When attempting to influence or
guide human behavior in a certain direction the general belief is that there
should be rewards for complying, punishments for not complying and a control
mechanism aimed at identifying and punishing those who do not comply. In brief
it is the “Carrots and Sticks” view.
In order to make the employee
(agent) work the company (principal) offers a reward – the salary – and at the
same time it threatens the employee with a punishment (penalty) for not
working. This penalty is applied if the employee (agent) is caught not working
and for this a control mechanism is put in place. Since the control mechanism
is not perfect or the employee is cunning there is a probability of getting caught
(a probability smaller than 100%). In
some forms of the “principal and agent problem” the agent (employee) has an “outside
option” which in our example could be unemployment benefit.
In this economic view the
principal has a “production function” which determines what the principal gets
if the agent works and the agent has a “utility function” which determines the
benefits of the agent. In typical theoretical principal and agent problems
these functions are known (don’t ask me how to do that in real life) and the questions
are to determine the amount of the reward (salary), the amount of the
punishment and the optimal probability of getting caught (calibrating the
control mechanism).
I’ve presented this model of
carrots and sticks using the example of a working contract, but there are
countless examples of it or variants of it being used in day to day life. Take
traffic regulations for example. There is no reward for respecting the regulations,
but there are punishments for not doing so and there is a control mechanism and
inherently probabilities of getting caught that applies these punishments.
From a rational thinking
perspective this is the way human behavior should be guided in the desired
direction. People as rational agents should be happy with the reward (if any),
be afraid of the punishment and comply in order to not get the punishment.
This model is so profoundly embedded
in popular culture that every time one hears about something undesirable going
on the first reaction is to “Increase penalties (fines and years in jail)”, to “put
more police on the street” (which means increase probability of getting caught)
and so on. Similarly to encourage certain behaviors (financial) rewards are
offered or increased. Just think how much people in top positions in the
financial sector receive as bonuses…
The truth is that this model has certain
validity in real life, but by far is in no way perfect or even adequate for being
used exclusively to guide human behavior. One point of validity of the model is
that rewards are useful in stimulating people to behave in a certain way. For
example students study harder for an extra point in their final grade and
probably would do not do so if there would be no reward - increase in the final
grade. Another point of validity is that
fear is a very powerful motivator of human behavior. Fear is deeply rooted in
our evolutionary past and we act in certain ways in order to avoid negative consequences.
The week points of the model are four-folded.
First, it ignores a vital learning from prospect theory, namely that people
underweight average and large probabilities. To put this in easier to
understand language people perceive probabilities differently from the
objective (numerical) probabilities. For example an objective probability of
40% is perceived (and subsequently used in judgment) as a 30% (subjective) probability.
Similarly an objective probability of 90% is perceived as roughly 70%
subjective probability. Certainty, namely a probability of 100%, is perceived
as 100% subjective probability.
The implications for the
principal and agent model are highly significant. The model is based on the
agent knowing (or at least guessing) the probability of getting caught. If
people underestimate objective probabilities it means that for the agent to
perceive for example a (subjective) 60% probability of getting caught the
actual (objective) probability has to be around 85%. Moreover, there is
research done and or presented by Dan Ariely in his book “The honest truth
about dishonesty” that shows that the probability of getting caught plays no
real role in cheating behavior. Now, this could be taken with a grain of salt.
No one (sane) would commit a crime in front of a police patrol. In front of a
police patrol can be translated as probability of getting caught of 100%.
Similarly if the getting caught probability is 99% the undesired behavior would
be virtually inexistent.
In real life, however, most
control mechanisms do not function with 99-100% accuracy, meaning that the
probability of getting caught is usually not very high. In my opinion this
probability gravitates around 50-60%. Adding to this that people underweight
(underestimate) probabilities in human perception the 50-60% chance of getting
caught is perceived roughly around 40%.
Second, the principal and agent
model makes one major assumption, namely that the control mechanism is
costless. In my opinion this is a major mistake for an economic model. In real
life control mechanisms cost money and usually a lot of money. Assuming that
the current control mechanism costs X Euros and gives an objective probability
of getting caught of 40% which is perceived subjectively as about 30%, what
would be the cost of increasing the perceived probability to 70%? Remember that
the subjective (perceived) probability of 70% means an objective probability of
roughly 90%.
One might say that the costs of
increasing the accuracy of the control mechanism would be covered by the increase
in revenues from penalties. Of course, this is a reasonable idea, but there are
several limits to it. Increasing the probability of getting caught is meant to
make people comply and not actually pay fines. Moreover, penalties should
actually be paid by the people who get them and this is not always the case. In
addition to this, in some cases fines paid by wrong-doers do not go into the
budget of the organism that enforces the control. For example in my
home-country traffic fines (when paid) go to the central or local budget of the
government and not to the traffic police budget.
Third, the principal and agent
model is myopic when it comes to setting the amount (level) of penalty or
punishment. The theoretical model takes into account the individual’s “utility
function” when setting the level of the penalty. However, in real life this is
virtually impossible since regulations are made for everyone and subsequent
penalties applied are similar across individuals. For example traffic fines are
set based on formulas that have as starting point the minimum wage in the
country. This might be a good or adequate formula for countries where the
differences between rich and poor are small, but in polarized societies the
difference in the “pain” of loss for a “rich” and for a “poor” could be
considerable.
It is true that prospect theory
states that gains and losses are not relative to one’s wealth (as the normative
expected utility theory says), but to one’s expectations. At the same time,
paying 100 Euros as a fine has different consequences for a person who earns 600
Euros per month as for a person who earns 8000 Euros per month.
Fourth, the principal and agent
model completely ignores other motivations that people have to behave in a
certain way. Let’s take the example of a student who is studying hard for a
better grade (reward) and that is afraid of failing the exam (punishment). Even
if these rewards and punishments are in place, there are other motivations such
as liking what she is studying or studying hard because her friends are
studying hard and she wants to not be perceived as falling out of the group or
she is doing so with the hope of getting the attention of her handsome
colleague. Examples of motivations for human behavior are countless and usually
they don’t include rewards punishments and probabilities of getting caught.
I would like to end this post in a more philosophical
note. Apart from the pros and cons of the Principal and agent model as the
proper way of inducing or guiding behavior, there is a deeper question here. Do
we actually want to live in a world of carrots and sticks? Would we behave in a
way only because we want to get the carrot and avoid the stick?
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