Quick Definition: The Cobra Effect, also called Perverse Incentives, describes unintended negative consequences when a reward or incentive is offered to solve a problem.
Where the Cobra Effect Got Its Name
The story goes that many years ago, in colonial India, there was a cobra infestation in the city of Delhi. So the British created a bounty for cobra skins. They thought by offering a reward for dead cobras, the public would solve the snake overpopulation problem. But instead of capturing feral cobras and killing them, people started farming cobras for their skins.
The British eventually got wise to the cobra-farming industry, and canceled the bounty. But with no bounties to collect, the cobra farmers set their snakes free in the city — making the infestation even worse than before. It’s from this (likely ahistorical) story that the so-called Cobra Effect gets its name.
Coined by German economist Horst Siebert, the Cobra Effect can ruin the best laid plans of bureaucrats and business people.
Real World Examples of the Cobra Effect
1. Bogota: Fewer Cars, Less Pollution?
In Bogota, Colombia the government was in solution-mode. The city was battling high levels of pollution, caused by excess traffic. So the politicians had a brilliant idea - they would reduce the number of cars on the road.
As bureaucrats are wont to do, they created a law to address the issue. It only allowed people to drive on certain days of the week. And to keep everything straight, the day you could drive was determined by the last two number on your license plate.
That setup seemed pretty reasonable to the people in charge, but to lots of families, especially those where both parents worked, it was a problem.
They needed to drive every day.
But they were law abiding citizens, they didn’t want to break the law by doing something sketchy like buying an illegal license plate and switching it out. So they just found a legal loophole in the system - they bought more cars. Sometimes up to four for a single family.
The result was more pollution because there were now more cars on the road.
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2. Wells Fargo: More Accounts, Happier Customers?
When a bank wants to make more money, what do they do? Getting existing customers to open more accounts is an easy way to improve their bottom line. And that’s exactly what American bank Wells Fargo tried to do. They offered their employees incentives and created quotes for getting old customers to open new accounts.
But with bonuses for management and punishments for others on the line, it was clear that this scheme was the perfect environment for the Cobra Effect to rear its head.
And that’s exactly what happened.
Many employees resorted to secretly opening accounts in customers’ names, forging signatures, and other unethical practices.
This attempt to improve its bottom line created a customer experience, regulatory, and PR fiasco for Wells Fargo.
3. Miami Dolphins: Losing Team, Higher Draft Position?
In the NFL, the order in which a team can pick players in the annual draft is down to their performance in the previous season. That reward seems fair at face value, since teams with worse performance could hypothetically draft better players and improve.
But in 2021 the owner of the Miami Dolphins, Stephen Ross, was suspended for six games after allegedly encouraging the team to lose games on purpose so they could increase their draft position. Brian Flores, the former Dolphins head coach who blew the whistle even suggested that he was offered his own incentives - monetary bonuses - to throw games.
When the NFL offered a reward in the form of a higher draft position to teams with low performance, they inadvertently fell victim to the Cobra Effect.
The Bottom Line: How to Avoid the Cobra Effect
Anytime you deal with a reward or incentive (even a punishment), you’re likely to run across the Cobra Effect in some form or fashion. But if you’re the one in charge of designing these rewards, it pays to know how to avoid it. Steven Levitt, economist and Freakanomics co-author, suggests two ways to avoid the Cobra Effect:
- Create simple incentives. The more complicated you make a scheme, the easier it is to find loopholes.
- Try to outsmart yourself. Before you put a reward scheme in place, try and figure out a way to game it, then adjust your program accordingly.
You may not be able to avoid Perverse Incentives completely, but being aware is the first step to beating them.
If you enjoyed this article, check out my podcast episode about the Cobra Effect: