Saturday, 3 May 2008

Three kinds of structure

The motivation principle: People act in their best interest, in the light of the information available to them, over a time period that they can accurately foresee.

The first two of these statements seem relatively obvious but perhaps the third is not so clear. It means that people will not take an action today, for some nebulous potential benefit one day in the future. They must gain something in return for the action either immediately, or within a time horizon that they can clearly grasp. How long is that? If I make a calm and considered decision, the time horizon may be as much as a few hours; while in the heat of the moment it may only be a few seconds. Either way, in order to act in my longer-term interest, I must get some kind of short-term payoff or else it's too easy to sell out on my decision. For example, if I want to lose ten pounds and be able to run a marathon in six months, I won't succeed unless I give myself incentives that keep paying off for all those early morning runs and foregone pints of beer. Each time I take one more step and my leg muscles scream at me, I need some kind of motivation that overrides the pain.

Classical economics says that, provided sufficient information is available to everyone, every self-interested decision results in a benefit for society. Indeed it makes a stronger claim, which is that the information you need is the price of all goods and services available to you.

However with some thought, it becomes clear that simple short-term, local, selfish decisions are not always sufficient to get the best result. Two examples:
  • The prisoner's dilemma: In this example, two people are being separately interrogated about a crime they are supposed to have committed (it's not relevant whether they really did it). Each one is offered a deal - give up your friend and you'll get off more lightly. But if she gives you up and you don't confess, you'll be put away for years. Without going into the detail of it (have a look at the Wikipedia entry for that), if both prisoners act selfishly, they both lose out. If they act cooperatively, they both get the maximum benefit.
  • Investing for the future: By investing money today (in a sensible manner), you can get long-term benefit. For example, by buying a new machine for your company, you may be able to manufacture more goods and make lots more money in the long-run. But you are giving up something in the present to get it. You can't buy the same dinners or holidays this year as you would if you saved the money from the machine. But in the long term, you will have more dinners or more holidays by investing.

A different way to look at it: If everyone was best served by acting in their own interest with no coordination, there would be no role for companies or organisations. We could just let everyone be self-employed and trade services with each other. If you work in a company with more than a few people, imagine for a moment that everyone is released to work as a freelancer. You are still making the same stuff and based in the same place - but instead of the company organising what people do, they all make their own decisions each day according to what they think best for themselves.

It would probably work okay for a while. But what happens when some new equipment is needed? Or when someone has an idea for a new product? It's not in anybody's interest to invest time or money in it. What if you need to plan a six-month project? If you can't plan who will be available to work on it, the project may never go ahead.

Of course in businesses, we have ways of coordinating people so that these decisions can be taken in the long-term interest of the company. Everyone benefits from that because their jobs are more secure, their equity is more valuable, and they know what money they'll take home at the end of the month. The point is that if we recognise and understand these structures better, we will be able to design better ones and get even better results.

Three kinds of structure are available, corresponding with the three parts of the motivation principle.

  1. Structures for incentives
  2. Structures for information
  3. Structures for time horizon

Examples of each of these to follow in a future post.

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