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The Mental Model of Incentives

Charlie Munger wrote in Poor Charlie’s Almanack:

“Perhaps the most important rule in management is to get the incentives right.” (see 30+ Charlie Munger Quotes).

Charlie argues that people respond most strongly to what they view as their incentive or disincentive.

In business, there is almost always someone else involved in whatever you are trying to do. Munger recommends that you always reflect on:

“What is someone getting out of this.”

Charlie gives a few business examples of incentive bias (source: Poor Charlie’s Almanack).

FedEx — he said that they couldn’t get the planes to shift packages from plane to plane in a timely manner.

The problem was that the workers were being paid per hour. When FedEx changed to paying the workers per shift, the workers were able to to shift packages faster.

Xerox — Joe Wilson had to return to Xerox to help figure out why their older, inferior copy machines were outperforming their newer, better machines. Wilson found the explanation in a perverse commission structure that incentivized selling the older machines more than the new machines.

Munger has talked about incentive bias related to two clients his father (an attorney) had:

  1. Grant McFayden — McFayden owned a Ford dealership and was a brilliant man of enormous charm and integrity and who made excellent decisions.
  2. Mr X — Mr. X (Munger leaves out his name) was a blowhard, overreaching, pompous, difficult man.

Charlie, when he was 14, asked his dad why he did so much work for Mr. X, the blowhard, instead of doing more work for wonderful men like McFayden.

Charlies says his father told him:

“Grant McFayden treats his employees right, his customers right, and his problems right. If he gets involved with a psychotic, he quickly walks over to where the psychotic is and works out an exit as fast as he can. Therefore, Grant McFayden doesn’t have enough remunerative law business to keep you in Coca-Cola. But Mr. X is a walking minefield of wonderful legal business.”

Translation: lawyers have a much stronger financial incentive to represent clients who get in trouble and even break the law and will likely see less financial gain from working for highly ethical clients.

“That’s what partly drove me out the profession,” Charlie wrote in Poor Charlie’s Almanack.

For a sports example of incentives, check out Are Cubbie Fans The Reason The Cubs Have Sucked For 100+ Years? for a fascinating theory on why the Chicago Cubs under-performed for so long (in short, they theory is that the Cubs organization has less of an incentive to win because the fans show up whether they win or lose).

Disincentives are equally important. Charlie suggests, in Poor Charlie’s Almanack, that a “very significant fraction of the people in the world will steal if:

A) it’s very easy to do and

B) there’s practically no chance of being caught

To succeed in business, you need to disincentevize/discourage a negative behavior such as stealing by, for example, making it extremely difficult to do and likely to be detected (that’s usually accomplished through systems and controls).

This article on incentives continues my quest to list out the Top 100 Mental Models Needed to Succeed in Business, inspired by Charlie Munger.