Introduction

Incentive structures shape nearly every decision we make. They’re important! Whether in business, healthcare, or software, how people are rewarded affects how they behave. In this post, we’ll explore how aligning incentives can lead to better outcomes—using simple ideas from game theory and real-world examples.

Game Theory Fundamentals

What’s Game Theory?

Game theory is the study of rules and strategies of a game—but in this case, the "players" can be people, companies, or even whole industries. Each player makes choices based on what they believe will give them the best outcome.

Nash Equilibrium

At the heart of game theory lies the concept of Nash Equilibrium.

Imagine two roommates deciding how to split rent. Each proposes a price they think is fair. After some back and forth, they settle on a number neither loves, but neither is willing to change. This is a Nash equilibrium: no one can improve their outcome by acting alone, even if the final result isn't ideal for either of them.

This illustrates how individual rational decisions can still lead to collectively suboptimal outcomes.

Healthcare: Incentives Designed Wrong

The Healthcare Challenge:

Healthcare involves several key players:

• Patients: Often don’t see the real cost of their care because of insurance.
• Providers: Like doctors and hospitals, who are sometimes incentivized to see as many patients as possible.
• Insurance Companies: Aim to cut costs, sometimes at the expense of long-term health outcomes.

Where Things Misalign:

• Patients: Since they’re not paying directly, there's little incentive to choose cost-effective or preventative care.
• Providers: May prioritize quantity over quality.
• Insurers: Might focus on short-term savings rather than long-term health improvements.

Even when each group acts rationally within their role, the overall system can stagnate or worsen—a classic case of misaligned incentives leading to poor collective outcomes.

Startups: Incentives Designed Well

The Startup Example:

Contrast this with startups, where incentives are often better aligned:

• Founders: Own a large portion of the company, so they work hard for success.
• Early Employees: Typically receive equity, making them invested in the overall outcome.

Why It Works:

With everyone having a personal stake, there's more long-term thinking, collaboration, and shared motivation. Aligned incentives create a healthier system and often lead to better results.

Applying it to Software Engineering

Just like in healthcare and startups, the success of a software product can hinge on how teams (or "players") are structured and incentivized.

One approach to better alignment is discussed in Team Topologies, where the authors advocate for stream-aligned vertical product teams.

From my own experience, I've seen how vertical teams drive better outcomes compared to horizontal teams. Let's explore this further.

Vertical Product Teams

Vertical teams are responsible for the entire product, from design and development to testing and deployment. A typical vertical team might include frontend and backend engineers, along with a product manager.

Benefits:

• Holistic Ownership: Teams feel responsible for the entire product experience.
• Aligned Goals: Shared accountability leads to better collaboration and innovation.

The Incentive: When a team’s success is tied directly to the product’s success, they’re more likely to focus on outcomes that matter.

Horizontal Product Teams

Horizontal teams focus on specific functions. For example, a company-wide frontend team and a backend team might both contribute to the same checkout experience.

Challenges:

• Misaligned Priorities: Teams may optimize locally, without thinking about the end user experience.
• Friction: Work is often blocked by dependencies across teams, leading to delays and frustration.

When Horizontal Teams Work: Horizontal structures can work when supporting shared infrastructure. For example, an internal platform or data team can improve productivity across all vertical teams by building and maintaining common tools (like Airflow, DBT, or Datadog). Here, incentives should be designed to reward enablement and developer satisfaction.

Conclusion

Whether in healthcare, startups, or software engineering, incentive structures shape system outcomes. Game theory shows us that even when individuals act in their best interest, poor system design can lead to suboptimal results.

If we want better outcomes, we need to design better incentives. From rent-splitting roommates to product teams, everyone plays better when the rules reward the right behavior.