Incentive Structure

It’s the Incentive Structure, Stupid

Since the purpose of profits is to signal what to produce, if the signal is imprecise the result can be disastrous – causing mayhem, disease, and death.   For example, prior to the 2008 banking collapse, people could make tons of money creating the collapse, but no one could make competitive profits preventing the collapse.  The results were the collapse, economic disruptions, poverty, psychological trauma, suicides, and more diseases of poverty.

In a similar analogy, people could make money rebuilding after the Katrina disaster, but no one could make substantial money preventing the disaster with steel reinforced dikes instead of earthen dikes.  The consequences of the California drought could have been ameliorated with a different incentive structure (National Geographic, 10/14).   In yet another example, the prevention of global roasting, which threatens all life, might have been more preventable, if the massive and lucrative fossil fuel industry were opposed by a substantial group that was larger than the struggling, fledgling renewable energy industry.   The implication of these examples is that some and possibly most disasters would be preventable under different incentive structures.

More evidence that incentive structures can have disastrous results comes from the persistence of many troublesome issues that appear to be resistant to solutions for our nation and for Washington D.C. like drug addiction, alcoholism, crime, corruption, obesity, diabetes, etc., etc. etc.  Since these issues have solutions, which are not rocket science; their persistence implies that we may not be spending enough money to solve these issues or that we are spending our money inappropriately.  Either way, their persistence implies that inappropriate incentive structures are probable contributors for their persistence.

More evidence for the incentive structure as the source for many troublesome issues comes from the existence of psychological phenomena.  Psychological phenomena drive all behavior, including economic and political behavior.   For example, alcoholism and addictions cause many troublesome issues.  Since psychological phenomena drive behavior, they also influence the incentive structure.  For example, some psychological phenomena like immediate gratification are usually more powerful or more likely to induce behavior than delayed gratification.  As a result, if one incentive structure offers a more powerful psychological phenomena like the immediate gratification of candy purchased at a check out counter and if another incentive structure offer long delays in benefits like the benefits of education for a pre-schooler,  for which the benefits and gratification may be decades away, the incentive structure with the greatest power will probably change and sustain behavior faster than the incentive structure with the least powerful psychological phenomena. Furthermore, marketers driven by competition must utilize the most powerful available to them in order to promote a product or service.  The result is a distortion in the economic playing field which provided advantages to the products sold with the most powerful psychological phenomena, provides a vicious cycle of disadvantages against products that can only be sold under weaker psychological phenomena, and results in suboptimal choices.

Since psychological phenomena drive behavior  and since some psychological phenomena are more powerful than others, we must control for the power of the psychological behavior before we can determine whether a behavior is optimal and rational for an individual or whether a psychological phenomenon drives behavior.  For example, if someone drinks 20 beers a day, you would want to have that consumer abstain from alcohol for 6 months and have the person consider whether or not a 20 beer per day consumption was truly optimal and rational or driven by the addiction of alcoholism in order to determine whether or not the individual was optimizing and rational in his or her consumption of beer.

If the incentive structure fails to adequately control for power of the psychological phenomena driving behavior then the results can be disaster, disease, and death as with the phenomenon of addiction to nicotine with cigarettes.  Furthermore, many and maybe most other psychological phenomena like cognitive framing (Daniel Kahneman) can result in suboptimal choices and distort the incentive structure toward persistent troublesome issues.  As a result, it is unlikely that we will be able to resolve many troublesome issues driven by psychological phenomena unless we correct the incentive structures to control for the power of psychological phenomena in order to balance the difference in power between psychological phenomena with incentive structures that will allow consumers to make more optimal choices.

While many governments try to accomplish this balance through taxes on addicting substances like alcohol and cigarettes and the prohibitions on other addicting substances like cocaine and heroine, governments are probably going to need to do a great deal more in order to balance between different levels of power between many types of psychological phenomena in order to correct and to balance the distortions in the current incentive structures resulting from psychological phenomena and thereby flatten the paying field between psychological phenomena, to ensure that consumers optimize choices, and to eliminate or reduce many persistent troublesome issues.

More evidence of incentive structures as a cause of persistent problems and a cause of policy failures to prevent disasters might start with the Constitution, because the Constitution forbids intellectual property for public policy, but advocates intellectual property like patents in various circumstances supporting private interests.  Since  laws like intellectual property laws influence the incentive structure, this difference in the availability of intellectual property for private and public interests suggests a potential innovative bias in favor of innovation for the private interests and against the public interests.   In addition, since innovation for the private sector is used to produce wealth, since “money is the mother’s milk of politics,” and since the Constitution prohibits intellectual property for public policy, even when it promotes the public good; the prohibition implies that the differences in wealth and profitability will help drive a vicious circle of political bias in favor of private interests at the expense of public interests due to competition for talent like lobbying talent, due to corruption, due to etc.

Furthermore, if people can profit satisfying the private interests, but can not profit protecting the public interests, all profit signals to determine what to produce become distorted, because  all markets interconnect.  Profits are like molecules of air in a balloon, which effect all other molecules in the balloon.  A distortion in one type of profit will lead to distortions in other profits like pressing in on a balloon forces the balloon to expand elsewhere.  As a result, failing to provide appropriate profits to protect the public will result in less precise profit signals with less public protection and a general bias in the politico-economy against the public good.

More evidence to support incentive structures as a source of public policy failures comes from Jim Collins, the business guru.  In his books From Good to Great and Built to Last, he advocates that incentive structures are key to success of a business organization.  If incentive structures are crucial for businesses, then shouldn’t they be equally important for governance and public policy?  As a result, if troublesome issues persist or exist, we must consider changes in the law to provide profits incentives for better laws and incentive structure to prevent or reduce these issues.

More support for incentive structures as a source of troublesome issues and the need for appropriate competitive profits for good public policy comes from B.F. Skinner’s work in behavioral psychology (including Beyond Freedom and Dignity).  He demonstrated the importance of rewards.   Since profits are rewards and since governments usually use punishments as the drivers of their policies, the implication is that the failure to resolve enduring problems and prevent disasters suggests that we are not using correct incentive structures.

To gain a deeper understanding about why incentive structures relate to persistent, troublesome issues and to disasters and why appropriate profits for public policy to protect the public good are necessary for public policy, we should consider the perspective of the frontline individuals, who have the best perspective into the potential for disasters or into the sources for other unyielding troublesome issues and into potential solutions to prevent disasters and troublesome issues.

If  the only alternative to profit for front line individuals is to service their own or some other private interest group rather than serve the public interest, then there is a high probability that they will throw their energies into working to support private or self interests.  For example, bankers and hedge fund managers couldn’t profit preventing the 2008 banking collapse.  Instead, the bankers could profit while lobbing for laws, which worsened the collapse.  The hedge fund managers could profit when they sold short on the 2008 banking collapse.   In addition, those on the front lines might even perversely suppress information necessary to protect the public interests in order to maximize profits from injuries to the public good.   As a result,  there will always be a bias toward the private interests, which will frequently be at the expense of the public good, as long as governments fail to make the public good competitively profitable.

In addition, this failure to provide adequate and appropriate profits to those on the front lines will squander the insight of those, who should be most able to protect the public.  This waste of talent and opportunities is unaffordable by any nation.  As a result, failing to provide an incentive structure that appropriately compensates those front lines, when they protect the public interests is insanity.

If governments are going to avoid squandering the insights of those on the front lines and are going to ensure the enactment of all of the best protecting legislation with the greatest swiftness to optimize benefits without delay or without the loss of the beneficial legislation forever by discouraged innovators, governments must provide adequate and competitive profits for those on the front lines and for their investors to encourage them to overcome numerous obstacles to new legislation, including:

  1. competition from competing opportunities in the general market for the policy innovators and their supporters
  2. risks of failure
  3. ignorance and misperceptions in the general public, which require funds to educate the public
  4. apathy in the public, which require enough funds to motivate enough of the public to act in order to motivate enough of their legislators to act
  5. ignorance and misperceptions in candidates and legislators, which require funds for the candidates’ and legislators’ education
  6. apathy of candidates and legislators
  7. prejudice and political inertia due to ignorance, prejudice, or self-interests
  8. competing self-serving interest groups
  9. the need to reach a majority or plurality in all of the committees of the legislature
  10. the need to reach a majority in the working houses of the legislature
  11. the need to develop enough support in the legislature to ensure executive and legislative passage of the legislation.

Only appropriate markets and market surrogates can provide the most precise indication of the lowest competitive compensation to overcome these obstacles and to successfully realignment of the incentive structure.  Furthermore, only markets or market surrogates can balance the relative value of the benefits of an innovator’s policy with the innovator’s competition, relative to the rest of the economy.

Here, I would like to return to the Constitutional prohibition against intellectual property for public policy.  The reason why intellectual property can be supremely beneficial is because it can supply infinite benefits in return for costs of a limited duration.  As a result, intellectual property is one of the best investments that any nation can make and governments should err on the generous side to ensure that they capture all or most of the benefits from the insights of frontline individual.  Furthermore, the failure to provide appropriate patents and intellectual property for public policy can be suicidal for the citizens of a nation or a government, because the world changes so fast.  It can also be especially suicidal when dealing with challenges unique for that country, because a nation will fail to identify appropriate measures in a timely fashion.

A natural experiment, which shows the value of intellectual property policy was India in the 1980’s and the 1990’s (see Sherwood).  India at that time failed to have strong patents, but India had great copyright laws, which protected software.  As a result, the industrial sector in India during that time struggled, while their software industry thrived because programmers in India would work on programs from the United States, while the U.S. programmers were sleeping.  This example implies that much of the poverty and misery in India was due to the failure of the Indian government to provide appropriate patent protection.

In a similar analogy, I believe that one reason for delays in a cure for malaria was because many underdeveloped countries governments, where malaria is rampant, refused to award patents, especially for medicine.  The result was an absence of incentives to prevent and/or cure malaria and the subsequent deaths of millions.  It is also feasible that the deaths and loss of property in New Orleans after Katrina and the deaths and misery resulting from unemployment after the 2008 banking collapse were the result of a bias against the public good due to our current incentive structure and the Constitutional prohibition against intellectual property for public policy, which might have prevented these disasters.  The above examples suggest that the absence of properly designed intellectual properly system for public policy can have a profound negative impact on a nation and its citizens, while a properly designed intellectual property system for public policy can have a profoundly beneficial impact on citizens.

The importance of intellectual property also comes from neoclassical economics.  Since the purpose of profits in neoclassical economics is to signal what to produce and since innovators and inventors produce knowledge, which others can be easily copy; governments need  to protect innovators with intellectual property in order to signal to future innovators the value of a stream of innovation is important for its citizens.  The fair level of compensation for this intellectual property should be determined through the marginal revenue product, because the marginal revenue product determines the standard of fairness for compensation in market economies.  As a result, this approach is necessary in order to provide a precise signal for innovation relative to the rest of the economy to innovators and to future innovators and to ensure an optimal amount of innovation.  In order to do this, governments should consider approxiamately 50% of the estimated value of the innovation, when there is no competing innovation, for the duration of the estimated lead interval that  the innovator had over the next published potential competing policy innovator as fair compensation for the first innovator.  This approach would allow individuals and governments to construct a compensation model for the innitial innovators.  At the end of that lead interval, then a new auctions could determine fair compensation for the initial and potential policy innovators.

If there are competing alternative, then competition should drive compensation.

It is important that all innovators receive at least this compensation, regardless of whether it is for a public policy, for business practices, or for the creation of a new life form, etc. in order to provide the most precise profit signals to the markets.  It is again important that nations err on the generous side of compensation, because innovation as knowledge creation can provide an infinite benefit in return for costs of limited duration.  Therefore, a continuous and generous stream of appropriate innovation will provide rich rewards and is crucial for the survival of all nations.

In addition, most governments will compensate service providers like physicians, architects, and accounts for their thoughts.  If they will compensate others for their intellectual services, then shouldn’t they compensate policy innovators for their intellectual services?  If a govenment fails to provide or accept intellectual property rights for public policy that protects the public good and then enacts those policy innovations into law without appropriate compensation for the innovator, this failure is like the theft of property by the state because the insight came from a private source, the mind of the innovator, and is therefore unethical even when some economist might consider it a “public good.”

Furthermore, it is easy for a politicial to appear smug, when denying intellectaul property to a policy innovator, assuming that the denial will benefit the public, but it is impossible to measure the lost opportunities from a future stream of policy innovation from such a denial.  The evidence from India’s history suggests that the  losses in lost innovation will be painful.  For example, what if intellectual property rights for public policy could have protected us from the 2008 banking collapse. As a result, it appears both moral and potentially supremely benefitical to the public interest to provide appropriate fair and competitive compensation for policy innovators through intellectual property for policies that protect the public welfare in order to correct the current failing incentive structure.

Here, I would like to return to enduring troublesome issues.  The source for many of these issues appears to be psychological phenomena like alcoholism and drug addiction, which appear to distort the incentive structure.  Many other psychological phenomena may cause suboptimal choices in the market place.  For example, many people complain of the high salaries of athletes, which may be driven by the following psychological phenomena:

  1. variable ratio reinforcement schedules of the wins for the supported team for each watched game,
  2. variable interval reinforcement schedules of the goals of the supported team during each game,
  3. the fixed ratio reinforcement schedules with immediate gratification for the purchase of the beer
  4. alcoholism, because 50% of the advertised beer is probably drunk by alcoholics.  The high salaries of movie stars versus teachers, researchers, etc. may also result from relatively more powerful psychological phenomena like sexual psychology driving purchasing behavior for the star than the others.

In another example, there are two psychological phenomena that can result in disasters.  First, human beings (even experts) as individuals are generally terrible judges of probability, except under certain conditions, when large groups can provide reasonably accurate estimates (See The Wisdom of Crowds).  Second, humans generally prefer immediate gratification.  As a result, politicians and their constituents are going to be far less likely to support appropriate actions to prevent disasters without a change in the incentive structure to encourage the prevention of disasters.

Whether driven by disasters or psychological phenomena, the final result can be poverty.  As a result, changing the incentive structure to make improvements in the public welfare profitable could also reduce poverty, when those changes reduce disasters and reduce the distortion on the incentive structure of powerful psychologacal phenomena.

Why is Crucial for Any Nation

Until the United States changes its current incentive structure to allow competitive profits for those on the front lines, who could protect public interests, and for their supporters; the public interests will always be underserved, will always underperform, and will continue to fail.

If governments are going to make the public interests profitable, they need a broad financially measurable definition for good government to provide some level of objectivity for evaluation and verification of benefits of new policies and laws.  Then, governments need a market to determine to lowest competitive costs to sustain good governance. The only system with such a definition and market is  As a result, while people may choose to ignore and even smirk at it, all other choices will probably fail to deal with our failing incentive structures and will have worse outcomes than, because is the only available system designed to make the public interest profitable and thereby correct the imbalance from our failing incentive struture.  As a result, nations can run, but they cannot hide.  Any other current alternative will fail, because it will fail to address the pervasive failures due to the existing incentive structures in the comprehensive, prioritized way that only can.  As a result, any other alternative is folly.  Nations and governments have no choice and must embrace or continue with failing incentive structures, become uncompetitive, and obsolete.

If you believe that our nation is providing optimal solutions for problems like disaster prevention, crime, corruption, global warming, drugs, obesity, alcoholism, hypertension, diabetes and their associated diseases, etc., then you should forget  But, if you believe that we can do better and if you don’t like these inefficiencies, then you should support to help make the appropriate changes to our failing incentive structure.   If the United States and Washington D.C. are going to make major improvements in their welfare, then they must embrace

It is necessary for the nation to embrace now, because could provide an intellectual property system for public policy through its patents in order to prove the value of intellectual property for public policy.  When the patents expire in ten years, this protection will no longer be available. Then, starting an intellectual property system will be much harder.

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