The Role of Incentives in Economics

In economics an incentive is any factor (financial or non-financial) that enables or motivates a particular course of action, or
counts as a reason for preferring one choice to the alternatives. It is an expectation that encourages people to behave in a
certain way. Since human beings are purposeful creatures, the study of incentive structures is central to the study of all
economic activity (both in terms of individual decision-making and in terms of co-operation and competition within a larger
institutional structure). Economic analysis, then, of the differences between societies (and between different organisations
within a society) largely amounts to characterising the differences in incentive structures faced by individuals involved in
these collective efforts. Ultimately, incentives aim to provide value for money and contribute to organisational success.

Incentives can be classified according to the different ways in which they motivate agents to take a particular course of
action.

One common and useful taxonomy divides incentives into four broad classes:

Remunerative incentives (or financial incentives) are said to exist where an agent can expect some form of material reward
— especially money — in exchange for acting in a particular way.

Moral incentives are said to exist where a particular choice is widely regarded as the right thing to do, or as particularly
admirable, or where the failure to act in a certain way is condemned as indecent. A person acting on a moral incentive can
expect a sense of self-esteem, and approval or even admiration from his community; a person acting against a moral
incentive can expect a sense of guilt, and condemnation or even ostracism from the community.

Coercive incentives are said to exist where a person can expect that the failure to act in a particular way will result in
physical force being used against them (or their loved ones) by others in the community — for example, by inflicting pain in
punishment, or by imprisonment, or by confiscating or destroying their possessions.

Natural Incentives such as curiosity, imagination, mental or physical exercise, admiration, fear, anger, pain, joy, or the
pursuit of truth, or the control over things in the world or people or oneself.

The study of economics in modern societies is mostly concerned with remunerative incentives rather than moral or coercive
incentives — not because the latter two are unimportant, but rather because remunerative incentives are the main form of
incentives employed in the world of business, whereas moral and coercive incentives are more characteristic of the sorts of
decisions studied by political science and sociology. A classic example of the economic analysis of incentive structures is
the famous Walrasian chart of supply and demand curves: economic theory predicts that the market will tend to move
towards the equilibrium price because everyone in the market has a remunerative incentive to do so: by lowering a price
formerly set above the equilibrium a firm can attract more customers and make more money; by raising a price formerly set
below the equilibrium a customer is more able to obtain the good or service that she wants in the quantity she desires.

Incentive structures, however, are notoriously trickier than they might appear to people who set them up. Human beings are
both finite and creative; that means that the people offering incentives are often unable to predict all of the ways that people
will respond to them. Thus, imperfect knowledge and unintended consequences can often make incentives much more
complex than the people offering them originally expected, and can lead either to unexpected windfalls or to disasters
produced by unintentionally perverse incentives.

For example, decision-makers in for-profit firms often must decide what incentives they will offer to employees and
managers to encourage them to act in ways beneficial to the firm. A strong incentive is one that accomplishes the stated
goal. If the goal is to maximize production, then a strong incentive will be one that encourages workers to produce goods at
full capacity. A weak incentive is any incentive below this level. Incentives help people to make the right decision, or the
decision one would like them to make. To accomplish things you want done in economics you must give the consumer or
the producer incentives, without them they would have no reason to do what you ask.
 The Israeli Day Care Centre

Imagine for a moment that you are the manager of a day care centre. You have a clearly stated policy that children are
supposed to be picked up by 4 pm. But very often parents are late. The result: at day's end, you have some anxious
children and at least one teacher who must wait around for the parents to arrive. What to do?

A pair of economists who heard of this dilemma - it turned out to be a rather common one - offered a solution: fine the tardy
parents. Why, after all, should the day care centre take care of these kids for free?

The economists decided to test their solution by conducting a study of ten day-care centres in Haifa, Israel. The study lasted
20 weeks but the fine was not introduced immediately. For the first four weeks the economists simply kept track of the
number of parents who came late; there were, on average 8 late pick ups per week per day care centre. In the fifth week,
the fine was enacted. It was announce that any parent arriving more than 10 minutes late would pay $3 per child for each
incident. The fee would be added to the parent's monthly bill, which was roughly $380.

After the fine was enacted, the number of late pickups promptly went up. Before long there were 20 late pick ups a week,
more than double the average.

Much of Economics is involved with the concept of incentives and how humans react to them.

Please read the extract and answer the questions below:

1)     Initially what was the incentive to pickup your child on time? (Remember the vast majority of parents did this).

2)     How and why did the incentive change with the fine? (Make sure that you incorporate in your answer the reason why
you believe the fine led to an increase in the number of late parents).

3)     After the fine was removed in week 17 of the trial, the number of late remained at an average of 20 per day. Why do
you think this was the case?

4)     What do you think the day centres should/could have done to reduce the numbers of late parents a) back to an
average of 8, as before an b) down to zero

5)     Picture this: Mrs Q's mother-in-law has just produced a delicious Christmas lunch with all the trimmings: turkey,
browned to perfection; gravy, roast potatoes, stuffing…the lot! Mrs Q stands up at the end of the meal and hands over
some rolled up notes to her mother-in-law and states, "thank you very much for the meal, I think £25 should cover it." Why
do you think Mrs Quiddington's mother-in-law would be upset? Think about whether homo economicus should be rational
all the time?

6)     Businesses can offer a discount, a free item or a gift to the prospective purchaser of an item or service in the hope that
this bonus will motivate the purchase of the item/service. This incentive is used successfully in retail clothing chains and
generally works very effectively as an advertising technique to bring traffic into the store. Familiar examples of buying
incentives are "Buy One, Get One Free" or "Buy One for the Regular Price, Get One Half Price.

Shops sometimes offer BOGOF deals. (Buy one, get one free) and sometimes offer goods at half price. Analyse the
difference in these two practices for:

·         Customers

·         Shops

·         Producers

* Homo economicus, or Economic human, is the concept in some economic theories of humans as rational and narrowly
self-interested actors who have the ability to make judgments toward their subjectively defined ends. "It is not from the
benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."
Adam Smith