Credence Goods and Incentive Compensation

Credence goods and incentive compensation….  The two just don’t mix.

I recently blogged over on the Eccles Outdoor Industry Club site about how IDFL — a local tester of down and feather products — sells a what economists call a credence good.

And here’s a link to an article from Saturday’s New York Times about another such firm: USIS, a provider of background checks for security clearances for the US government.   Why are they on the front of the NYT?  Here’s a quote:

In interviews this week, former and current USIS employees detailed how the company had an incentive to rush work because it is paid only after a file is marked “FF,” for fieldwork finished, and sent to the government. In the waning days of a month, investigations were closed to meet financial quotas, without a required review by the quality control department, two former senior managers said.

This is a credence good because the government never really finds out if USIS did a good job or not.  To see why, suppose USIS does a thorough background check on an individual with a solid background, and reports to the government that all is clear.  Now suppose USIS doesn’t do a thorough investigation on a shady individual — due to financial pressures, perhaps — and reports, again, to the government that all is clear.  In one case the firm did a good job and in the other it did a poor job, but the two cases are indistinguishable to the government.

If you’re selling a credence good, your customer’s trust is pretty much the most important asset you have.  So, putting in place incentives for your employees to violate that trust — as USIS did by tracking time spent on cases and imposing short deadlines on its investigators — is a bad idea.  Credence goods and incentive compensation just don’t mix…