Incentive Compatibility

Incentive compatibility means that the interests of two or more individuals are aligned; in contrast, when interests are not aligned, the incentives governing behavior are said to be incompatible. From an organizational perspective, incentive compatibility means that the incentives that motivate individual members in their actions are consistent with the organization's goals.

Incentive compatibility is important in situations in which there is asymmetric information, that is, when at least one participant in an interaction does not know perfectly what another participant knows or does. The problem is that the participant with the more complete information might use that information in a way that benefits him or her at the expense of others. Incentive compatibility means that the interaction is structured in such a way that the participant with the more complete information is motivated to act in the interest of the other party (or has less incentive to exploit his informational advantage). For instance, if an insurance company offers a discount to people who do not engage in high-risk behaviors, such as smoking or skydiving, then persons who engage in such behaviors might try to identify themselves as low risk to take advantage of the discount. This type of problem is known as adverse selection—high-risk persons know they are high risk but have an incentive to “select” or identify themselves as low risk. An incentive-compatible solution would ensure that people who engage in high-risk behaviors identify themselves as such. For example, if the insurance company requires a medical exam for all persons reporting themselves as low risk, then high-risk persons may have less incentive to misrepresent themselves. Similarly, if workers promise to work hard in exchange for a high fixed salary, and if the boss cannot directly observe worker effort, then the workers might have an incentive to shirk. This type of problem is known as moral hazard—after obtaining employment, the workers work less hard than promised, thus creating a “hazard” for the boss. An incentive-compatible solution would ensure that workers work hard as promised. For example, the boss could pay workers on commission, with pay tied to observable performance measures, thus mitigating the incentive to shirk.

In economics, incentive compatibility is used as one of two important constraints in an optimization problem in which a person (such as a firm owner) must rely on others to maximize some social welfare criteria (such as profits). The participation constraint ensures that people want to participate, in that they are at least as well off by participating as they would be by not participating. The incentive compatibility constraint ensures that people are motivated to behave in [Page 1114]a manner consistent with the optimal solution. Usually this means that the compensation people receive when the desired outcome is achieved is at least as high as the compensation they could earn when some other outcome occurs. For example, suppose a factory owner needs employees to work in his or her factory. The participation constraint ensures that some people would rather be employed in the factory than do something else. The incentive compatibility constraint ensures that the employees are motivated to act in the owner's interest.

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