Concept 6: Incentives

Beginner

Understanding the role of incentives is critical to understanding the economic way of thinking. Incentives are benefits or costs of an action that influence people’s decisions and behavior. Stated another way, incentives can make people do something they wouldn’t otherwise do. Incentives are important to economics for two reasons: how people respond to them and how they are created and used.

People tend to respond predictably to incentives. Businesses and government institutions know this and use incentives to encourage certain behaviors. Sales, coupons, buy-one-get-one deals, limited time offers, cash back promotions, and free trials are all incentives used by businesses to get consumers to choose their product. Governments at all levels use strategies like tax breaks, grants, infrastructure assistance and fines or penalties to incentivize behaviors. At school, when students ask “Is this for a grade?” they are weighing incentives in making their decisions. Economics studies human decision making, and incentives are critical to how we make decisions.

Intermediate

In the beginner reading we stated people tend to respond predictably to incentives. Sometimes people respond in unpredictable ways. People regularly pay more for a good or service than they would have if they had used a coupon. There are companies that have chosen to pollute even though they faced a fine when they did so. Many students choose not to study or complete work even though it harms their grades.

In these cases, and many others like them, the issue is not that these people are immune to incentives; rather, the incentives were usually not strong enough. For incentives to work as expected, they must meet two criteria. First, the incentive must be meaningful to the individual. Telling a very wealthy person they can save 75 cents on a box of cereal if they clip a coupon may have less effect than telling someone who is unemployed and running out of savings. For a student who does not care about their GPA, grading an assignment is not going to get them to do it. Meaningful incentives are critical.

Second, an incentive must be clearly tied to the behavior. Most state and local governments fine people who are caught driving above the speed limit. This is supposedly a disincentive to speed. Despite this, the vast majority of drivers speed at least some of the time. The problem is the disincentive (the fine) has no practical, predictable relation to the activity (driving fast). Most drivers are not actively monitoring their bank account while speeding to see if they can afford to speed or not. So, even though money is meaningful to most people, it is not clearly tied to the behavior until after the fact. Also, most drivers are not ticketed most of the time when they speed, so they do not expect a fine or consequence. There is no strong connection between speeding and fines.

Advanced

Behavioral economics is a field dedicated to studying how people and businesses maximize their satisfaction and the role incentives play. Most of the models used in economics operate under the assumption that people make rational choices, meaning they weigh their costs and benefits and make the decision that maximizes their benefit. As various incentives are presented and removed, therefore, people’s decisions change over time. In addition, there are also complicating factors at work including choice overload, decision fatigue, framing, physical and mental stress, lifestyle, peer pressure, etc. To try to identify a single incentive that triggers a decision may be impossible in some cases. In fact, some behavioral economists have put forth the theory that it is more likely humans are predictably irrational in most cases. To learn more about behavioral economics, click here.