Incentive problems in everyday life
A couple of fun incentive situations that I have seen/been mentioned to me.
Overcome information asymmetry by removing the incentive to exploit — Case Study UK Vehicle MOT Tests
TL;DR: If someone knows more than you about something sometimes the best way to protect yourself against exploitation is to remove the opportunity to exploit that information, not close the information gap.
In the UK you need to get an MOT every year on your car. An MOT is an annual test of if your car is safe to be on the road, and if it meets emission requirements. The test is performed by nearly all mechanics, and the prices are regulated to be kept low. Currently they are between $40 and $85, depending on the size of your car.
The problem is the mechanics are incentivized to identify “problems” with your car during the MOT. This leads to the constant problem of an unexpected “failure” in your MOT, and a sad looking mechanic saying they have no choice but to charge you $500 to get you on the road. As most people know little to nothing about how vehicles actually work they are forced to accept whatever the mechanic says is the issue.
So how do you get around this problem of incentive to identify “problems” and information asymmetry?
The first thing is to identify that you don’t need to remove both of the problems. If you removed the information asymmetry, by learning more about cars, you would be able to prevent unscrupulous upselling by mechanics. If you remove the mechanics incentive to upsell their information asymmetry is not a risk to you.
The second thing to identify is which of the two problems is hardest to solve? Learning enough about vehicles to identify lying mechanics is a lot of work. Mechanic apprentices train for 2–3 years, and even a best case scenario would have you training for several months.
So what mechanics it the UK have no incentive to upsell you additional services? All you need to do is find one mechanic and your problem is solved.
The answer are council MOT centers for government vehicles e.g. police cars. They will do public MOT tests but do not/are not allowed to perform repairs on public vehicles.
By removing the ability to make money off upsell it doesn’t matter that the information asymmetry still exists. You can bring your car for the MOT safe in the knowledge that the mechanic will only fail your car if it has actually failed the MOT.
Know which game everyone is playing. Repeated games have different incentives to single play games —Case Study VC Lawyers (Not seen myself but read about in this article)
TL;DR: Some advisors you hire may interact with your counterparty many times, whereas you may hire the advisors one time. You may think the advisors work for you, but they may instead be focused on preserving the relationship with the counterparty.
When you hire a lawyer you assume they work for you. You pay their bills, and want to please you to try and win repeat business or gain a reputation boost through word of mouth.
However this may not be the case.
Imagine a lawyer who works on VC deals in the tech space. They get work from individual founders approaching them, and from venture capitalists who provide work either for themselves or their portfolio companies.
The amount of work provided by venture capitalists is not only larger but is repeated. If the lawyer annoys a venture capitalist they don’t just lose access to a single large piece of work, they lose access to a large future flow of work.
This incentive for the lawyer to maintain good relationships with individual VC’s is further strengthened by the small size of the industry, particularly at the elite levels. If you annoy a top VC’s not only do you lose a very large share of work flow, your reputation is likely to quickly drop amongst other VC’s. Soon you will have lost the majority of top level work, making it even hard to attract individual entrepreneurs to use your services.
Now imagine you have hired this lawyer to push for more preferential terms in a negotiation with a top VC. If the lawyer pushes to get you a great deal they will damage their long term financial position. They are far more incentivized to push you to settle for less, so as to keep their future flow of work coming.
Note this holds true even if you pay them a large amount, or even tie their payment to the your success in the negotiation. The payoff for keeping the VC happy is just so much larger, due to the repeated game the lawyer and the VC are playing compared to the one time game you are playing.
