Incentives 101

A lot of what constitutes “thinking like an economist” involves asking the right questions. Those questions typically involve looking for the incentives people face in a particular situation.

For instance, one response to inflation — a sustained increase in an economy’s general price level — is to think that making it illegal to charge more than a fixed amount for any given product would solve the problem. That is, you see an outcome you don’t like, and without understanding why it is the way it is, you try to impose what you think is a better outcome. In the case of price ceilings, the consequence is chronic shortages.

Similarly, a common response to rising residential rents in some cities is to declare, “the rent is too damn high!” (In fact, there’s a political party in New York that actually calls itself The Rent Is Too Damn High Party.) This declaration is usually followed by a demand for regulations that would make it illegal to charge more rent than someone in authority thinks is necessary.

On the other hand, if an economist determines that rents are indeed too high in a district, she will then ask how they got that way. (The all-too-common answer — greed — doesn’t go far, because self-interest is no more a cause of high rents than air is a cause of fire.) In many cases, it’s because the supply of residential property has been artificially restricted — perhaps by building codes, minimum parking requirements, and landlords “warehousing” livable buildings in order to escape existing rent-control policies. Armed with some basic economic principles, she would try to figure out what choices people made that caused rents to rise and why they made those choices.

This is another way of saying that incentives matter.

When incentives matter

I believe there’s a very important sense in which financial incentives don’t always matter. I’ll get to that point later. But most of the time, when people claim that incentives don’t matter or don’t work, they’re just not thinking things through.

Some appear to argue that incentives don’t matter at all. For example, you often hear claims that municipalities that have increased the legal minimum wage — a wage below which it is illegal for anyone to work — have not experienced the negative effect on employment that critics predicted. Mind you, most of these same people probably realize that raising the price of other production inputs, such as electricity, would have a negative impact on businesses and employment.

Even if people don’t seem to be following incentives — for example, if we don’t see employers firing employees in droves and businesses closing down or moving out of town because of the higher minimum wage — they’re still following incentives of some kind, though perhaps not the ones you expect. Employers compensate workers in ways in addition to wages, such as with benefits or discounts, and artificially raising wages means that an employer, who typically has a fixed budget in the short run, has to cut back in those other areas. And, over time, the minimum wage increase will indeed decrease jobs, often because machines will become relatively cheaper than higher labor costs.

Gun control is another area where we can see incentives at work. Like me, you probably find the statistics regarding gun-related injuries and deaths in the United States very troubling. However, instead of simply reacting by calling for legislation banning or severely restricting firearm ownership by private persons, an economist should first ask what economic incentives might lie behind these violent incidents. (I acknowledge that there are noneconomic factors also involved.) If they tend to occur where gun control is already relatively strict, for example, that might suggest looking into whether such controls lower the cost of committing violence against an unarmed populace. (Some might find interesting the work of John Lott and his critics on gun control.)

In short, as I’ve said in a previous column, one could almost define economics as the science that explains why passing a law just won’t get it done.

While we’re on the subject of incentives, I’ve noticed a tendency to conflate the use of financial incentives with the free market. While voluntary exchange often involves paying money to someone, that doesn’t mean any given transaction is consistent with free-market principles. A business owner who pays a bribe for a special privilege and the government official who takes it are both responding to incentives, but a market is free only to the extent that the people in it aren’t using political power to gain an advantage over their competitors.

Non-pecuniary incentives are essential for a free society

At the same time, the free market flourishes when everyone, most of the time, refrains from taking advantage of each other’s vulnerability.

Many people, especially college professors, are surprised by how much honesty, reciprocity, and trust exist among those who engage in business. The biggest, most successful corporations in the world, such as Google and Apple, are renown for how much they trust their employees and how much independence they give them. (There are much smaller companies that do so, too.) A very successful entrepreneur I know told me recently that the key to running a large, profitable business is to treat your employees, suppliers, and customers with respect and like responsible people. It’s just not possible always to be looking over someone’s shoulder.

When you trust people to reciprocate that trust, you’re taking a chance that they may take advantage of you. Such pessimism, however, means your relationships with other people — your suppliers, employees, and customers — will never have a chance to flourish. That’s why it goes against your long-term interests to hunker down and never leave yourself vulnerable to opportunistic behavior.

The incentive to treat people right by following norms of honesty and fair play is nonmonetary, but it can make your business prosper. It seems that the best business owners aren’t driven primarily by profit-seeking, although they probably wouldn’t do what they’re doing without earning that profit. No, the incentives they follow often have more to do with knowing that they’ve done things the right way and so deserve all that they’ve earned. (Which is why they can get very upset when a politician says, “If you’ve got a business, you didn’t build that.”) That knowledge is something all the money in the world can’t buy.

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