I am currently reading Richard Thaler’s new book, “Misbehaving – The making of Behavioural Economics” which has again brought up an interesting and long running debate on the application of positive incentives (gains or “carrots”) or negative incentives (losses or “sticks”) in Performance Based Contracts (PBCs). While this debate appears divided along the lines of buyer and seller, it also appears divided along regions (e.g. Australia vs. North America).

As with any debate there are 2 points of view. In this case the points of view are centred on how to motivate contractor performance as follows:

• Approach 1 – ensures contractor performance by placing a proportion of contract price at risk for performance and applies remedies (negative incentives / loss / stick) if the required performance is not delivered.
• Approach 2 – ensures contractor performance by having the contractor earn an amount of contract price (positive incentive / gain / carrot) based on performance against increasing levels of required performance.

Now I am guessing a few of you are thinking why the debate? That there is very little difference between the 2 approaches given the first approach takes money away for a failure to deliver while the second approach simply awards money for an ability to deliver. Mathematically the approaches are the same, including the contractor’s likelihood of delivering a certain level of performance. So why the ongoing debate?

Well, this is where behavioural economics comes in and hence the reference to Thaler’s book. Specifically, there is a particular behavior called loss aversion which describes how humans are keen to eliminate loss altogether since losses hurt twice as much as gain makes you feel good. Figure 1 illustrates this effect.

Figure 1 – The value function from Thaler (see Figure 3, pg 31, “Misbehaving – The Making of Behavioural Economics“)

Accordingly, while mathematically and probabilistically the same, Approach 1 causes twice as much hurt as Approach 2 makes you feel good. But of course, feelings shouldn’t matter in a contract between 2 companies should they? Hopefully, you now see why the debate!

But more in this in Part 2.