Crowding In and Crowding Out

Murray Fulton

In a previous post, I outlined how a failure to find the right balance between intrinsic and extrinsic motivations can lead to a crowding-out effect in which the introduction of more extrinsic incentives results in poorer, rather than better, performance. With the right balance, however, extrinsic motivations can significantly enhance performance — the crowding-in effect.

Crowding-in and crowding-out effects can have a real impact on how decisions are made, on the effectiveness of policy, and on the performance of organizations, including co-operatives. Here are a couple of examples.

German Energy Co-ops

A recent post, based on a presentation by Brett Fairbairn, explored the rapid rise in German energy co-operatives and how they helped meet a host of intrinsic objectives —the reinforcement of community, the management of conflict, and the fulfillment of a desire for decentralization and for more environmentally friendly energy sources. As the post notes, the introduction of a renewable energy law in 2000 “provided generous feed-in tariffs as incentives for generating renewable energy. As a result, the country has seen increases every year in the proportion of energy coming from renewable sources — mainly photovoltaic, wind, and bio-energy. The co-operatives that have formed to provide this energy are found in every region of the country.”

This case is a good example of how extrinsic motivations — in the form of generous feed-in tariffs — dovetailed with the intrinsic motivations of community members. The introduction of increased financial rewards appears to have been perceived as supporting community desires, which enhanced local agency and, in turn, led to the formation of co-operatives. Put another way, the alignment of financial rewards and community desire created a space for local agency.

This interpretation suggests a way for policy makers to advance some of the significant changes that will be required in critical areas such as energy. Extrinsic incentives such as subsidies can work, but only if they are paired with organizational structures that provide people with a sense of agency and control that aligns with strongly held values. Without this alignment, people may be reluctant to make the change, as is evident, for example, in the fierce opposition to the introduction of wind turbines in numerous areas.

CEO Compensation

A great deal of attention has been paid to CEO and executive compensation over the last ten to fifteen years as salaries and bonuses have skyrocketed. One of the reasons for the large executive payouts is the aggressive use of pay-for-performance (PFP) schemes, which are said to be required as an incentive for good management.

Co-operatives, for the most part, have not adopted PFP structures, but rather, have used contracts in which a CEO receives a bonus or other reward subject to achieving a particular level of performance. In addition, pay scales for co-op executives are typically far below those used by investor-owned companies in the same industry.

While co-operatives might well perform better under a more aggressive PFP scheme, there is no evidence that co-op performance is inferior to that of their investor-owned counterparts as a result of the compensation schemes they have used. Indeed, in a number of sectors — e.g., the gasoline and retail sector in western Canada and the financial sector in most parts of the country — co-ops and credit unions have performed very well.

One reason why less aggressive PFP schemes correspond to relatively strong performance could be the interplay between extrinsic and intrinsic motivation. If implicit contracts with subjective performance measures result in a greater sense of agency and control for CEOs, then the outcome could be as strong as in cases where more weight was given to extrinsic motivation.

The argument above assumes, of course, a proper sense of mission — sufficient common ground between what the CEO finds satisfying and what is in members’ interests. Thus, instead of focusing on pay and bonuses alone, co-operatives might consider selecting CEOs on the basis of values consistency in addition to managerial competence. They might also take measures to nurture values consistency among managers.

Summing Up

Extrinsic motivations are typically used to change behaviour — be it the adoption of new technologies or the effective management of an organization. The intersection of extrinsic and intrinsic motives is critical for knowing how behaviour will actually be affected. The alignment of financial incentives with community values transformed the renewable energy sector in Germany; misalignment in CEO compensation might produce counterintuitive, unpredictable, and negative outcomes in organizations.

The examples above suggest that we need to rethink how extrinsic incentives are used. A common mindset in policy and governance theory holds that good performance depends solely upon getting the extrinsic incentives correct. Achieving good performance, however, is more difficult than simply providing an appropriate financial or legal structure. We must also pay attention to how these structures affect people’s sense of mission, ownership, and agency. In governance, it’s not the rules alone that matter — it’s also the context and the working of ideas in people’s minds.

Hueth, Brent, and Philippe Marcoul. 2009. “Incentive Pay for CEOs in Cooperative Firms.” American Journal of Agricultural Economics 91 (5): 1218–23.

If you find our blog useful, please add our link to your website.