The basic idea that rewards, and in particular monetary rewards, may crowd out intrinsic motivation emanates from two quite different branches of literature in the social sciences. In his book The Gift Relationship, Richard Titmuss (1970) argued that paying for blood undermines cherished social values and would therefore reduce or totally eliminate people's willingness to donate blood. However, he was unable to come up with any serious empirical evidence.
A second strand of literature stems from psychology. A group of cognitive social psychologists identified that, under particular conditions, monetary (external) rewards undermine intrinsic motivation (Deci, 1971; Deci and Ryan, 1985; Deci with Flaste, 1995). People have intrinsic motivation when they just like to act in a certain way or because they have internalised social norms. Providing monetary rewards for undertaking an activity may have the negative consequence that people reduce their work effort.
The theories on intrinsic motivation emanating from social psychology have in the meantime been integrated into economic theory (Frey, 1992). Arguably, this 'crowding-out effect' is one of the most important anomalies in economics. It suggests the opposite of the most fundamental economic 'law' stipulating that raising monetary incentives increases supply of effort. If the crowding-out effect holds, raising monetary incentives reduces, rather than increases, this supply. Under certain circumstances, it is therefore not advisable to use the price mechanism to elicit a higher supply. Moreover, one should rely on a quite different type of incentive, namely intrinsic motivation.
This article discusses the crowding-out effect and its correlate, the 'crowding-in effect', with special regard to its empirical validity. It is demonstrated that these effects are empirically well-founded and have been observed in many different and important areas of the economy and society.
Intrinsic motivation in economic thinking
Monetary incentives crowding out the motivation to undertake an activity may be considered a major anomaly: it predicts the reverse reaction to the one expected according to the relative price effect, on which much of economics is based. The successes of the 'economic approach to human behaviour' (Becker, 1976; Frey, 1999) and its 'economic imperialism' (Lazear, 2000a) are due to the skilful application of the relative price effect. It is based on extrinsic motivation, i.e. on incentives coming from outside the person in question. By way of contrast, major schools in psychology emphasise the intrinsic motives coming from within the person.
Standard economic theory does not normally differentiate between different sources of motivation. Motivation is just seen as a manifestation of the underlying preference for the reward that is associated with performing a task. Intrinsic motivation is assumed to be an exogenously given constant, and often it is completely disregarded. Motivation crowding theory tries to mediate between standard economic thinking based on purely extrinsic motivation and psychological theories by stipulating a systematic interaction between extrinsic and intrinsic motivation.
For the analysis of economic issues, the 'hidden cost of reward' has been generalised in two respects:
1) All interventions originating from outside the person under consideration, i.e. both positive monetary rewards and regulations accompanied by negative sanctions, may affect intrinsic motivation.
2) External interventions may crowd-out or crowd-in intrinsic motivation (or leave it unaffected).
The figure below shows the interaction of the crowding-out effect and the price effect graphically. S is the traditional supply curve based on the relative price effect: raising the external reward for work effort from O to R increases work effort from A to A' leading to a location in point B. …