Ways to distinguish yourself #117 Understand the power of incentives

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I want to draw your attention to two items:

1. Real Estate agents and their incentives:

I was reading Freakonomics the other day. Steven Levitt beautifully explains the power of incentives in several chapters. In one example, Levitt talks about his study where it was found that the real estate agents tend to sell their own properties for significantly higher prices than their clients’.

Assume that you have a home that is worth anywhere between $300,000 – $350,000. The world view is that the real estate agent will sell the home for the highest possible price because of the incentives involved. The higher the price, the higher the commission. Right? Wrong, says Levitt. If there is an offer made for $300,000 for that home but there was a possibility of getting another $10K, the real estate agent won’t waste his time to get the additional $10K and may convince the owner to sell the home for $300K. The way incentives are structured is what prompts this behavior. Here are the details:

Commission for the real estate agent (A): 3% (6% split between buyer and seller agents)
Agency commission percentage (B): 1.5%
Actual commission percentage (C): 1.5%
Actual commission for additional $10K: $150

$150 is not a big enough incentive for the real estate agent to wait for a better price.

2. TV Show: Deal or No Deal

Kavitha and I watch this TV show sometimes. The rules (as explained in the website) are simple:

There are 26 briefcases at the start of the game each one filled with amounts anywhere from $.01 to $1M (or more sometimes) and the contestant picks a briefcase of his choice. Every round, Howie Mandel (the host) asks the contestant to open a set of boxes.

Then as each round progresses, the contestant must either stay with your original briefcase choice or make a “deal” with the bank to accept its cash offer in exchange for whatever dollar amount is the contestant’s chosen case.

Once you decide to accept or decline the bank’s offer, the decision is final.

Contestants are encouraged to ask friends or family in the audience for advice; however, only the contestant’s answer will be considered binding and final.

You would think that the contestants can make a lot of money. Most of the time, contestants make less than a few hundred dollars at the end of the game. It is interesting to watch the reaction of the audience everytime the contestant has to make a choice between “Deal” or “No Deal.” There is an overwhelming cry of “No Deal” from the audience even when the odds are not very good. Since there are hundreds of people saying “No Deal” the contestant might think that “No Deal” may be the right way to go. But look at the incentive for the audience. If the contestant takes a lot of risks irrespective of the outcome (win or lose) the show becomes a thriller. If the contestant does not take any risks, the show gets to be boring. What is the way for the audience to ensure that the show is thrilling? Just keep saying “No Deal” and influcence the contestant to not make a deal.

Incentives are extremely powerful. There are incentives for you to behave the way you do and there are incentives to make the people around you behave the way they do. Understanding the power of incentives will help you to understand people’s behavior.