Incentive Schemes

They alter the perceived marginal benefit or marginal cost of each available choice. A performance payment can make additional effort more attractive, while a penalty can increase the perceived cost of unwanted behavior. Because decision-makers compare these changed consequences when choosing among alternatives, the scheme can redirect actions toward organizational or social objectives without directly controlling every decision.

Incomplete information affects different stages of decision-making. Moral hazard can arise when one party changes behavior after an agreement because that behavior is difficult for another party to observe. Adverse selection concerns differences among participants that exist before an arrangement is made. Recognizing this distinction helps explain why a contract may produce unexpected outcomes even when its objective is clear.

Participants may respond to the measured consequence rather than to the broader objective. If a scheme rewards one observable result too narrowly, individuals or firms may redirect effort toward that result while neglecting other relevant outcomes. Such strategic responses can weaken productivity, innovation, or efforts to reduce unwanted behavior, showing why incentive design must account for possible reactions.

These mechanisms influence behavior through different kinds of consequences. Contracts and performance-based compensation commonly connect an individual's or firm's outcome to a payment, whereas taxes and penalties raise the cost of selected actions. Subsidies and rewards increase the attractiveness of desired choices, while regulations establish constraints. Their suitability depends on the behavior being influenced and the information available.

Design begins by identifying the desired behavior, the decision-makers whose actions matter, and the consequences that can change their marginal benefits or costs. The arrangement should also account for incomplete information, differing objectives, and possible strategic responses. These considerations help align individual actions with organizational or social goals while limiting moral hazard, adverse selection, and other unintended effects.

They are relevant when an employer wants employee actions to support organizational objectives, particularly when effort or performance cannot be fully observed. Performance-based compensation and other contractual consequences can connect individual outcomes with organizational goals. Their economic importance lies in addressing differing incentives between decision-makers, while recognizing that narrow measures may encourage responses that do not improve overall performance.

A well-aligned arrangement can make productive effort, innovative activity, or socially preferred conduct more rewarding than alternatives. Conversely, penalties, taxes, or regulatory consequences can make unwanted behavior less attractive. In microeconomics, the resulting outcome depends on whether the changed marginal benefits and costs guide decisions toward the intended objective rather than encouraging moral hazard, adverse selection, or strategic adaptation.