Getting the Incentives Right

I never took psychology in school and it is definitely one of my weak points. I am not good at using psychology, since I am ignorant of even the very basic tenets. I read a book called “On Success” by famed investor Charlie Munger, who talked about how important psychology is in business and management. After reading what he had to say, I really felt like there was a huge hole in my education.

Munger, who was self-taught in psychology, came up with his own list of human tendencies or behavioral patterns, one of which he calls the “Reward and Punishment Super Response Tendency.” This is the first on his list of twenty-five human tendencies, in recognition of how important incentive and disincentive is to human behavior. Munger summarizes the issue with a famous quote from a Soviet worker: “They pretend to pay us and we pretend to work.” Munger says that the most important rule in management is to “get the incentives right.”

He describes how Federal Express at first struggled to get packages shifted rapidly between aircraft at the central hub each night. Everything they tried did not get the task accomplished quickly enough. Then someone had the brilliant idea to pay the night shift by the shift, rather than by the hour, and let them go home early if all the planes were loaded. That simple and elegant solution worked.

Munger talks about what he calls “incentive-caused bias” that leads to immoral behavior. His example is a surgeon in Lincoln Nebraska who removed “bushel baskets full of normal healthy gallbladders”. This medical fraud was rationalized by the surgeon, who believed the gallbladder was the source of all disease. He was well paid to exercise his talent, whether the patient needed the gallbladder removed or not. HE was eventually removed from the medical profession and rightly charged with malpractice.

Incentive-caused bias is prevalent in every business and profession. Bad or immoral behavior, according to Munger, is “intensely habit forming when well rewarded.” We have certainly seen many examples of this in recent years. Enron’s manipulative accounting misdeeds, Bernie Madoff’s gigantic Ponzi scheme, the whole residential mortgage debacle, are examples of immoral behavior well rewarded. In my profession, it’s the insurance salesman who’s only and every answer to making an investment recommendation is an annuity that pays a high commission.

It appears to me that poorly designed incentives and controls are at the core of bad behavior in every case.

There’s an old saying that says, if the only tool in the draw is a hammer, every problem looks like a nail. We keep banging away at cancer, using chemo, radiation and surgery without getting significantly better results. Could it be that alternative treatments are less lucrative than the orthodox treatments and therefore not pursued? Are cancer patients the unwitting victims of incentive-caused bias by the medical profession?

Munger muses that the cash register was a great moral instrument when it was created. It ended the inventor’s employees from stealing him blind. Widespread incentive-caused bias in all human endeavors causes Munger to distrust professional advice, especially if it is good for the advisor. How would Munger feel if he were a cancer patient?

I got to thinking about this incentive-caused bias in relation to cancer treatment. It makes me wonder if drug companies, insurance companies and the medical industry as a whole, are properly incented to do what is best for patients. Certainly that should be the goal, but incentive-caused bias may make some treatment alternatives more attractive than others.

What is the equivalent of the cash register when it comes to treating cancer? The role of government regulation should be to ensure that the medical industry does what is best for patients. Maybe we should start by examining the incentive-caused bias in medicine. Reform needs to ensure that we get the incentives right.