Practical Economics: Incentives Shape Our Decisions

This is a post in The Wisdom Journal series: Practical Economics. In this series, we will examine the way economic principles work in the real world.

reward Incentives prod us or repel us in our decision making process. We regularly choose an economic course of action based on our belief that the result of that decision will benefit us, alleviate pain or grief, benefit a cause we believe in, or otherwise bring us pleasure. That one fact is the foundation of all economic principles and laws, that changing the costs or benefits of making a decision automatically alters the course of action people will take.

Think of it on a personal level. If your boss cut your pay in half, you probably wouldn’t perform to the same level you do today (you might not perform at all!). Conversely, if she doubled your pay, you might be willing to put up with a lot more of her mindless blather and gross inexperience.

That incentives matter is the basis of how virtually all markets work. Buyers and sellers change their behaviors when incentives change. When buyers desire more of any good or service than sellers are able or willing to provide, prices automatically start to rise. As the price increases, sellers are willing to provide more of that good or service, even if it means investing in more productive equipment or hiring more employees. Over the course of time, the price will bring the amount demanded and the amount supplied into equilibrium.

Incentives matter on macro levels as well as micro levels. Governments respond to trade embargos or tariffs on its goods by retaliatory duties or taxes on goods from the offending country. Corporations move operations to countries where the tax rates are more favorable. A car company may build a plant and employ 5,000 people simple because the state offered a 99 year tax abatement as an incentive.

Alter the incentives and you’ll alter behavior. Make it worthwhile to invest and you’ll get more investment. Make it less worthwhile to invest and you’ll get less of it. It’s really very simple and as such, I have to wonder why so many people in Washington act as if they don’t understand it.


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