The Incentive Flip

A major advertising agency believed production companies were padding their budgets. So they invented cost plus — instead of competitive bidding the agency would estimate what the job should cost and pay the production company that amount plus a flat ten percent markup.

The governor — the margin that lived inside the gap between the bid and the actual cost — had been removed. And without the governor the rational behavior became the exact opposite of what the model intended. The more the production cost the more the ten percent was worth. Spend as much as possible.

The model designed to remove padding created a systematic incentive to spend. It didn't last long but while it ran it demonstrated a principle that shows up in every industry in every era.

When you remove the incentive for efficiency you don't get honesty. You get whatever incentive replaces it.

The insurance billing system that rewards more procedures. The legal billing model that rewards more hours. The compensation structure that rewards the appearance of activity rather than genuine results. Same glitch. Different costume.