Element 1.1: Incentives Matter

“Call it what you will, incentives are what get people to work harder.”

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 of 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 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 gas prices will reduce the number of gallons sold. Attendance in college classes will be below normal the day before spring break. 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 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.

This basic postulate explains how changes in market prices change incentives in ways that work 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 will want to 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 a good at the current price, they will cut the price. In turn, the lower price will encourage people to buy more—but it 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.⁽¹⁾

Consider what happens when strong demand pushes a price up. Take gasoline, for example. The higher price will make it more costly to purchase gasoline. Consumers will respond by driving less, combining trips, and carpooling more often. In time, consumers will also shift to electric-powered and smaller, more fuel-efficient vehicles to reduce expenditures on gasoline. At the same time, the higher price will entice sellers to produce more. If not restricted, producers of gasoline will increase their drilling, develop new techniques such as fracking to recover more oil from existing wells, and intensify their search for new oil fields. This combination of forces will bring the amount demanded by consumers into balance with the amount supplied by producers. Over time, the larger supply will reverse the price increases. Price signals provide both buyers and sellers with incentives to make adjustments and bring their choices into harmony.

For instance, during the summer of 2014 in Georgia, peach prices saw a dramatic increase of 180% compared to the previous summer. This significant price hike didn't result in long lines of consumers at markets, eager to buy peaches. Instead, the steep increase prompted many to switch from peaches to other fruits, avoiding the high costs. In reaction to the higher peach prices, the behavior of sellers adjusted as well. Peach suppliers expanded their orchards by planting more trees, and some farmers even transformed their apple and pear orchards into ones dedicated to peaches. These changes gradually increased the supply of peaches. By the time these newly planted trees started to produce fruit two years later, the increased supply led to a reduction in peach prices.

One can observe the principle that people react to incentives through the example of the collective farming system (kolkhoz) in former Soviet Union countries. Under this system, farmers were required to meet quotas by delivering a fixed amount of produce to the state. Any production above that quota, however, they could sell at the local market. Initially, the quotas were set very high, leaving little to no surplus for the farmers to sell for their own profit. This created little incentive for the farmers to produce more than the bare minimum required by the state since the additional effort did not yield any personal financial benefit. Recognizing the lack of motivation and the resulting inefficiencies in production, the Kolkhoz system underwent several changes and reforms throughout its history, reflecting the ongoing interaction between state policies and farmers' responses to the incentives those policies provided.

Just as incentives influence choices in the marketplace, they also influence political choices. Voters will be more likely to support those candidates and policies they think will provide them with the most personal benefits, net of their costs. Voters will tend to oppose policies when the personal costs are high relative to the expected benefits. For example, senior citizens consistently vote against candidates and proposals that would reduce their Social Security or Medicare benefits. Similarly, polls indicate that students disproportionally support candidates promising loan forgiveness and “free” education. Producers in businesses ranging from sugarcane and beet farming to steel and lumber tend to support candidates that favor trade restrictions, pushing up the prices of the goods they sell and reducing foreign competition. As discussed later, social programs and trade policies can often be counterproductive once costs are compared to the benefits.

There’s no way to get around the importance of incentives. They are a part of human nature. Incentives matter just as much under socialism as under capitalism. In the former Soviet Union, managers and employees of glass plants were at one time paid according to the tons of sheet glass produced. Because their revenues depended on the weight of the glass, sheet glass at some factories was so thick that you could hardly see through it. In response, the rules were changed so that compensation was based on the number of square meters of glass produced. Under these new rules, Soviet firms made glass so thin that it broke easily.⁽²⁾ 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. But the choices of both the self-centered and the altruistic will be influenced by changes in personal costs and benefits. For example, both the selfish and the altruistic person will be more likely to attempt to rescue a child in a shallow swimming pool than in the rapid currents approaching Iceland’s Dettifoss waterfall, the most powerful one in Europe. And both are more likely to give a needy person their gently used clothes rather than their best ones.

Even though no one would have accused the late Mother Teresa of greediness, her self-interest caused her to respond to incentives, too. Consider Mother Teresa’s organization, the Missionaries of Charity. It attempted to open a shelter for the homeless in New York City, but the city government required expensive (and, in Mother Teresa’s view, unneeded) 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 increased, Mother Teresa searched for alternative locations where her resources could do more good compared to costs.⁽³⁾ Changes in incentives influence everyone’s choices and drive decisions, regardless of the mix of greedy, materialistic goals on the one hand and compassionate, altruistic goals on the other.