Getting Incentives Right

In September 2010, a natural gas pipeline owned by Pacific Gas & Electric company (PG&E) ruptured in a subdivision of San Bruno, California, starting a fire that killed eight people, destroyed 53 homes, and damaged 120 more. Because San Bruno is only a few miles from the Aplia offices, I took particular notice when I saw the following headline in the San Francisco Chronicle: “PG&E incentive system blamed for leak oversights.”

According to the Chronicle article, PG&E had delegated leak survey crews to find leaks on its pipelines but had been paying bonuses to “supervisors whose leak survey crews found fewer leaks and kept repair costs down.” Two years before the fire, PG&E ended the policy of bonuses and, worried about the consequences of the bonus system, began to redo leak surveys. The subsequent surveys revealed “many more” leaks than had originally been reported.

This result doesn’t come as a surprise if we think about a supply curve for undiscovered leaks -- leaks that exist but are not discovered by the survey crew. While it may at first take some mental gymnastics to think about undiscovered leaks being “supplied,” when you contemplate how the bonus system would effect the effort and diligence of leak survey crews, you can easily imagine the usual upward sloping supply curve like the one on the graph:

As with any upward sloping supply curve, the more that is paid for undiscovered leaks, the more “undiscovered” leaks will be supplied. Equivalently, fewer “discovered” leaks will be supplied.

(Note: The analysis doesn’t rely on the definition of the quantity supplied used here. A similar analysis based on the supply of discovered leaks, which may be easier to think about, leads to the same upward sloping supply curve. The difference is that the bonus system makes the payment for discovering a leak negative, and to account for this, the supply curve has to start at a price below zero (that is, even at a price of zero, there would be leaks discovered, so the price at which no leaks would be discovered would be below zero.)

This analysis doesn’t mean that incentive-based pay is a bad idea. It would make sense to pay to anyone responsible for preventing leaks a bonus based on fewer discovered leaks (assuming that the people in charge of discovering are different from the people in charge of preventing). What this analysis does mean, though, is that you have to match the incentives to the result you want. The price of mismatching incentives is, in some cases, very high.


Discussion questions:

1. Think of an incentive system that would have resulted in fewer leaks going undiscovered. What would be some of the drawbacks of this incentive system, particularly in terms of cost?

2. In the United States, students take standardized tests at various points in their academic career, and in some states, their teachers face dismissal if their students perform poorly on the exams. In those states there have also been reports of teachers fixing their students answers on the tests, and complaints that teachers focus on “teaching to the test,” to the exclusion of skills that cannot be tested. How are the incentives faced by teachers like the incentives faced by PG&E’s leak survey crews? How are they different?

3. What other situations do you know of where an incentive system produces undesirable results? Would the results improve more by changing the incentives or by removing the incentive system altogether?

A Penny Saved Is...

Which scenario would you prefer: (a) losing $30, or (b) losing $30, then losing $90, then regaining the original lost $30? While in most circumstances the first option is the unquestionably preferable, I recently found myself in a situation favoring the latter.

As a member of the Marin Sun Farms “meat club CSA” (community supported agriculture), I order a custom package of meats from a local farm that is delivered (frozen) once a month to a pick-up location near my home. While this arrangement offers me an excellent supply of local meat at a discounted price, the difficulty is remembering the monthly pick-up time. As disclaimed on the Marin Sun Farms website, “Packages not picked up promptly will be forfeited.”

This past Sunday I was sifting through emails when I discovered buried amongst online coupon offerings, eStatements, and a “Hello!” from mom, a reminder email sent the previous Thursday: “Pick up your CSA box today!” My heart sank as I pictured my box of grass-fed beef, lamb, and chicken slowly defrosting, decomposing, and ultimately being discarded. It had been a small shipment, only $30 worth, but nonetheless, I cringed at the waste.

Monday morning I awoke to another minor financial misfortune: a $90 parking ticket proclaiming my violation of section VC22500E – DRIVEWAY BLOCKING. D’oh! I knew when I parked that the rear of my car extended a few inches beyond the curb and into the neighboring driveway, but after half an hour searching for a spot I decided to take my chances (always thinking in economic terms, I figured that the expected cost of a ticket—equal to the true cost times the probability of actually receiving a ticket—was outweighed by the benefit from no longer looking for parking).

Chagrined by my back-to-back oversights, I called the number of the CSA pick-up location, just in case. To my surprise and relief, the woman in charge had managed to store my meat—not their usual policy—and I picked it up later that day.

By Monday night I had experienced the aforementioned $30 (perceived) loss, $90 loss, and $30 (perceived) gain, yet I felt better than I had felt on Sunday night when then I perceived only the $30 loss of meat. This may have had something to do with the order of events (after internalizing the loss of the ticket in the morning, the gain of $30 remained more salient at the end of the day), but I think it had more to do with how I perceived the true value of each loss. To a meat-loving economist, a discarded order constitutes a clear waste of resources—$30 of value—gone. The $90 parking ticket, on the other hand, represents a transfer of resources from me to the city of San Francisco, which ostensibly will put the money to use in the creation or maintenance of the public services I enjoy.

In introductory economics, we make a similar distinction between the deadweight loss and government revenue generated by taxes. Deadweight loss reflects the decrease in benefits to society (producers and consumers) resulting from fewer total transactions taking place. Economists view this loss to consumers and producers as different from the revenues a tax generates. Although both come at the direct expense of consumers and producers, the latter provides governments with the means to furnish public goods and services which indirectly benefit consumers, while the former—like rotten meat—is just no good.


Discussion Questions:

1. Why else might the $90 parking ticket be less painful than losing the meat shipment? Think about the “value” I got from time saved by parking illegally.

2. How does risk aversion factor into the decision of whether it’s worth taking the chance of doing something illegal? Consider a person who frequently speeds and occasionally gets speeding tickets. Ignoring the potential effects on others, might this too be a rational decision?

3. Consider other instances in which financial losses of the same dollar value might be felt in different ways (e.g. forgetting to take a $20 bill out of your pocket before washing it versus accidentally leaving an extra $20 as a tip on a restaurant bill?)