Incentives

Learning Objectives Explain how incentives affect individual behavior Explain how poorly designed incentives can have perverted results

RG 30-34 How does the black rhino illustrate the importance of incentives?

Incentives Incentives are what motivates an individual or group to behave in a certain way or perform a certain action In a market economy prices are often the most important incentive

Incentives Why do people kill black rhinos? Because they can make a lot of money relative to getting caught People weigh benefits versus costs Maximize their Personal Utility

Incentives and Productivity “In any system that does not rely on markets, personal incentives are usually divorced from productivity. Firms and workers are not rewarded for innovation and hard work, nor are they punished for sloth and inefficiency.” Examples?

Perverse Incentives What are some examples of “perverse incentives?”

Examples Lawyers bill by the hour rather than get paid for any reasonable metric that measures the quality and efficiency of their work Providing CEO-level employees with bonuses for reporting higher earnings encourages executives to artificially inflate earnings statements and make decisions targeting short term gains at the expense of long term profitability. Doctors are financially incentivized to order more procedures rather than encourage prevention

Perverse Incentives Perverse Incentive: an incentive that has an unintended and undesirable result which is contrary to the interests of the incentive makers.

Perverse Incentive Examples In Hanoi, under French colonial rule, a program paying people a bounty for each rat tail handed in was intended to exterminate rats. The Rat population increased When a day care put a small late fee on late parents late pick ups increased Several states have enacted laws requiring judges to impose tough sentences for a third felony conviction.  The result?  An increase in the murder rate.

Describe how London reduced its congestion.

RG Question What is the principal-agent problem?

Principle- Agent Problem When the interests of one person making decisions on behalf of a another person (principle) do not align with that person The two parties have: Different interests Asymmetric information

Prisoner Dilemma A paradox in which two individuals acting in their own best interest pursue a course of action that does not result in the ideal outcome. both parties choose to protect themselves at the expense of the other participant. By Trying to maximize their individual utility both participants find themselves in a worse state than if they had cooperated

How does the fishing industry reflect the prisoner’s dilemma?

What is creative destruction?

Creative destruction A term coined by Joseph Schumpeter in his work entitled "Capitalism, Socialism and Democracy" (1942) to denote a "process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one."

Why is it difficult to transfer money from the rich to the poor Why is it difficult to transfer money from the rich to the poor? Think about aligning incentives. (49-51)