Incentive Compatibility

incentive compatibility, state in game theory and economics that occurs when the incentives that motivate the actions of individual participants are consistent with following the rules established by the group. The notion of incentive compatibility was first introduced by Russian-born American economist Leonid Hurwicz in 1960.

Incentive compatibility is important in interactions in which at least one participant does not know perfectly what another participant knows or does. Problems may arise when the participant with more information has an incentive to use that information for personal benefit at the expense of others. However, when the interaction is structured so that the participant with more information is motivated to act in the interest of the other party (or has less incentive to exploit an informational advantage), the result is incentive compatibility. For instance, if an insurance company offers a discount to people who do not engage in high-risk behaviours, such as smoking or skydiving, then persons who engage in those behaviours have an incentive to identify themselves as low-risk. An incentive-compatible solution would ensure that people who engage in high-risk behaviours identify themselves as such.

In economics, incentive compatibility is used as one of two important constraints in an optimization problem in which a person (such as a firm owner) must rely on others to maximize some criteria (such as profits): the participation constraint ensures that people want to participate, in that they are at least as well off by participating as they would be by not participating, and the incentive compatibility constraint ensures that people are motivated to behave in a manner consistent with the optimal solution. Usually, the optimal solution means that the compensation people receive when the desired outcome is achieved is at least as high as the compensation they could earn when some other outcome occurs. For example, suppose a factory owner needs employees to work in the factory. The participation constraint ensures that some people would rather be employed in the factory than do something else. The incentive compatibility constraint ensures that the employees are motivated to act in the owner’s interest.