An incentive is something that motivates or drives one to do something or behave in a certain way.[1] There are two types of incentives that affect human decision making. These are: intrinsic and extrinsic incentives. Intrinsic incentives are those that motivate a person to do something out of their own self interest or desires, without any outside pressure or promised reward.[2] However, extrinsic incentives are motivated by rewards such as an increase in pay for achieving a certain result; or avoiding punishments such as disciplinary action or criticism as a result of not doing something.[1][2]  

A florist offers a "buy one, get one free" incentive to encourage purchase of a certain flower.

Some examples of extrinsic incentives are letter grades in the formal school system, monetary bonuses for increased productivity or withholding of pay for underperforming in the workplace.[2] Examples of intrinsic incentives include wanting to learn a new language to be able to speak to locals in a foreign country or learning how to paint for self enjoyment.

In the context of economics, incentives are most studied in the area of personnel economics where human resources management practices focus on how firms manage employee incentives such as pay and career concerns, compensation and performance evaluation.[3]


Classified by David Callahan, the types of incentives can be further broken down into three broad classes according to the different ways in which they motivate agents to take a particular course of actions:[4][5]

Class Definition
Remunerative incentives exist where an agent can expect some form of a material reward like money in exchange for acting in a particular way.[5]
Moral incentives exist where a particular choice is widely regarded as the right thing to do or is particularly admirable among others.[5] An agent acting on a moral incentive can expect a sense of positive self-esteem, and praise or admiration from their community. However, an agent acting against a moral incentive can expect a sense of guilt, condemnation or even ostracism from the community.[5]
Coercive incentives exist where an agent can expect that the failure to act in a specific way will result in physical force being used against them by others – for example, by inflicting pain, or by imprisonment, or by confiscating or destroying their possessions.[5]

Incentives in economic contextEdit

The economic analysis of incentives focuses on the systems that dictate the incentives needed for an agent to achieve a desired outcome.[6] When a firm wants their employees to produce a certain amount of output, it must be prepared to offer a compensation scheme such as a monetary bonus to influence the employees to reach the target output.[6] Compensation must achieve two goals. The first is its ability to attract workers to the jobs and be able to retain them.[6] The second is its ability to incentives workers to produce an output as workers who do not produce do not generate any profit for the firm.[6] A rise in pay variance across occupations reflects an increased demand for highly productive workers thus, influencing compensation to shift towards pay-for-performance.[7] Firms use a variety of methods to implement productive behavior. Some methods are commission based where the employee, for examples a salesperson receives a payment directly correlated to their output level. Other methods are less direct, for example awarding periodic bonuses to top performers, offering a possibility of a promotion to higher-paying position or profit sharing for team projects.[6] Alternatively, firms can also incentives their employees to perform by threatening to demote or terminate them.[6]

Firms must design the compensation plan to induce workers to operate in the firms best interest and put forth a certain level of output that maximizes the firms profits.[6] However, since the interest of workers and their employer do not always align and asymmetric information, where one (worker/ employer) does not know some relevant facts about the other, make the compensation plan difficult to establish.[8] Here, the principal-agent theory is used as the guiding framework when aligning incentives with the employees effort to obtain the efficient level of output for the firm.[6] For example, a manager may want a certain level of output from an employee but does not know the capabilities of the employee in the presence of imperfect monitoring, and to achieve the best outcome, an optimal scheme of incentive may be set to motivate the worker to increase their productivity.[8]

The Tournament theory also provide a framework of compensation but at different levels of the firms hierarchy.[3] The theory demonstrates that individuals are not promoted on the bases of their performance and output , instead on the relative position in the organization.[3] The theory also explains that the compensation does not necessarily motivate the employee currently working at that level but instead motivates the employees below that level who aim at getting promoted.[3]

Potential issuesEdit

Incentives are arguably beneficial in increasing productivity, however, they can also have an adverse effect on the firm.[6] This is evident through the ratchet effect. A firm may use its observation of the employees output level when they first get employed as a guide to set performance standard and objectives for the future.[9] Knowing this, an employee may purposely reduce their output level when first employed or hide their ability to produce at a higher output with the intent of exploiting being rewarded in the future when they strategically increase their output level.[9] Thus, the ratchet effect can significantly diminish production levels of a firm and planned economies.[10]

Neither do incentives not always increase motivation as they can contribute to the self-selection of individuals, as different people are attracted by different incentive schemes depending on their attitudes towards risk, uncertainty, competitiveness.[11] For example, some corporate policies popular during the 1990s aimed to encourage productivity have led to failures as a result of unintended consequences.[12] For example, providing stock options were intended to boost CEO productivity through offering a remunerative incentive to aligning the CEOs interests with those of the shareholders to improve company performance.[12] However, CEOs were found to either make good decisions which resulted in a reward of a long-term price increase of the stock, or were found to have fabricated the accounting information to give the illusion of economic success and to retain their incentive based pay.[12] Furthermore, it has been found to be extremely costly for the firms to incentivize the CEOs with stock options, nevertheless, firms are forced to pay substantial amounts of money for the provision that the CEO acts in the best interest of the firms and profit maximization.[6]

Incentives can have a bipolar effect on the company. On the one hand, the company's incentives to employees may create a pay gap. For example, low-paid employees may reduce their production or contribution to the company. For example, low-paid employees and high-paid employees may not be able to communicate and cooperate effectively, causing low-paid employees to gradually lose their enthusiasm for work.[13] Therefore, incentives may be counterproductive.

On the other hand, incentives have a positive effect on education. For example, students may underestimate their own learning ability. Incentive not only makes teachers or parents pay more attention to students' abilities, but also encourages students to bring good learning returns. However, it is worth noting that monetary incentives may not be positive. There may be bribery education in monetary incentives, and this monetary incentive is often contrary to morality.[14]

Teamwork will also serve as an incentive for the company. When employees encounter difficult problems, the company effectively incentives employees' performance by establishing teams to communicate and collaborate with each other. In particular, when the abilities of employees form complementary forms, the company's incentive effect achieves a good performance. On the contrary, when employees rely too much on the output of the team, the incentive of teamwork will have a certain negative effect on the company's production.[15]

External factors will affect the incentive mechanism. For example, noise may reduce the output of employees and pose a certain risk to employees. In the case of controllable risks, more incentive mechanisms are needed instead of a single incentive mechanism. In addition, according to the agency theory, when employees produce high-risk products, the company's remuneration incentive effect is not ideal, and incentive measures should be taken cautiously.[16]


Motivation theory initially built on the earlier motivational theory developed by psychologists such as Clark Hull. This theory first emerged in the 1940s and 1950s. Under incentive interventions, individuals receive some tangible and desirable consequence (e.g., money, privilege) contingent on emitting some observable and verifiable behavior. Incentives have been used all around the world from the United States, to Africa, to the United Kingdom, and many other countries (Silveman, Jarvis BP, Jessel and Lopez 2016).

Motivation theory holds that people subconsciously steer away from actions that have negative consequences and toward actions that bring rewards. The important thing is that people generally do not focus on the underlying factors behind incentives. There are many examples in the real world, such as studying hard and working hard, all of which are positively influenced by reward incentives. Motivation can be used to get people to engage in certain behaviors or to stop certain behaviors. Motivation becomes very effective when a person is faithfully rewarded. For example, if an assignment is too difficult, students will have no incentive to get a high score in the exam. Besides, money is an excellent example of extrinsic rewards that motivate behavior. In many cases, employees will pay for their bonuses by doing things they might otherwise avoid, such as working overtime or meeting sales targets.

Driven-reduction theory, arousal theory and instinct theory all say that individuals are internally motivated to act. Motivation theory, on the other hand, holds that individuals are motivated by external incentives. Psychologists and other professionals from different theoretical and conceptual backgrounds have started to use motivational interventions. Incentive interventions are rooted in a great deal of basic research on both non-humans and humans. These studies show that many human behaviors are affected by the consequences of such behaviors (Pierce and Cheney 2013).

See alsoEdit


  1. ^ a b Armstrong, Michael (2015) [2005]. Armstrong's handbook of reward management practice: improving performance through reward (5th ed.). London; Philadelphia: Kogan Page. ISBN 9780749473891. OCLC 910859327.
  2. ^ a b c Krugman, Paul (2 October 2020). "Understanding Incentives in Economics: 5 Common Types of Economic Incentives". MasterClass. Retrieved 18 October 2020.
  3. ^ a b c d Lazear, Edward. P; Shaw, Kathryn. L (2007). "Personnel Economics: The Economist's View of Human Resources" (PDF). Journal of Economic Perspectives. 21 (4): 91–114. doi:10.1257/jep.21.4.91.
  4. ^ Callahan, David (2004). The cheating culture: Why more Americans are doing wrong to get ahead. Harcourt. ISBN 9780156030052.
  5. ^ a b c d e Dalkir, Kimiz (2011). Knowledge Management in Theory and Practice (Second ed.). The MIT Press. ISBN 9780262015080.
  6. ^ a b c d e f g h i j Neilson, William.S (2007). Personnel Economics. Pearson Education Inc. p. 11. ISBN 9780131488564.
  7. ^ Lazear, Edward P; Shaw, Kathryn L (2007). "Personnel Economics: The Economist's View of Human Resources". The Journal of Economic Perspectives. American Economic Association. 21 (4): 91–114. doi:10.1257/jep.21.4.91. JSTOR 30033753.
  8. ^ a b "LectAgent Problem" (PDF). Archived from the original (PDF) on 2015-11-23.
  9. ^ a b Kanemoto, Yoshitsugu; MacLeod, W. Bentley (1992). "The Ratchet Effect and the Market for Secondhand Workers". Journal of Labor Economics. University of Chicago Press. 10 (1): 85–98. doi:10.1086/298279. JSTOR 2535130.
  10. ^ Cooper, David J.; Kagel, John H.; Lo, Wei; Gu, Qing Liang (1999). "Gaming against Managers in Incentive Systems: Experimental Results with Chinese Students and Chinese Managers". The American Economic Review. 89 (4): 781–804. doi:10.1257/aer.89.4.781. ISSN 0002-8282. JSTOR 117159.
  11. ^ Chiappori; Salanié (2003). M. Dewatripont; L. Hansen; S. Turnovsky (eds.). "Testing contract theory: a survey of some recent work" (PDF). Advances in Economics and Econometrics. Cambridge: Cambridge University Press. 1: 115–149. doi:10.1017/CBO9780511610240.005. ISBN 9780511610240.
  12. ^ a b c Jain, Abha (2019). Sports Psychology. India: Friends Publications. p. 215. ISBN 978-93-88457-75-0.
  13. ^ Breza, Emily; Kaur, Supreet; Shamdasani, Yogita (10 October 2017). "The Morale Effects of Pay Inequality*". The Quarterly Journal of Economics. 133 (2): 611–663. doi:10.1093/qje/qjx041.
  14. ^ Gneezy, Uri; Meier, Stephan; Rey-Biel, Pedro (1 November 2011). "When and Why Incentives (Don't) Work to Modify Behavior". Journal of Economic Perspectives. 25 (4): 191–210. doi:10.1257/jep.25.4.191.
  15. ^ Lazear, Edward P; Shaw, Kathryn L (1 November 2007). "Personnel Economics: The Economist's View of Human Resources" (PDF). Journal of Economic Perspectives. 21 (4): 91–114. doi:10.1257/jep.21.4.91.
  16. ^ Pendleton, Andrew; Robinson, Andrew (1 November 2017). "The productivity effects of multiple pay incentives". Economic and Industrial Democracy. 38 (4): 588–608. doi:10.1177/0143831X15583099.

Silverman K, Jarvis BP, Jessel J, Lopez AA. Incentives and motivation. Transitional Issues in Psychological Science. 2016;2(2):97-100. doi:10.1037/tps0000073

Pierce, W. D., & Cheney, C. D. (2013). Behavior analysis and learning (5th ed.). New York, NY: Psychology Press.