Incentive mechanism design is a specialised, complex and often misunderstood sub-field of microeconomics that capitalises on game theory and which considers methods on how to design and apply good system-wide solutions to problems involving several self-interested individuals trying to promote their own agendas, all with private and externally-unobservable information about their preferences. A typical method deployed in incentive mechanism design is to offer incentives (for instance with suitable payments, terms and conditions) to promote conformity to a set of rules so that an optimal solution to the distributed optimisation problem can be calculated. A process wherein all the participants fare best if they know that their best strategy is to follow the rules no matter what the other participants will do, is said to be incentive-compatible. Conforming to the rules may, however, also be a so-called ordinal Bayes-Nash equilibrium. This, essentially, is a situation wherein if the other participants follow the rules, then a given participant’s best self-interested response is to follow the rules as well.
Within the economics discipline, contract theory investigates how people make contracts. This topic, often characterised by the presence of asymmetric information (a situation where one party is more knowledgeable about the subject of the contract than the other), was first addressed in the 1960s by Kenneth Arrow. His principal–agent theory explained, by way of example, the connection between the asset’s owner (principal), and the people (agents) employed to manage that asset on behalf of the same owner. Where contracts are complete, there is little room for divergences between the purposes and needs of the principal and the agent’s expected obligations. However, the majority of contracts are, to a larger or smaller extent, incomplete in that they do not cater for every possible eventuality.
Incomplete contracts may give rise to problems. For instance, the agents may follow a hidden agenda, exchanging their own purposes for the principal’s. Such asymmetrical information favours the agents engaged in the day-to-day running of the principal’s asset as it is hard and uneconomic for the principal to monitor their behaviour in great detail. Further down the organisational hierarchy, moral hazard problems (problems arising because a party will have an incentive to take risks because the profits deriving from a risky action accrue to the party undertaking the action but the costs from a realisation of that risk would be incurred by someone else) may also occur if employees work at less-than-optimal productivity. To solve these problems, principals may use several incentive payment schemes in order to bring in line their agents’ interests with their own. These comprise executive share option schemes, long-term incentive plans, employee share ownership plans, profit sharing schemes and commission payments. Certain contracts may also feature adverse selection. Here, the principal is not informed about particular features of the agent. For instance, health insurance is more likely to be bought by persons who are more likely to get sick. However, the agent can utilise what we call signalling in order to indicate his type to the principal. By way of example, someone wanting to signal to a health insurer that s/he is in good health could provide evidence of medical history and genetic data (where allowed by law) to show that his/her genetic coding is not associated with any known chronic or genetically-attributable problems in health. Such signalling, which can work in a variety of situations (such as in Michael Spence’s job-market model and in the education sector), can help mitigate the problem or resolve it altogether.
One essential factor in making effective management arrangements is to make sure that the different motives of the contractors line up as closely as possible with the client’s. This is mostly determined by the contract details established between the different parties. Incentives are largely made up of cost, performance, technical, schedule and delivery incentives. When incentivisation is applied correctly, both the client and contractors can focus on the business objectives which will lead to successful project results. Incentives should be quantifiable and objective, using relevant benchmarks. Incentivisation works better with long-term contracts when trust and commitment between the contracting parties is present and when non-compliance with contractual obligations can hinder future business, making deviation from such obligations more costly. Contract incentivisation also requires:
- granularly-defined objectives with respect to what is to be attained;
- a full understanding of the market/industry and its technicalities;
- effective contract management by both parties;
- an assessment of the potential benefits at the procurement planning stage; and
- an effective preplanning of payments to ensure appropriately-timed incentive payments.
In the course of business, it is also vital for companies to evaluate their existing contracts and those they are considering going into. Aside from utilising contracts to transfer work and motives, the present business climate is one of intensified risk awareness and continued attempts to outsource and transfer such risk. Failure to discover attempts to disguise the transfer of such risk may have harmful effects on an organisation. Contract evaluation could help detect potential loss-making contracts, ones lacking essential safeguards, ones that are doomed to fail, or contracts in which valued proprietary rights are relinquished. They can also set the right basis for human resource performance appraisal and reward systems that work and that motivate people to be productive.
Incentive mechanism design precepts have had a significant impact on current policy-making in almost every policy area. Policy incentive mechanism design aims to link incentive mechanisms to the goals of the policy. This is always subject to technical, market, and financial constraints.
There are a number of instruments that can be utilised to attain a desired outcome, including education instruments, command and control instruments, system architecture instruments and market instruments that affect price such as taxes, grants, subsidies, rebates and tax concessions. It is essential to identify whose behaviour is being targeted in order to meet the policy goal. The incentive chosen should be designed to affect the behaviour of these
groups or individuals, keeping in mind the estimated costs and benefits associated with the proposed changes, and the likely impacts of these costs and benefits.
Aside from better policy design, today there is increasing pressure to evaluate the effectiveness of policy measures.Policy evaluation is the process of assessing the design, implementation and results of policies. It uses social science research methods to analyse policy effects. Evaluation contributes to evidence-based policy making and public sector accountability.
Deciding on an evaluation design can also be a challenging task. Various approaches can be utilised, and the decision about which evaluation model/s to adopt are contingent on the questions of interest and also on the nature of the policy or programme to be appraised. At the most basic level, in designing an evaluation the chief questions to be considered are:
- Is more knowledge with respect to how the policy/programme operates required? If yes, in which areas is more information required, and how should this information be collected? This type of evaluation is termed process evaluation.
- Is more knowledge about the impact the policy/programme with respect to the desired outcomes required? If yes, is more information with regard to what would happen if the policy/programme did not exist required? How is such information to be gathered? This type of evaluation is termed impact evaluation.
Sometimes, evaluations may only need to focus on either of the policy/programme’s process or impact. More frequently, the evaluation carried out will involve both elements.
Another distinction often utilised in the literature is that between formative and summative evaluation. The former is evaluation carried out to provide information on how to ameliorate a programme, whereas the latter forms a summary judgement about how a programme performed over a period of time.
The Equinox Advisory team can assist you with a multitude of areas relating to incentive mechanism design and evaluation for both contracts and policies. These include:
- Policy and program development, incentive mechanism design and incentive mechanism evaluation in areas of public and economic policy;
- Technical and financial assistance with respect to the evaluation of proposals;
- The design of incentive-compatible personnel performance appraisal and reward systems;
- The design of performance standards, incentives, performance enhancement strategies and penalties relating to the contractor’s performance;
- The development of adjustment mechanisms with respect to contractor payments, user rates and fees;
- The development of incentive-compatible fee and tariff structures for commercial contracts;
- The negotiation and development of contracts; and
- The organisation and conduct of meetings with prospective contractors.