Steven D. Levitt: it’s all about incentives

Posted: 09/01/2011 - 00:00

If you walk past a bookstore or watch 60 Minutes you have likely heard of the wonderful works by the academic economist Steven D. LevittFreakonomics and Superfreakonomics. Levitt teamed with his journalist collaborator Stephen J. Dubner to create two bestsellers I highly recommend reading. The books are fun and clever, but more importantly they reveal basic insights about human economic activity while exploring “the hidden side of everything.”

The books are based on some fundamental concepts:

  • “Morality is what people should do.  Economics is what people do.”
  • “The conventional wisdom is often wrong”
  • “Incentives are the cornerstone of modern life”
  • “Dramatic effects often have distant, even subtle, causes”
  • “Knowing what to measure and how to measure it makes a complicated world much less so”

One of Levitt’s most powerful points is what he calls the “law of unintended consequences.” While he tells lively stories of how unintended consequences drive the behaviors of schoolteachers, realtors, crack dealers, prostitutes and expectant mothers, this law also greatly affects outsourcing deals as well.

In fact, an outsourcing deal that is not collaboratively planned, tracked and governed will suffer from all sorts of random, unintended but predictable negative consequences. In my research at the University of Tennessee I outline 10 common unintended consequences which I call ailments – all of which diminish or derail the effectiveness of an outsource partnership.

Levitt stresses in his second book, Superfreakonomics, that “People respond to incentives.” Incentives are the “cornerstone of modern life,” and while people respond to them, unfortunately they do not necessarily respond “in ways that are predictable or manifest,” which is where unintended consequences enter the fray and become perverse incentives.

Our research has also found that some of the most successful outsourcing deals leverage incentives heavily to motivate service providers. Deals are structured around business results – or Desired Outcomes – versus paying a service provider by transaction or headcount.

In The Vested Outsourcing Manual, I say that companies should always incorporate incentives – whether they are cost, performance, awards or nonmonetary incentives – that are mutually beneficial to the parties in order to offset the flaws of using conventional firm fixed price or cost-reimbursement models, which can lead to perverse incentives. If one side’s incentives come at the expense of the other side then the outsourcing deal is in jeopardy.

The challenge is to motivate outsourcing teams to make the collaborative decisions on pricing, performance and outcomes that ultimately will translate into the incentives that breed success and the win-win.

In outsourcing, it’s important to consider Levitt’s insight: “Morality is what people should do. Economics is what people do.” He also says that “in economics as in life, you’ll never find the answer to a question unless you’re willing to ask it, as silly as it may seem.”

Here’s a parting word of advice if you are looking to structure an outsourcing deal. You’ll never find the right incentive package unless you’re willing to ask the right questions with your outsourcing partner. So rather than use your procurement and negotiation muscle, stop and ask the service provider what motivates it and how it would structure a deal that’s designed to achieve what you want. That’s not silly to me at all.

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About The Author

Kate Vitasek's picture

Kate Vitasek is an international authority for her award-winning research and Vested® business model for highly collaborative relationships.   Vitasek, a Faculty member at the University of Tennessee, has been lauded by World Trade Magazine as one of the “Fabulous 50+1” most influential people impacting global commerce.    Her work has led to 6 books, including: Vested Outsourcing: Five Rules That Will Transform Outsourcing, Vested: How P&G, McDonald’s and Microsoft Are Redefining Winning in Business Relationships and Getting to We: Negotiating Agreements for Highly Collaborative Relationships.

Vitasek is known for her practical and research-based advice for driving transformation and innovation through highly-collaborative and strategic partnerships.   She has been appeared on CNN International, Bloomberg, NPR, and on Fox Business News.  Her work has been featured in over 300 articles in publications like Forbes, Chief Executive Magazine, CIO Magazine, The Wall Street Journal, Journal of Commerce, World Trade Magazine and Future of Sourcing.