intro to economics - incentives

8/8/2019 Intro to Economics - Incentives

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Incentives Matter

(ch 2)

Dr. Katherine Sauer

A Citizens Guide to Economics

ECO 1040


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In your own words,

what are the main points of this chapter?


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1. People respond to incentives

Incentives influence our daily decisions

A negative incentive can cause a person to not behave in

a certain way.

Apositive incentive can entice a person to behave in a

certain way.


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incentives from parents:

positive:

negative:

incentives from professors:

positive:

negative:


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incentives from the tax code:

positive:

if you give to charity, deduct it from your taxes

negative:

if you dont purchase health insurance, you

must pay a penalty


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In non-market systems, personal incentives areusually NOT related toproductivity.

East Germany example:

India example:

North Korea example:


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2. Incentives and Policies

Individuals, firms and governments can change the

costs and benefits associated with an activity in order

to get you to change yourbehavior.

- when costs or benefits change, incentives change


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When apolicy change results in creating incentives that

are not what was intended, it is calledperverseincentives.


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Car seats on airplanes example:

Mexico City example:


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When designing any policy from

getting your kids to clean their room

to employee time-off policiesto Federal laws

it is important to think through the incentives of each

involved party and also whether or not any perverseincentives are being created.


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Goodpolicies both

- take into account incentives

- think through how individuals might respond to

the policy

Badpolicies either

- ignore incentives

- fail to anticipate how individuals might respond


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When we observe a negative outcome in the world,

examining the incentives that lead to itis a useful step

before designing a policy to fix the outcome.

(Simply outlawing something rarely fixes the problem.)


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3. Application: Depletion of Common Resources

A common resource is a good that

- everyone has access to- is not unlimited in quantity

ex: wildlife on public land


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Because common resources dont belong to anyone in

particular, it is no ones responsibility to see that they

are used wisely.

Common resources often end up overused or exploited.

- overgrazing - deforestation

- over fishing - pollution


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Experiment: Lets Go Fishing

You are a fisherman/fisherwoman. Your income dependsonly on how many fish you catch. There is a certain

number of fish currently living in the area where you like

to fish.

Since the ocean is open to anyone who wants to fish, other

fishermen/women may also fish in the spot you like. Any

fish that they catch represents money you lost out on

earning. That is, the other fishermen/women are your

competition and moreover, you dont happen to like them

very much.


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W

e will play 2 rounds.

Your objective is to maximize your income by catching

as many fish as possible.

You will fish by using your non-dominant hand.

In round 1, fish are worth $1000 each and in round 2

fish are worth $1500 each.

Fish are not replaced between rounds.


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Private Property Rights

Now, divide up the ocean and assign each person an

area.

You cant fish in anyones section but your own.

Equally divide the fish among each group members

section.

We will again fish for 2 seasons. Same values for fish

as before.


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TheT

ragedy of the Commons illustrates that whenprivate incentives differ from social incentives, people

will act in their own best interest to the detriment of

society.

- private incentive is to take as much as possible

- social incentive is to take as much as is

sustainable


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Classic Story:

In medieval Europe, shepherds would share a common

piece of land and were entitled to graze their sheep on it.

An individual shepherd had an incentive to increase hisflock size as much as possible.

However, the grazing land can only support so many

sheep.


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When a shepherd gets a new sheep, he grazes it on the

land.- he gets the entire benefitfrom the sheep

- the damage to the commons is sharedby

everyone

When individual shepherds are making economically

rational decisions, they will all try to graze as many sheep

as possible, which will destroy the commons.

When the commons are depleted, all the shepherds are

then worse off.


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Some potential solutions:

- regulations

- permits

- taxes

- privatize property rights

- social norms


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4. Application: Principal-Agent Problem

Theprincipal-agent problem is the arrangement thatexists when one person or entity (called the agent) acts

on behalf of another (called the principal);

problems can arise due to a difference in incentives and

incomplete information.

The arrangement works wellwhen the principal and

agent have similarinterests and incentives.

When the incentives differ, that is whenproblems can

come up.


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example:

If you have a job, you are the agent and your employer is

theprincipal.

While some of your interests may be in line with your

employer, they arent 100% the same.

You have an interest in showing up to work and doing

your job in order to keep your job. Your employer

wants you to work hard and do your job.

However, perhaps you take a long lunch or make a few

personal calls while at work. This behavior is hard for

the employer to spot.


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example:

If you are selling your house and hire a realtor, then you are

theprincipal and they are the agent.

While you both have an interest in selling your house, your

interests arent 100% the same.

- You want the highest price possible for your house.- Your realtor wants a high price for your house, but

balances that against the time and effort it would

take to get that price.

Lowering your asking price by $5000 is not very good for

you, but would be only a small reduction in commission for

the realtor.


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5. Application: The Prisoners Dilemma

Parties might have an incentive not to cooperate, even if

it is in their own best interestto cooperate.


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The Classic Prisoners Dilemma example:

Bonnie

Clyde

confess not confess

confess 5years5years

10years1year

not confess 1year

10years

2years

2years

*


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How does this apply to environmental situations?


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6. Application: Taxes

With regard to incentives, how can taxes alter behavior?

Bjorn Borg example:

marriage tax:

corporate taxes:

very high taxes:


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Summary:

Incentives influence behavior.

Effective policies take into account incentives.

The Tragedy of the Commons illustrates that whenprivate incentives differ from social incentives,

individuals act in their own best-interest to the

detriment of society.

The Principal-Agent Problem illustrates that when

incentives differ, problems can arise.


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The Prisoners Dilemma illustrates that incentives may

cause people not to cooperate, to their detriment.

Taxes cause people to change their behavior.


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What did you learn today?

Please explain 2 concepts from todays class.

intro to economics - incentives

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