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Common Sense Economics
What Everyone Should Know About Personal and National Prosperity

Element 1.1

Incentives Matter

Changes in benefits and costs will influence choices in a predictable manner.

All of economics rests on one simple principle: Changes in incentives influence human behavior in predictable ways. Both monetary and nonmonetary factors influence incentives. If something becomes more costly, people will be less likely to choose it. Correspondingly, when the benefits derived from an option increase, people will be more likely to choose it. This simple idea, sometimes called the basic postulate of economics, is a powerful tool because it applies to almost everything that we do.

People will be less likely to choose an option as it becomes more costly. Think about the implications of this proposition. When late for an appointment, a person will be less likely to take time to stop and visit with a friend. Fewer people will go picnicking on a cold and rainy day. Higher prices will reduce the number of units sold. Attendance in college classes will be below normal the day before school holidays. In each case, the explanation is the same: As the option becomes more costly, less is chosen.

Similarly, when the payoff derived from a choice increases, people will be more likely to choose it. A person walking along the street will be more likely to bend over and pick up a Euro or a Dollar than a cent. Students will attend and pay more attention in class when they know the material will be on the exam. Customers will buy more from stores that offer low prices, high-quality service, and a convenient location. Employees will work harder and more efficiently when they are rewarded for doing so. All of these outcomes are highly predictable and they merely reflect the “incentives matter” postulate of economics.

The Power of Incentives by Dwight Lee
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This basic postulate explains how changes in market prices alter incentives in a manner that works to coordinate the actions of buyers and sellers. If buyers want to purchase more of an item than producers are willing (or able) to sell, its price will soon rise. As the price increases, sellers will be more willing to provide the item while buyers purchase less, until the higher price brings the amount demanded and the amount supplied into balance. At that point the price stabilizes.

What happens if it starts out the other way: if sellers want to supply more than buyers are willing to purchase? If sellers cannot sell all of their goods at the current price, they will have to cut the price of the item. In turn, the lower price will encourage people to buy more—but will also discourage producers from producing as much, since it is less attractive to them to supply the product at the new, lower price. Again, the price change works to bring the amount demanded by consumers into balance with the amount produced by suppliers. At that point there is no further pressure for a price change.

For example, bad weather raised the prices of peaches in the U.S. state of Georgia in the summer of 2014, forcing a price increase of 180% compared to the previous year. Despite the huge increase in price, consumers did not complain. Why? When the higher prices made it more costly to purchase peaches, most consumers easily substituted other fruits for peaches, either totally or partially, and made their winter jam reserves from pears or quinces instead.

Furthermore, as buyers reacted to higher peach prices, so did sellers. The farmers supplying peaches planted new trees. Other farmers cut down their apple and pear orchards and planted peach trees instead. Eventually, after two years (when the newly planted trees became fruitful) the price of peaches fell as supply expanded.

Incentives also influence political choices. There is little reason to believe that a person making choices in the voting booth will behave much differently than when making choices in the shopping mall. In most cases voters are likely to support political candidates and policies that they believe will provide them with the most personal benefits, net of their costs. They will tend to oppose political options when the personal costs are high compared to the benefits they expect to receive. For example, senior citizens have voted numerous times against candidates and proposals that would reduce their pension benefits. Opposition to proposed reductions in pension benefits is widely blamed for the poor showing of the United Russia party in Russia’s September 2018 gubernatorial elections. Similarly, polls indicate that students are strongly supportive of educational grants to college students.

There’s no way to get around the importance of incentives. They are a part of human nature. Incentives matter just as much under as they do under . In the former Soviet Union, managers and employees of glass plants were, at one time, rewarded according to the tons of sheet glass they produced. Because their revenues depended on the weight of the glass, most factories produced sheet glass so thick that you could hardly see through it. As a result, the rules were changed so that the managers were compensated according to the number of square meters of glass produced. Under these rules, Soviet firms made glass so thin that it broke easily. Similarly, when quotas for the number of shoes were set for Polish factories which were, in turn, provided with too little leather, is it any wonder that there was a glut of children’s shoes on the market?

Some people think that incentives matter only when people are greedy and selfish. This is untrue. People act for a variety of reasons, some selfish and some charitable. The choices of both the self-centered and altruistic will be influenced by changes in personal costs and benefits. For example, both the selfish and the altruistic will be more likely to attempt to rescue a child in a shallow swimming pool than in the rapid currents approaching Dettifoss waterfall. And both are more likely to give a needy person their hand-me-downs rather than their best clothes.

Even though no one would have accused the late Albanian, Mother Teresa, of greediness, her self-interest caused her to respond to incentives, too. When Mother Teresa’s organization, the Missionaries of Charity, attempted to open a shelter for the homeless in New York City, the city required expensive alterations to its building. The organization abandoned the project. This decision did not reflect any change in Mother Teresa’s commitment to the poor. Instead, it reflected a change in incentives. When the cost of helping the poor in New York went up, Mother Teresa decided that her resources would do more good in other areas. Changes in incentives influence everyone’s choices, regardless of the mix of greedy, materialistic goals on the one hand and compassionate, altruistic goals on the other, which are driving a specific decision.

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