Perverse Incentives – Part 2

In the previous article (see Perverse Incentives – Part 1) I discussed why PBC practitioners need to be aware of the potential for perverse incentives in our PBC arrangements.  In this article let’s look at how PBC practitioners, both buyers and sellers, can avoid accidentally including perverse incentive. In a previous article (see Unintended and Perverse Outcomes) I looked at a couple of recent cases that highlighted some possible actions.

From the buyer’s perspective, this requires “testing” of the PBC to see whether the Performance Management Framework (PMF) works as intended based on the three tests described above. You can undertake this testing by:

  • testing the arrangement for all areas of performance, from 100% (or above if incentivised) to 0% performance, observing what conditions result in this, and potential response from the seller;
  • including non-monetary performance measures such as Strategic Performance Measures (SPMs), potentially reflecting enterprise performance and enterprise behaviour  aligning buyer and seller outcomes and behaviours (see When is a KPI not a KPI? for SPM description).
  • monitoring of the performance and behaviours of the seller to watch whether unintended outcomes are occurring, their response as part of  the routine contract management activities.

However, “testing” it isn’t solely the buyer’s responsibility.  I believe sellers have a reciprocal responsibility to make sure, regardless of whether the PMF of the arrangement allows it, to behave fairly.  For example, during both the tendering process and operation of the contract, I believe sellers should have the courage to tell the buyer of any issues they find in the arrangement, especially one that may lead to a perverse incentive.  Equally, buyers should reward constructive feedback from sellers.

For example, in building the first transcontinental railroad in the 1860s, the United States Congress agreed to pay the builders per mile of track laid; a form of ‘time and materials’ basis of payment.  As a result, Thomas C. Durant of Union Pacific Railroad lengthened part of the route forming a bow shape unnecessarily adding miles of track to maximise payment.  In this case, perhaps both buyer and seller needed another performance measure rewarding the most direct route and speed of construction.

While many will argue that this perverse outcome was a result of dishonesty on behalf of the seller, I believe we as PBC practitioners should acknowledge the potential for perverse incentives in our arrangements and take action to remove, minimise or mitigate putting buyers and sellers in this position.

But regardless of the approach, we all need to be aware of perverse incentives to make sure we don’t end up in our very own cobra effect.

This entry was posted in Behavioural Economics, Behaviours, the What and tagged , , , , , , , , . Bookmark the permalink.

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