and try to identify the common factors. Is it the people who deliver the best results, or the people who are most visible to senior leadership? Is it the people who take smart risks, or the people who never make mistakes? Is it the people who build the best teams, or the people who take credit most effectively? The pattern of actual promotions reveals the real promotion incentives, which may be very different from the criteria in the HR manual.
"What Would Happen to Someone Who Fully Optimized for the Stated Goal?"
This thought experiment is one of the most revealing diagnostics in incentive analysis. Imagine a person who single-mindedly pursued the organization's stated mission, with zero attention to internal politics, career positioning, or metric gaming. Would this person be rewarded or punished? In many organizations, such a person would be regarded as naive, difficult, or "not strategic," which reveals that the actual incentive system rewards political skill and self-promotion alongside (or instead of) mission achievement.
"Follow the Rewards, Not the Rhetoric"
When there is a contradiction between what leaders say and what the system rewards, behavior will follow the rewards. A CEO who gives inspiring speeches about innovation but cancels any project that doesn't show returns within two quarters is actually incentivizing short-term thinking, regardless of the rhetoric. A manager who says "my door is always open" but becomes visibly annoyed when interrupted is actually disincentivizing communication. Watch what is rewarded, not what is said.
"Who Benefits from the Status Quo?"
Every system has beneficiaries, people whose power, income, status, or comfort depends on things staying roughly the way they are. These beneficiaries have a strong incentive to resist changes that threaten their position, even changes that would benefit the system as a whole. Identifying these stakeholders and their specific interests explains why dysfunctional patterns persist and why reform efforts so often fail.
"What Is the Cost of Doing the Right Thing?"
In well-designed systems, doing the right thing should also be the rewarded thing. In poorly designed systems, doing the right thing carries costs: it takes more time, it conflicts with metrics, it requires confronting powerful people, or it puts the individual at risk. The magnitude of these costs reveals the strength of the misalignment. If the cost of doing the right thing is very high, the incentive system is deeply misaligned, and you should expect widespread gaming and shortcuts regardless of how ethical the individual actors may be.
How Can I Redesign Incentives More Effectively?
Once you have analyzed the existing incentive structure and identified its misalignments and unintended consequences, the natural next question is: how do you design better incentives? Incentive redesign is notoriously difficult because incentive systems are themselves complex systems with feedback loops, unintended consequences, and emergent behaviors. But several principles, drawn from decades of research and practical experience, significantly improve the odds of success.
Align Rewards with Desired Outcomes, Not Proxy Metrics
The most fundamental principle of good incentive design is to reward the actual outcomes you want rather than proxy metrics that may or may not correlate with those outcomes. If you want customer satisfaction, measure and reward customer satisfaction directly (through surveys, retention rates, or net promoter scores) rather than rewarding proxy metrics (call handling time, upsell rates, ticket closure rates) that may or may not correspond to actual satisfaction.
This principle sounds obvious but is surprisingly difficult to implement because the outcomes organizations actually want, innovation, quality, customer loyalty, employee engagement, ethical behavior, are often harder to measure than the proxy metrics that already exist in their data systems. The temptation is always to reward what is easy to measure rather than what is important to achieve.
Use Multiple Complementary Metrics to Prevent Gaming
A single metric can almost always be gamed. Multiple metrics that create checks and balances against each other are much harder to game because optimizing one at the expense of another triggers a signal that something is wrong. If a sales team is measured on both revenue and customer satisfaction, gaming revenue by pressuring customers into unwanted purchases will show up as declining satisfaction. If a software team is measured on both feature delivery and code quality, gaming delivery speed by cutting corners will show up as declining quality metrics.
The key word is "complementary": the metrics must measure genuinely different dimensions of performance that cannot all be optimized simultaneously through gaming. Two metrics that can both be gamed in the same way (for example, "lines of code written" and "files committed") provide no additional protection.
Consider Non-Monetary Incentives
For complex, creative, and judgment-intensive work, non-monetary incentives are often more effective than financial ones. These include: autonomy (giving people more control over how they do their work), mastery (providing opportunities for learning and skill development), purpose (connecting work to meaningful outcomes), recognition (publicly acknowledging excellent work), and interesting work (assigning challenging, engaging projects).
Non-monetary incentives are also less susceptible to gaming because they appeal to intrinsic rather than extrinsic motivation. A person who is motivated by the opportunity to learn and grow is less likely to game a metric than a person who is motivated by a financial bonus tied to that metric.
Provide Autonomy Where Possible
Incentive systems that specify both what to achieve and how to achieve it are more controlling and more motivation-destroying than systems that specify what to achieve while leaving the how to the individual. When people have autonomy over their methods, they maintain a sense of ownership and agency that sustains intrinsic motivation. When methods are prescribed, they become interchangeable executors of someone else's plan, which erodes the engagement that produces the best work.
Test Incentive Changes on a Small Scale Before Rolling Out
One of the most common mistakes in incentive redesign is implementing changes across the entire organization simultaneously, without first testing on a small scale. Because incentive effects are difficult to predict (especially the unintended consequences), a pilot program that tests the new incentives with a single team, department, or location provides invaluable feedback about what works, what doesn't, and what unintended behaviors emerge, at a cost that is a fraction of a full-scale rollout.
During the pilot, monitor not just the intended metrics but also: what gaming behaviors emerge? What unintended consequences appear? How do participants feel about the new system (surveys, interviews)? What behaviors increase and which decrease? How do the new incentives interact with the existing ones that were not changed? This monitoring provides the data needed to refine the incentive design before committing to organization-wide implementation.
| Incentive Design Principle | What It Addresses | Example Application |
|---|---|---|
| Align with outcomes, not proxies | Metric gaming, goal displacement | Reward customer retention, not call volume |
| Multiple complementary metrics | Single-metric gaming | Measure both speed and quality |
| Include non-monetary incentives | Crowding out intrinsic motivation | Offer autonomy, mastery, recognition |
| Preserve autonomy | Controlling incentive effects | Specify goals, not methods |
| Pilot before scaling | Unpredictable unintended consequences | Test with one team first |
| Periodically review and revise | Incentive decay and adaptation | Annual incentive structure audit |
Analyzing Incentives Across Different Contexts
Incentive structures operate in every domain of human activity, but the specific incentive patterns vary significantly across contexts. Developing facility with incentive analysis requires practicing in diverse settings.
Organizational Incentives
In organizations, the formal incentive structure (compensation, promotion, recognition) interacts with the informal incentive structure (social norms, cultural expectations, unwritten rules about "how things work here") to produce the actual behavior patterns you observe. Often, the informal incentives are more powerful than the formal ones because they operate continuously (every meeting, every conversation, every interaction) while formal incentives operate periodically (annual reviews, quarterly bonuses).
When analyzing organizational incentives, pay particular attention to the middle management layer, which is where stated values from the top most often diverge from actual incentives. Senior leaders may genuinely believe in the values they articulate, but middle managers, who are subject to intense performance pressure and limited autonomy, often create incentive micro-environments that optimize for their own metrics at the expense of the organization's stated values.
Market Incentives
In markets, prices serve as incentives that guide the allocation of resources. High prices incentivize production and discourage consumption; low prices do the reverse. But market incentives can be distorted by externalities (costs or benefits that affect parties not involved in the transaction), information asymmetries (one party knows more than the other), and market power (one party can set prices rather than accepting market prices).
Analyzing market incentives requires asking: Does the price reflect the full cost of production, including environmental and social costs? Does the buyer have access to the same information as the seller? Are there barriers to entry that allow existing players to charge above-competitive prices? Distortions in any of these dimensions create incentive misalignments that can produce market failures.
Policy Incentives
Government policies create incentives through taxes, subsidies, regulations, and enforcement. Policy incentive analysis asks: What behaviors does this policy incentivize? Are those the behaviors the policy intends to encourage? What gaming opportunities does the policy create? Who bears the costs and who captures the benefits?
The cobra bounty story is a policy incentive failure. Tax policy is replete with similar examples: tax deductions for mortgage interest incentivize homeownership but also incentivize larger mortgages and higher home prices, which may not be the intended outcome. Pollution fines that are cheaper than pollution prevention incentivize paying the fine rather than cleaning up. Welfare cliffs (where earning one additional dollar causes a large loss of benefits) incentivize staying just below the threshold rather than pursuing additional income.
A Worked Example: Analyzing a Sales Team's Incentive Structure
To make the analytical process concrete, consider a detailed example of analyzing the incentive structure of a B2B software sales team that is underperforming despite what management considers a generous compensation plan.
Step 1: Map the Formal Incentives
The formal compensation structure includes a base salary of $80,000 per year plus commissions of 10% on closed deals, with an accelerator that increases to 15% once the salesperson exceeds their quarterly target. There is also an annual "President's Club" trip awarded to the top 5% of salespeople by total revenue, and a "Rookie of the Year" award for the best-performing first-year salesperson.
Step 2: Map the Informal and Social Incentives
Through observation and interviews, you discover several informal incentive patterns. The weekly sales meeting begins with a public leaderboard ranking all salespeople by quarterly revenue. The top performers receive visible praise from the VP of Sales; the bottom performers receive pointed questions about their pipeline. Deal size is celebrated more than customer fit or long-term account potential. The stories told about "legendary" salespeople focus on their largest single deals, not on their customer retention rates or their mentoring of junior colleagues. New territories are assigned based on recent performance, so top performers get the most lucrative territories, creating a reinforcing advantage.
Step 3: Map the Career Incentives
Promotion to Senior Account Executive requires consistently exceeding quota for four quarters. Promotion to Sales Manager requires both performance and "leadership presence," which is informally understood to mean being visible, confident, and assertive in meetings. The path to VP of Sales has historically gone through people who built large individual books of business rather than people who built effective teams.
Step 4: Identify What's Actually Being Incentivized
The formal and informal incentives together create the following behavioral incentives:
- Maximize deal size (commissions, public leaderboard, cultural stories): Salespeople are incentivized to pursue the largest possible deals, even when smaller deals might be a better fit for the customer or more likely to close.
- Compete rather than collaborate (individual rankings, individual commissions, territory assignments based on individual performance): There is no incentive to share leads, help colleagues, or contribute to team learning.
- Prioritize closing over qualifying (revenue-based metrics, no measurement of customer fit or post-sale satisfaction): Salespeople are incentivized to close any deal they can, regardless of whether the customer is a good fit for the product.
- Focus on short-term revenue (quarterly targets, quarterly accelerators): There is no incentive to invest in long-term relationship building, account development, or pipeline quality.
Step 5: Identify the Misalignment
Management's stated goals include: growing sustainable revenue, building long-term customer relationships, reducing churn, and developing a collaborative sales culture. But the actual incentive structure rewards none of these goals directly. It rewards individual short-term revenue maximization, which is a different goal that produces different behaviors. The team's "underperformance" (high churn, low collaboration, poor customer fit) is not a failure of execution but a predictable consequence of the incentive structure. The team is performing exactly as the incentives direct them to perform.
Step 6: Design Interventions
Based on this analysis, potential redesigns include: adding a customer retention component to compensation (aligning incentives with long-term relationships), introducing team-based bonuses alongside individual commissions (incentivizing collaboration), measuring and rewarding pipeline quality metrics (incentivizing qualification), and revising the promotion criteria to include customer satisfaction and team contribution (aligning career incentives with organizational goals).
The Ongoing Practice of Incentive Analysis
Incentive analysis is not a one-time exercise but an ongoing practice. Incentive structures evolve over time as the system's participants learn to game them, as the external environment changes, and as new formal incentives are introduced that interact with existing ones in unpredictable ways. An incentive structure that was well-aligned when it was designed may become misaligned as conditions change, as people discover gaming strategies, or as the organization's goals evolve.
The most effective approach is to treat incentive analysis as a regular diagnostic activity, like a health checkup for the organization or system. Periodically ask: Are the incentives still producing the intended behaviors? Have new gaming strategies emerged? Has the environment changed in ways that alter the incentive landscape? Are the unintended consequences acceptable, or have they grown to the point where they undermine the system's goals?
The capacity to analyze incentives is, in the end, a capacity for a specific kind of honesty: the willingness to look at what the system actually rewards rather than what it claims to reward, and to follow the implications of that observation wherever they lead. This honesty can be uncomfortable, because it often reveals that the people designing the incentives, including ourselves, have created systems that produce exactly the outcomes they were designed to prevent. But that discomfort is the first step toward designing better systems, systems where doing the right thing and doing the rewarded thing are one and the same.
References and Further Reading
Kerr, S. (1975). On the folly of rewarding A, while hoping for B. Academy of Management Journal, 18(4), 769-783. https://doi.org/10.5465/255378
Pink, D. H. (2009). Drive: The Surprising Truth About What Motivates Us. Riverhead Books. https://www.penguinrandomhouse.com/books/305513/drive-by-daniel-h-pink/
Deci, E. L. & Ryan, R. M. (1985). Intrinsic Motivation and Self-Determination in Human Behavior. Plenum Press. https://doi.org/10.1007/978-1-4899-2271-7
Gneezy, U. & Rustichini, A. (2000). A fine is a price. Journal of Legal Studies, 29(1), 1-17. https://doi.org/10.1086/468061
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