My previous post on Incentive theory

The two posts above over the past couple of weeks were essentially intended to explain the Grand Unified Theory (hereby referred to as GUT). So, what is GUT?

Signals and Incentives are intertwined with each other. I’d say, if incentives are to be secured, then sending signals is a given. To quote a simple example, if a baby wants to secure a chocolate/toy, it can’t secure it just by thinking of the chocolate/toy. It has to direct its parents’ attention through prodding/crying for that chocolate/gift. Thereby, sending the right signal is of paramount importance if the incentive/interest is to be secured.

GUT, as stated in the topic precisely says this. It states that almost every action in the world by human beings (a little more than the Pareto ratio in fact) can be explained through GUT. It may or may not be extendable to all living beings like plants/animals etc., but I will restrict the discussion here to human beings. I will try to explain (if its not already intuitive) through some examples why GUT is universal.

a) Education System: Government education system is a case in point. Most government schools have endowments/grants given by the government. However, the allocation of these grants is with respect to the grades/performance of the school. Better the grades, better the performance, more number of students pass – the higher are the grants. This is a skewed proposition. Applying GUT to this education system, we find that the incentive to the management of the school is to get higher grades – by whatever means possible as long as its not outright fraud. This can be done in multiple ways, primarily being Grade Inflation, wherein the teachers are instructed to be lenient on grades – thereby lending to the perception (signal to be precise) that the school is doing much better than it actually is, thereby receiving better grants (the incentive) than usually should be the case. There is no good way to prove Grade Inflation, which makes the incentive for inflating the grades even stronger.

b) Work: GUT can be applied in multiple ways at work. Education background at work is a case in point. Let’s consider two employees A and B. Both work at the same level doing the same job. However, during work, A works that bit harder and secures an advanced degree (MS/MBA, you name it) from a night school. He updates his employer about his degree in a very diplomatic fashion, through some kind of party/celebration (signal). Now, consider a situation where the employer thinks he should promote someone (incentive) from the level of A and B to a higher level. Whom do you think he/she will choose if A and B worked at a similar skill level? Definitely A – and that’s because of his advanced degree. Note that the advanced degree may or may not have anything to do with the kind of work he does, but the very act of getting a degree (signal) indicates to the employer that a) A is sincere about moving up the corporate ladder b) Or, A will move out of his employment if he is not promoted.

c) Corporate actions: The act of transitioning a company from private to a public limited company can be explained through GUT. In this case, the management is bringing on public shareholders onto its board and is responsible to answer to its shareholders for all its corporate actions going forward. It also has to undertake various legal and government hassles to get listed as a public limited company. But what is the company trying to achieve by moving from a private to a public limited company (signal)? The incentive here is cheaper and wider access to capital. If a company has to extend beyond a certain size, it needs to take on debt/equity as the case may be. The cost of raising capital being a private company is much much higher than when raising as a public limited company. This difference in the cost of capital makes up more than the legal, government and shareholder hassles. Hence the signal of moving from a private to a public company to secure the incentive of cheaper capital.

d) Relationships: GUT can also explain relationships. For example, the male/female try to send out all the right signals during courtship – whether it being well-dressed/groomed, funny anectodes, giving gifts, holding doors – anything and everything to impress and secure the relationship (incentive). The same couple, after marriage, might not display all the lovey-dovey features (lack of signal) due to lack of incentive (no more competition, the boy/girl is secured etc.) After marriage, people tend to think that they understand the other person very well and hence no signaling/very little signaling is required, often leading to fights/quarrels/misunderstandings. Signals, as you realize, are forever.

One critical caveat though before we start applying GUT to anything and everything. Incentives and Signals, the core of GUT rely on one assumption – information asymmetry. This asymmetry can be in the form of material, psychological or otherwise, but critical for GUT to work. If all parties involved in the conversation are on the same page and have the same understanding, GUT can no longer be used.

GUT, as stated in incentive as well as signaling theory blogposts is not in any manner path breaking; it is more intuitive (in that sense, its really a gut feeling (ha!)). It is a framework of understanding and primarily negotiating. In the future, I will try to explain some of the happenings in and around the world I understand through GUT and look at the implications of applying this framework to real world situations.

P.S: Put in Incentive Signaling theory or Signaling Incentive theory on Google search and check what comes up on the first link (nudge, nudge). Never knew so little was written about these two in combination.