The Power of Incentives in Decision Making

Most of economics can be summarised in four words: " People respond to incentives. " The rest is commentary. INTRODUCTION The organisation of the workplace is evolving. In many industries, mass production by large, vertically integrated, hierarchically organised firms is being replaced with more flexible forms of both internal organisation and industrial structure (Brynjolfsson & Mendelson, 1993). Work is increasingly accomplished through networks of smaller, more focused enterprises. Added value is generated by ever-changing coalitions, where each member of a coalition specialises in its area of core competence and controls it through the use of strategic partnerships. The information systems (IS) revolution has had an enormous influence on how organisations are managed. Electronic access, communication, and decision support influence several managerial processes and systems including the nature and scope of managerial roles, organisational structure, strategic planning systems, budgeting, performance measurement and review, incentive compensation systems, and knowledge management. In today's world of business, investors must ask how they can motivate independent, self-interested , self-organising, somewhat-coordinated managers so they focus their skills on the common goal of maximising the value of the company. Meanwhile, managers must also inspire their employees to work hard, their suppliers to pro-1830 The Power of Incentives in Decision Making vide a good service at the right price, and their customers to purchase their products. Within companies, team structures are replacing the traditional hierarchical form and incentives are being used to encourage performance (Baker, 1992; Holmstrom, 1979). What are incentives? Incentives are mechanisms offered to you to help in the decision-making process. In economics, an incentive is any factor that provides a motive for a particular course of action. Some incentives make people better off and reward them for their actions. Other incentives leave people worse off and penalize them for their actions. Economics is to a large extent a study of incentives: incentives to work hard, to produce high quality goods, to study, to invest, to save, and so forth (Laffont & Martimort, 2002). The aim of this article is to examine how incentives assist in the managerial decision-making process at individual, group, and firm level. We argue that incentives are an integral component of a successful business. Suitably designed incentives provide a tool to elicit correct and timely information , to encourage and reward performance, and to promote coordination and cooperation between firm owners, managers, and employees. We begin by examining the source of the …