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In general, incentives are anything that persuade a person to alter their behaviour. It is emphasised that incentives matter by the basic law of economists and the laws of behaviour, which state that higher incentives amount to greater levels of effort and therefore, higher levels of performance.


Divisions

Incentives can be broken down into two categories; intrinsic incentives and extrinsic incentives. The
motivation Motivation is the reason for which humans and other animals initiate, continue, or terminate a behavior at a given time. Motivational states are commonly understood as forces acting within the agent that create a disposition to engage in goal-dire ...
of people's behaviour comes from within. In activities, they are often motivated by the task itself or the internal reward rather than the external reward. There are many internal rewards, for example, participating in activities can satisfy people's sense of achievement and bring them
positive emotions The broaden-and-build theory in positive psychology suggests that positive affectivity, positive emotions (such as happiness, and perhaps Interest (emotion), interest and Anticipation (emotion), anticipation) broaden one's awareness and encourage no ...
. An intrinsic incentive is when a person is motivated to act in a certain way for their own personal satisfaction. This means that when a person is intrinsically incentivised, they perform a certain task to please themselves and are not seeking any external reward, nor facing any external pressure to perform the task. On the other hand, an extrinsic incentive is when a person has external pressure persuading them to act in a particular way. The external pressure could include either a reward for completing the task or could be a form of punishment or consequence if the task is not completed. When people have difficulty completing a task or lack interest in participating in an activity, extrinsic incentives can often be effective in helping people improve their motivation. Intrinsic incentives and extrinsic incentives are both important and drive people's behaviour. However, people's intrinsic motivation tends to decrease when they are offered too many extrinsic rewards, in order to maintain the action, constant incentives have to be provided, which is known as the
Overjustification Effect The overjustification effect occurs when an expected external incentive such as money or prizes decreases a person's intrinsic motivation to perform a task. Overjustification is an explanation for the phenomenon known as motivational "crowding out" ...
. In the context of economics, incentives are most studied in the area of
personnel economics Personnel economics has been defined as "the application of economic and mathematical approaches and econometric and statistical methods to traditional questions in human resources management". It is an area of applied micro labor economics, but t ...
where economic analysts, such as those tho take part in human resources management practices, focus on how firms make employees more motivated, through pay and career concerns, compensation and performance evaluation, to motivate employees and best achieve the firms desired performance outcomes. Overall, the standard "law of behaviour" suggests that more incentives will result in higher performance and higher effort, people can reach their performance to the next level by rewarding. As a result, extrinsic incentives are commonly used within the workforce by employers and managers. This is because, employers believe that the more they encourage their employees to act in a certain way, the more the company will benefit in reaching its organisational goals. However, there are some parties who opposed the benefits of using extrinsic incentives and believe they cause more harm than good. This is because these opponents believe that the constant use of extrinsic incentives can lead to crowding out of intrinsic incentives, which are also valuable performance motivators. When people are constantly being incentivised by external pressures, they neglect their intrinsic motives which could consequently ruin their work ethic. This is because, these people can become too comfortable with always gaining some reward for acting in a certain way, people think that they deserve to earn rewards for doing certain things, not for the benefits of the firm but benefits of themselves, leading to them to take no action if no extrinsic incentive is involved. Nonetheless, incentives (both intrinsic and extrinsic) can be beneficial in altering a persons behaviour and can be effectively used and executed within many different areas of life including in the workforce, in education and within one's personal life.


Classification

Classified by
David Callahan David Callahan (born 1964/1965) is an American writer and editor. He is the founder and editor of ''Inside Philanthropy'', a digital media site, and Blue Tent Daily, which offers in-depth reporting on progressive organizations and the Democratic ...
, the types of incentives can be further broken down into three broad classes according to the different ways in which they motivate agents to take a particular course of actions:


Monetary incentives

Monetary incentives are a monetary good given to someone to incentivize their actions. This is a type of extrinsic incentive and is commonly seen in the workplace. They can come in the forms of
profit sharing Profit sharing is various incentive plans introduced by businesses that provide direct or indirect payments to employees that depend on company's profitability in addition to employees' regular salary and bonuses. In publicly traded companies thes ...
, bonuses, stock options or even paid vacation time. Well-chosen monetary incentive programs can produce positive motivation and influence the productivity and output of individuals and firms. Firms use a variety of methods to implement productive behavior. A common monetary incentive system is the performance-based pay where incentives are paid based on their productivity or output. Some methods are commission based where the employee, for examples a salesperson receives a payment directly correlated to their output level. Firms also pay extra wages or rewards for employees who work overtime and extra amount of work they done, incentives in this way make the employees feel fair and willing to do the same next time. Other methods are less direct, for example awarding periodic bonuses to top performers, offering a possibility of a promotion to higher-paying position or
profit sharing Profit sharing is various incentive plans introduced by businesses that provide direct or indirect payments to employees that depend on company's profitability in addition to employees' regular salary and bonuses. In publicly traded companies thes ...
for team projects. Alternatively, firms can also incentives their employees to perform by threatening to demote or terminate them. When employees feel their careers are threatened, they will show higher performance and efficiency in work. The effect of monetary incentives can depend on the framing of the rewards. For example, in cadaveric
organ donation Organ donation is the process when a person allows an organ of their own to be removed and transplanted to another person, legally, either by consent while the donor is alive or dead with the assent of the next of kin. Donation may be for re ...
, funeral aids are perceived to be more ethical (particularly in showing gratitude and honoring the deceased donor) and potentially increase donation willingness than direct cash payments of the same monetary value.


Non-monetary incentives

A non-monetary incentive is an incentive which takes the form of a non-cash incentive. They are still used as forms of motivation but are much more cost effective in incentivizing employees who have performed highly. Some examples of these incentives include extra time off, recognition, gifts, family benefits or even work based perks such as projects etc. Rewards such as these tend to boost employees job satisfaction as they feel more appreciated for their efforts. Firms with higher job satisfaction and morale have found to have better overall employee contribution and hence better productivity. Compared to monetary incentives, studies have shown that employees find non-monetary incentives more memorable as they are separated from normal pay and hence are more distinguishable. This creates more meaning and satisfaction in working environments. Effective use of non-monetary incentives can increase the morale of firms as well which has also seen to increase productivity. This type of incentive has commonly been used to directly enhance job satisfaction of employees. Studies have shown that non-monetary rewards, such as extra holidays and more responsibilities, increase job satisfaction more than monetary incentives. This is likely due to the correlation between non-monetary incentives and job satisfaction. Non-monetary incentives also offer an opportunity for skill and responsibility development of workers, which can often mean higher wage in the long run. These incentives are very important to firms and create better working environments for employees.


Incentives in economic context

The economic analysis of incentives focuses on the systems that dictate the incentives needed for an agent to achieve a desired outcome. Incentives can help companies link employees' rewards to their productivity. When a firm wants their employees to produce a certain amount of output, it must be prepared to offer a compensation scheme such as a monetary bonus to influence the employees to reach the target output. Compensation must achieve two goals: The first is to reduce employee turnover, compensating employees can help attract workers to work and retain their ability. The second is to improve productivity, compensation can not only stimulate the ability of workers to produce output, but also improve the enthusiasm of employees to work, thus promoting business development. A rise in pay variance across occupations reflects an increased demand for highly productive workers thus, influencing compensation to shift towards pay-for-performance. This helps employees recognize the direct relationship between their work output and their reward. More and more companies are realizing that they can offer different incentives to employees because they have different economic needs. Firms must design the compensation plan to induce workers to operate in the firms best interest and put forth a certain level of output that maximizes the firm's profits. However, since the interest of workers and their employer do not always align and
asymmetric information In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. Information asymmetry creates an imbalance of power in transactions, which can ...
, where one (worker/ employer) does not know some relevant facts about the other, make the compensation plan difficult to establish. Here, the principal-agent theory is used as the guiding framework when aligning incentives with the employees effort to obtain the efficient level of output for the firm. For example, a manager may want a certain level of output from an employee but does not know the capabilities of the employee in the presence of imperfect monitoring, and to achieve the best outcome, an optimal scheme of incentive may be set to motivate the worker to increase their productivity. The
Tournament theory Tournament theory is the theory in personnel economics used to describe certain situations where wage differences are based not on marginal productivity but instead upon relative differences between the individuals. This theory was invented by econo ...
also provide a framework of compensation but at different levels of the firms hierarchy. The theory demonstrates that individuals are not promoted on the basis of their performance and output, instead on the relative position in the organization. The theory also explains that the compensation does not necessarily motivate the employee currently working at that level but instead motivates the employees below that level who aim at getting promoted.


Potential issues

Incentives are arguably beneficial in increasing productivity, however, they can also have an adverse effect on the firm. This is evident through the
ratchet effect A ratchet effect is an instance of the restrained ability of human processes to be reversed once a specific thing has happened, analogous with the mechanical ratchet that holds the spring tight as a clock is wound up. It is related to the pheno ...
. A firm may use its observation of the employees output level when they first get employed as a guide to set performance standard and objectives for the future. Knowing this, an employee may purposely reduce their output level when first employed or hide their ability to produce at a higher output with the intent of exploiting being rewarded in the future when they strategically increase their output level. Best performances of employees can be limited from it. Thus, the ratchet effect can significantly diminish production levels of a firm and planned economies. Additionally, since the 1970s psychologists begun exploring the role of motivators, whilst economist were simultaneously studying crowding out effects. This came as a result of Richard Titmus' 1970 publication 'The Gift Relationship' which explained how the constant use of extrinsic incentives can result in conflict with other motivators and lead to crowding out effects. In his publication Titmus argued that the use of monetary incentives was disrupting social norms around the idea of voluntary contribution and would ultimately have a crowing out effect. He acknowledged that if the incentives are large enough it is more likely to offset crowding out effects, but noted that making the incentives too large could also have an adverse effect and result in people not meeting expectations. However, crowding out can still take place when incentives are removed over the long run. This is because the removal of incentives can result in employee effort levels being lower than when the incentives were offered thereby hindering motivation and performance. Neither do incentives not always increase motivation as they can contribute to the self-selection of individuals, as different people are attracted by different incentive schemes depending on their attitudes towards risk, uncertainty, competitiveness. For example, some
corporate A corporation is an organization—usually a group of people or a company—authorized by the state to act as a single entity (a legal entity recognized by private and public law "born out of statute"; a legal person in legal context) and re ...
policies popular during the 1990s aimed to encourage productivity have led to failures as a result of unintended consequences. Another example, providing
stock option In finance, an option is a contract which conveys to its owner, the ''holder'', the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified dat ...
s were intended to boost
CEO A chief executive officer (CEO), also known as a central executive officer (CEO), chief administrator officer (CAO) or just chief executive (CE), is one of a number of corporate executives charged with the management of an organization especially ...
productivity through offering a remunerative incentive to aligning the CEOs interests with those of the shareholders to improve company performance. However, CEOs were found to either make good decisions which resulted in a reward of a long-term price increase of the stock, or were found to have fabricated the accounting information to give the illusion of economic success and to retain their incentive based pay. Furthermore, it has been found to be extremely costly for the firms to incentivize the CEOs with stock options, nevertheless, firms are forced to pay substantial amounts of money for the provision that the CEO acts in the best interest of the firms and profit maximization. Incentives can have a bipolar effect on the company. On the one hand, the company's incentives to employees may create a pay gap. For example, low-paid employees may reduce their production or contribution to the company. For example, low-paid employees and high-paid employees may not be able to communicate and cooperate effectively, causing low-paid employees to gradually lose their enthusiasm for work. Firms should provide fair amount of incentives for both low-paid and other employees, incentives for low-paid works can be breaks rather than monetary incentives. Motivating employees with financial rewards may make a difference. That's because if the company is profitable in the first year, it may have plenty of bonuses to hand out to employees. However, if the company makes less money in the second year than it did in the first year, the company may not be able to give employees the same bonuses as in the first year even though they put in the same effort. This also reduces employees' motivation to work. Therefore, incentives may be counterproductive. Firm can provides other types of incentives rather than monetary incentives, such as promotion or vacation breaks for employees of highly performance. On the other hand, incentives have a positive effect on education. For example, students may underestimate their own learning ability. Incentive not only makes teachers or parents pay more attention to students' abilities, but also encourages students to bring good learning returns. However, it is worth noting that monetary incentives may not be positive. There may be bribery education in monetary incentives, and this monetary incentive is often contrary to morality. Teamwork is very important to the productivity of the company and will also serve as an incentive for the company. When employees encounter difficult problems, the company effectively incentives employees' performance by establishing teams to communicate and collaborate with each other. In particular, when the abilities of employees form complementary forms, the company's incentive effect achieves a good performance. On the contrary, in teamwork, by contrast, companies that reward individual achievement cause team members to split when employees rely too much on the output of the team, the incentive of teamwork will have a certain negative effect on the company's production. Ultimately, there is always potential for conflicts to arise, both in the short and in the long run, during the application of incentives in different areas, as incentives that seek to change behaviours can cause crowing out on intrinsic motivators. Growing evidence suggests that economists must broaden their focus when exploring the effects of incentives as the effect they have is largely dependent on how they are designed and specifically how they interact with intrinsic and social motivators in the short run and the long run.


See also

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Climate finance Climate finance is "finance that aims at reducing emissions, and enhancing sinks of greenhouse gases and aims at reducing vulnerability of, and maintaining and increasing the resilience of, human and ecological systems to negative climate change i ...
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Climate Investment Funds The Climate Investment Funds (CIF) is a multilateral fund established to finance and scale climate pilot projects in developing countries. Established in 2008 at the request of the G8 and G20, the CIF administers a collection of programs that help ...
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Bounty (reward) A bounty is a payment or reward of money to locate, capture or kill an outlaw or a wanted person. Two modern examples of bounties are the ones placed for the capture of Saddam Hussein and his sons by the United States government and Microsoft's ...
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Eco-investing Eco-investing or green investing, is a form of socially responsible investing where investments are made in companies that support or provide environmentally friendly products and practices. These companies encourage (and often profit from) new t ...
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Environmental Quality Incentives Program The Environmental Quality Incentives Program (EQIP) is a United States government program designed to assist farmers in improving environmental quality, particularly water quality and soil conservation. Congress established the program in the 1996 ...
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Externality In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either co ...
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Incentive-centered design Incentive-centered design (ICD) is the science of designing a system or institution according to the alignment of individual and user incentives with the goals of the system. Using incentive-centered design, system designers can observe systema ...
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Incentive payments The incentive payments are direct payments made under the National Wool Act (P.L. 83-690, Title VII) to producers of wool and mohair, which were similar to deficiency payments made to producers of grains and cotton. The incentive payment rate w ...
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Incentive program An incentive program is a formal scheme used to promote or encourage specific actions or behavior by a specific group of people during a defined period of time. Incentive programs are particularly used in business management to motivate employees ...
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Incentive trust In American estate planning parlance, an incentive trust is a trust designed to encourage or discourage certain behaviors by using distributions of trust income or principal as an incentive. A typical incentive trust might encourage a beneficiary ...
* Incentivization *
Investment incentive Investment incentive is a government-implemented incentive policy aimed to encourage investors into its domestic market or to promote expansion of existing businesses. Investment incentives encompass creating an environment that enables foreign bus ...
* Long-term incentive plan *
Loyalty marketing Loyalty marketing is an approach to marketing, based on strategic management, in which a company focuses on growing and retaining existing customers through incentives. Branding, product marketing, and loyalty marketing all form part of the c ...
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Loyalty program A loyalty program is a marketing strategy designed to encourage customers to continue to shop at or use the services of a business associated with the program. Today, such programs cover most types of commerce, each having varying features and ...
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Motivation Motivation is the reason for which humans and other animals initiate, continue, or terminate a behavior at a given time. Motivational states are commonly understood as forces acting within the agent that create a disposition to engage in goal-dire ...
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Motivational salience Motivational salience is a cognitive process and a form of attention that ''motivates'' or propels an individual's behavior towards or away from a particular object, perceived event or outcome. Motivational salience regulates the intensity of be ...
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Motivations of open source programmers The open-source-software movement is a movement that supports the use of open-source licenses for some or all software, as part of the broader notion of open collaboration. The open-source movement was started to spread the concept/idea of open- ...
* Motivations for online participation *
Performance-related pay Performance-related pay or pay for performance, not to be confused with performance-related pay rise, is a salary or wages paid system based on positioning the individual, or team, on their pay band according to how well they perform. Car salesmen o ...
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Perverse incentive A perverse incentive is an incentive that has an unintended and undesirable result that is contrary to the intentions of its designers. The cobra effect is the most direct kind of perverse incentive, typically because the incentive unintentionall ...
* Positive-incentive value * Profit motive *
Research and Development Tax Incentive The Research and Development Tax Incentive (R&D) is a government programme that aims to stimulate Australian investment in R&D. It has been in place since 1 July 2011 and replaced the R&D Tax Concession. The tax incentive reduces company R&D co ...
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Reward system The reward system (the mesocorticolimbic circuit) is a group of neural structures responsible for incentive salience (i.e., "wanting"; desire or craving for a reward and motivation), associative learning (primarily positive reinforcement and class ...
* Social Impact Incentives *
Steering tax {{Taxation A steering tax or ecological incentive tax is a tax which aims to change the behaviour of the tax payer, as defined by lawmakers, and not particularly to increase tax revenue. The term is not sharply definable because many tax related la ...
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Tax incentive A tax incentive is an aspect of a government's taxation policy designed to incentivize or encourage a particular economic activity by reducing tax payments. Tax incentives can have both positive and negative impacts on an economy. Among the posit ...
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Travel incentive Travel incentives are a reward subset of an incentive program, recognition program or a loyalty program, which is a business tool designed to change consumer behavior to improve profit, cash flow, employee engagement and customer engagement. It ...
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Wicked problem In planning and policy, a wicked problem is a problem that is difficult or impossible to solve because of incomplete, contradictory, and changing requirements that are often difficult to recognize. It refers to an idea or problem that cannot be fix ...


References

{{Authority control Personal finance Microeconomics Motivation Macroeconomics