Incentives Matter

Release Date
June 29, 2011


Basic Economics

According to Prof. Angela Dills, incentives are important and help economists predict individual behavior. Recognizing that incentives matter is fairly straightforward. What’s difficult is determining all the different ways a policy might affect people’s incentives and change people’s behavior. A good economist looks not only at the obvious incentives created by a particular policy, but also looks for the less obvious effects.

  • Incentives Matter [Article]: Russell Roberts, through the example of prisoner transportation, shows how a change in incentives reduced prisoner mortality rates from 12 percent to far less than 1 percent.
  • Incentives for Immoral Behavior (Video): Milton Friedman explains how government regulation often incentivizes, and therefore brings about, immoral behavior.
  • Always Think of Incentives [Article]: Stephen Davies argues that in order to understand human behavior, one must understand incentives.
  • Property Rights [Article]: Karol Boudreaux explains the vital role property rights play in promoting growth, alleviating poverty and conserving scarce resources (found on pp. 47-55).
  • Welfare (Video): Thomas Sowell explains how government welfare programs incentivize undesirable outcomes.

Incentives Matter
Incentives matter: this is the fundamental concept in economics. People respond to incentives, so in order for us to predict people’s behavior, we need to think about how their incentives have changed.
For example when gas prices rise, people buy less gasoline. They probably don’t stop buying gasoline, but they find ways to use less. Maybe they combine their errands so they can take fewer trips. Prices are powerful incentives. Government policy frequently relies on people’s response to incentives but often fails to consider all the different ways it affects people’s incentives.
For example there’s a strong desire in many corners for people to use less gasoline. One way that government policy does this is by CAFE standards. These are government mandates for car manufacturers to sell a fleet of vehicles that have an average fuel efficiency at or above the standard, for example, 25 miles per gallon. The idea is that if car manufacturers produce more fuel-efficient cars, consumers will buy more fuel-efficient cars and use less gasoline. Sounds great, but this is where economics comes in.
As a consumer what happens to my incentive? I buy a more fuel-efficient car. Well, now if before it took me 20 gallons of gasoline to drive to visit my parents, now maybe it takes me 18. It lowers the cost of me driving to visit my parents, so I’m going to drive to visit my parents more often. The change in mandate reduces the cost of driving, inducing consumers to drive more miles.
A good economist doesn’t just consider the obvious effect of a policy: The change in mandate leads to more fuel-efficient cars. A good economist also considers the less obvious effects: The change in mandate lowers the cost of driving, inducing consumers to drive more miles with the attendant effects on pollution and car emissions. Setting the right incentive and avoiding unintended consequences is difficult.
Incentives matter is a relatively straightforward concept. What’s difficult is to think about all the different ways the policymakers might affect people’s incentives, and how that would change people’s behavior.