Financial Incentives and Social Good: Dan Pallotta’s Faulty Assumptions

At the suggestion of WOVIN founder Darius Golkar, I recently watched Dan Pallotta’s TED Talk on the nonprofit sector.  Golkar recommended this video to me when I asked him why WOVIN donates only 50% of its profits to charitable causes.

Golkar founded WOVIN because clothes we donate to Goodwill, The Salvation Army, and other charities rarely have the effect we intend.  Our hand-me-downs often enrich international “clothing recyclers” who exploit the poor in countries like Ghana and Nigeria.  WOVIN addresses this problem by reconstructing donated jeans into bags, key rings, cardholders, and wallets, selling these products, and then giving a portion of the proceeds to organizations that assist impoverished people.  I sincerely admire this work.

When I first read about WOVIN, however, the 50% number bothered me.  And while Pallotta’s TED Talk may explain why Golkar chose to incorporate WOVIN as a for-profit company, Pallotta’s paradigm reflects many inaccurate and problematic assumptions we have about business.  Several of these assumptions pertain to executive compensation.

Pallotta begins to discuss compensation 3 minutes and 11 seconds into his talk.  He says:

So in the for-profit sector the more value you produce, the more money you can make.  But we don’t like nonprofits to use money to incentivize people to produce more in social service.  We have a visceral reaction to the idea that anyone would make very much money helping other people.  Interesting that we don’t have a visceral reaction to the notion that people would make a lot of money not helping other people.  You know, you want to make fifty million dollars selling violent videogames to kids, go for it, we’ll put you on the cover of Wired magazine, but you want to make half a million dollars trying to cure kids of malaria and you’re considered a parasite yourself.  And we think of this as our system of ethics, but what we don’t realize is that this system has a powerful side effect, which is, it gives a really stark, mutually exclusive choice between doing very well for yourself and your family or doing good for the world to the brightest minds coming out of our best universities…[T]ens of thousands of people who could make a huge difference in the nonprofit sector [are] marching every year directly into the for-profit sector because they’re not willing to make that kind of lifelong economic sacrifice.

He then uses the chart below (the Stanford MBA figure is the median salary for someone ten years out of business school and the CEO figures are averages) to argue, “There’s no way you’ll get people with $400,000 talent to make a $316,000 sacrifice every year to become the CEO of a hunger charity.”

Executive Compensation Bar Graph

While I agree with one aspect of Pallotta’s analysis – current economic and social incentives in the United States disproportionately advantage businesses that contribute little to society over more altruistic endeavors – Pallotta erroneously suggests we can fix this problem and better promote social good by making charitable organizations more like typical U.S. businesses.  This paradigm recurs during his analyses of several topics and reflects an overarching view of economics I plan to address in future posts.  For the purposes of this post, however, I will focus on four faulty assumptions he makes while discussing executive compensation:

Faulty Assumption #1: The value individuals produce in the for-profit sector correlates highly with the salaries they earn.

We erroneously believe personal success indicates remarkable personal characteristics – that belief is a well-documented psychological fact.  Yet chaos theory, regression to the mean, and intelligent analysis indicate that luck and privilege influence success considerably more than talent – even narrow definitions of luck in recent economic analyses show that luck plays a much larger role in market outcomes than most people think.  Whether it’s even possible for someone’s “talent” to produce the kind of value Pallotta describes is a hotly debated question.

In US society, our lack of regulation and accountability for moneyed elites helps promote inflated CEO salaries even when the individuals receiving these salaries have very clearly reduced a company’s value.  The bank bailout of 2008 and the huge profits reaped afterwards by executives directly responsible for the financial crisis clearly demonstrate the inaccuracy of Pallotta’s assumption.

Faulty Assumption #2: People make career decisions based primarily on monetary incentives.

Money certainly drives some people’s career decisions, but many people care at least as much, if not more, about some combination of prestige and ethics.  Teach For America (TFA) is an excellent example of an organization that knows this fact – while TFA can offer corps members only beginning teacher salaries in its placement districts, the organization attracts the top graduates from the best colleges in the country.  Why?  Acceptance into TFA impresses nearly everyone, looks fabulous on a resume, and helps corps members feel like part of a larger “movement for educational equity.”  While it’s certainly possible that some corps members join in hopes of the long-term payout TFA’s connections might provide, the vast majority of corps members I know applied because of TFA’s mission and status.

Faulty Assumption #3: High levels of compensation promote increased productivity.

Education research suggests that incentives only improve performance when they focus on behavioral inputs– to improve, students and teachers need to know exactly what behaviors they must produce to receive rewards.  They must also have the ability to execute desired behaviors.  Examples of input-based incentives that have produced desired outcomes include paying students to read books or paying teachers to relocate to more challenging schools.  Students and teachers who are instead offered prizes for behavioral outputs like student grades or test scores, on the other hand, do not improve their performance. Executive salaries and bonuses, like student grades and test scores, are often based on outputs (like company economic performance) and therefore unlikely to increase productivity.  I believe this phenomenon helps explain why researchers agree that merit pay initiatives are misguided.

Even when incentives are offered for clear, achievable tasks, the magnitude of the incentive drastically changes its impact.  Recent research suggests that when incentives are very high, performance actually declines.  Behavioral economist Dan Ariely conducted an innovative study which found that individuals offered substantial amounts of money for winning games succeeded considerably less often than individuals offered low to moderate amounts of money (Ariely believes that the stress we experience when confronted with high stakes causes this effect).

Faulty Assumption #4: High levels of compensation in the nonprofit sector will motivate more people to work for social good.

Wealthier individuals are, on average, less empathetic than the rest of society.  As Chris Hayes (in Twilight of the Elites) and Daniel Goleman have suggested, powerful people tend to surround themselves with other powerful people and often forget about or are ignorant of the circumstances of those less fortunate.  But psychology also plays a role – the mere mention of money predisposes people to behave less altruistically.  Since external incentives also erode internal motivation, a focus on salary in the nonprofit sector could potentially diminish compassion in that sector.

Our current incentives are highly problematic regardless of the flaws in these assumptions – on that point Pallotta and I agree.  But the remedy isn’t to embrace a business model that promotes selfishness and greed while failing to generate clear economic value.  In terms of executive compensation, a better solution would reduce exorbitant salaries across the board, call selfish career decisions what they are, and use psychology and behavioral economics research to increase the prestige associated with more ethical jobs.

3 Comments

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3 responses to “Financial Incentives and Social Good: Dan Pallotta’s Faulty Assumptions

  1. Well reasoned and argued, Ben; thank you!

    From having volunteered my time for 18 years with the citizens’ lobby, RESULTS, to end poverty, I found the selfishness and greed at the so-called “top” of politics and our most profitable businesses to be profoundly anti-empathetic. In fact, their actions are what coordinates our wars; a policy choice they favor over anything that resembles development for the benefits of other people.

    My conclusion is we will never have breakthroughs of real progress until a critical mass of the public recognize the key elements of our “leaders'” policies as criminal, and they are removed from causing the violence they prefer. These crimes are easy to verify in their centers of war and money. I’ve done my best to explain and document those lies and crimes that annually kill millions, harm billions, and loot trillions: http://www.examiner.com/article/how-a-government-teacher-easily-proves-occupy-s-claim-of-us-war-crimes

  2. Darius Liddell

    Great post, Ben. Read a few times, and actually took the time out to watch Palotta’s talk, which was interesting, although I tend to be quite cynical about TED.

    There is a nice thread going in the SSIR article that you linked to.

    http://www.ssireview.org/blog/entry/persistent_poverty_in_a_smug_meritocracy

  3. Hannah Spielberg

    Thanks for another great article Ben. I think the last sentence of your article is key: ‘In terms of executive compensation, a better solution would reduce exorbitant salaries across the board, call selfish career decisions what they are, and use psychology and behavioral economics research to increase the prestige associated with more ethical jobs.’

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