Living Economics: The Power of Incentives

*The game referenced in this article is ‘The Tribez‘ offered by Game Insight UAB.

In utilizing, managing, and trading resources, there are constant decisions to be made.

Buyers over small or large; green or black; delivered at home or to the office; cheap or costly; price limits. Sellers over production quantities; supplier selection; amounts sent to New York v. Beijing; ship by boat or by train; etc.

Economic actors face conscious and unconscious choices between potentially unlimited opportunities. Decisions vary, based on the personal goals, interests, and desires that motive actors to go one way instead of another. Tom may from personal preference choose a Grande Frappe; while Sarah choose a small cola for the lower cost.

To correctly monitor and guide efficient resource management, economists must understand the incentives that drive the resource-based decision-making processes.

Economists must understand the incentives that motivate decision-making processes in resource management.

Incentives are interests, goals, and desires that drive someone to prefer or desire a particular opportunity – they are the motivators of economic decision-making.

Incentives can be positive (rewards or benefits) or negative (punishments). The threat of fines or prison motivates a buyer not to defraud the old lady selling her car; the reward of profits drives companies to invest resources in new operations.

Incentives include present, future, and potential benefits or costs. Buyers choosing a car must consider not only the price paid to the seller, but future taxes and insurance alongside potential accident or repair fees.

Incentives can be either intangible or tangible. Happiness and entertainment are as tempting as wealth and new possessions.

Selfish and Social Interests produce the Incentives that motivate decision-making processes.

Incentives can be driven by either selfish or social. Selfish interests include personal desires and goals (e.g. improving one’s salary; buying a bigger home). Familial or friend oriented interests are also selfish in their own way, putting the people one knows and cares for above others. Social interests are those relevant to the community (clean air, national security, better transportation).

Generally, individuals emphasize selfish interests. Shoppers continue using plastic bags for personal convenience. Businesses increase prices, knowingly contributing to inflation. To reference that old ethical dilemma, imagine a train was coming to an intersection. Your most beloved parent stands on the left. The national security advisor stands on the right. Who would you save?

Individuals tend to base decisions on selfish interests more than social interests.

Selfish interests are not necessarily unethical motivators. Historic and cultural value systems have long emphasized qualities such as patriotism, loyalty, honoring ones ancestors, putting family above all. A mother who feeds the world but starves her own children is no social heroine. Furthermore, selfish interests can be useful to society – improving efficiency and resource utilization. Who better to help the local community or your family than you who knows their greatest needs best? When a flight is in trouble, the parents are told to put their own oxygen mask on first, before helping others – this is for a reason.

It is not the economist’s job to persuade people to reject their social interests, but rather to use policies and incentives to align selfish and social interests.

Economists seeks to use policies and incentives to align selfish and social interests so all can benefit.

A local farming community has established all crops will be equally divided amongst all of the citizens. Thus, both those who can work and those who cannot (the elderly, young, infirm) are of equal standing and are cared for (Social Interest).

With 5,000 citizens in the community, the farmers produce 20,000 apples. According to the rules (based on social interests), this means each person in the community receives 4 apples. Sarah consider the situation and is considering working 2x as hard as everyone else. At the end of the day, she has produced 8 apples instead of the 4 everyone else did. Based on the rules, the community now has 20,004 apples – so Sarah is given 4.0008 apples (Selfish Interest). Not precisely motivating – how many people would one imagine will pitch in overtime?

Eventually 10 less motivated farmers skip to play some sports. Consequently, the community produced 19,960 apples and each of those 10 people received 3.99 apples. If choosing between working and playing where the result is virtually the same (4 Apples v. 3.99 Apples), how many people will continue working?

Above is an example of misaligned incentives – workers are rewarded for being lazy or for not putting in additional effort. Misaligned incentives are a key issue for economists, motivating many of the bad practices seen in business and government today.

The use of slave or child labor is a prime example. As late as 2016, 152 million children were still involved in child labor around the world (Department of Labor, 2019). 70% were working in agricultural industries with 48% under the age of 12. Why would companies continue a practice that fundamentally goes against all social interests? The simple answer is misaligned incentives — companies can profit more from the use of child labor than that of adult labor. Children tend to request lower salaries and are often working illegally, making it difficult for them to pursue financial recompense from low or unfair labor conditions. Were company to reject child labor, they would see profits fall and potentially investors pulling out of the company.

How then can we align the incentives such that a company’s selfish interests in profits and investments result primarily from the use of legal, adult laborers (social interests)?

Governments, citizens, and economists around the world have struggled with this issue for centuries, using policies like punitive fines, boycotts, and imprisonment to make child labor unprofitable.

Taxes are a necessary evil of government social services, providing the financial capital required for funding social security systems, unemployment resources, highways, national defense and more (all social interests). However, no company or citizen truly appreciates to provide those tax payments – it decreases their personal savings and money available for personal consumption (selfish interests). How can the government incentivize people to honestly pay their taxes when such is fundamentally undesirable on a personal level?

Only when selfish and social interests are correctly aligned will all parties be truly incentivized to do what is best for society at large.

IncentiveThose things that motivate one to choose Option A.
Selfish InterestsThose motivating factors that stem from personal relationships, passions, goals, and desires.
Social InterestsThose motivating factors that stem from social needs, goals, and desires.
AlignTo match or line up A to B such that desirable results occur.
MisalignedA and B are lined up such that undesirable results occur

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