The Power of Incentives

Incentives can be a powerful tool for creating desired behavior. However, the wrong incentives can cause undesired behavior. Consider the efforts of the U.S. military to cut the supply line of the North Vietnamese in the Vietnam War. To cut or slow down the supplies from the north that fortified the offensive in the south, the U.S. military decided to attack the supply line on the Ho Chi Minh Trail using airpower. The best way to determine the effectiveness of the strikes was through aerial photography. A successful strike was one that rendered the various trucks and vehicles inoperable. Probably the best way to destroy these lightly armored vehicles was with the gun cannons, bombs , or rockets used by the planes. After all, a few bullets or bits of shrapnel in an engine block would permanently ruin it. However, bullet holes in the hood of a truck are hard to see from a photograph. Photographic intelligence specialists could really only see when the truck was burned. Therefore, a "kill" was recorded when the vehicles appeared burned. This inferior measure of a kill caused the Air Force to switch tactics and bomb the supply lines with Napalm, which causes fires. However, a burned truck is not necessarily an inoperable truck. If the top of a truck was burned, a person might still be able to drive it. The inferior performance measure of the goal created the wrong incentive. Instead of using the most effective weapons, the Air Force used inferior ones.

Throughout this book, we have identified situations in which the incentives or measurement of performance was inferior. This has lead to inferior and undesirable outcomes . For example, auditing firms are hired by a public company and want to maintain a long- term relationship with the company. This gives auditing firms an incentive to accommodate the company's desires instead of challenging them. Under such an incentive, auditing firms become passive monitors instead of active monitors . Or consider how a company's stock price is a poor measure of the performance of its CEO. Over the long term, a CEO's actions will impact the price of the stock. However, in the short term, the price is strongly influenced by the economy, the mood of investors, and other influences outside of the CEO's control. Yet, the way equity-based compensation plans are currently designed, managers are rewarded simply when the stock price of the company for which they work increases . Often, the outcome is that ineffective managers can be rewarded in a bull market and good managers are not rewarded in a bear market. Poor measures of success lead to ineffective compensation.

It is our intent to suggest solutions to the corporate governance problems that better align incentives and better measure performance. We do not claim to be the originator of every solution we propose. We have designed our own solutions and we have also searched for good ideas elsewhere. The following proposals meet our goals of (1) fixing the problems and not just addressing the symptoms, (2) improving incentives or performance measures, and (3) avoiding excessive regulation.