Sunday, February 12, 2006

The Gravity of Incentives

There are very few wide ranging Rules of Economics, especially when you compare it to the hard sciences. Easily one of the most basic is "incentives matter." We see it everywhere: when prices increase, supply responds as fast as it can; when a grocery line is shorter, people are more likely to gravitate towards it; when wages for a job increase, more people are willing to do the work. Incentives play as vital role in economics as gravity does in physics.

So imagine my surprise when one of my first conversations with an AU econ grad student involved him saying "incentives aren't that important." I was stunned.

He stated that many people do things without monetary gain. In a way, it's true. Most of human history existed in a cooperative structure where people--in small family units--did favors for each other. But that doesn't mean incentives aren't important. Sometimes people do things for moral or social reasons. Sometimes it's as basic as simple survival. Sometimes you do something nice because it gives you a warm fuzzy feeling. All organisms are creatures of purpose and humans are no expection.

Ok, my colleague said, so why can't we use moral or social incentives do get things done? Why the emphasis of material incentives? He cited collective farms as a prime example where people pitch in out of sense of community. I have no doubt these communities exist because they emulate the social structure of hunter-gatherer societies. Large scale societies (and by "large" I talk of a hundred or more) tend not to be able to function in this way.

There are many reasons why this is but I would say enforcement is a main one. Allow me to digress into a personal example. I went to a very small school--my graduating class was ten and that was a big class. There were roughly thirty students in the high school in total. Thus we pretty much hung out with each other even if we had little in common. (In fact, of these thirty-odd people I only consider a few to be friends and I talk regularly to an even smaller number.)

Contrast this with most high schools, which are much larger. Clicks are not just common, they are a staple of growing up (and being an adult come to think of it). People gravitate towards those that are like them. In small societies, if you piss off others, you're alone. In large ones, if you piss off others, you just hang out with your friends. Typical strategies of guilt and ostracism don't work between strangers.

Not all kinds of incentives matter all the time. Social incentives work better in small groups; material incentives work better in large groups. But I'm not willing to say incentives aren't that important no more than I'm willing to point to a hot air balloon and question the significance of gravity.


mthomas1776 said...

A la Thomas Friedman, in "The World is Flat," the internet is a good example of incentives. Considering that everyone would have to have a new computer, something called a modem, and have to learn a new technology, the biggest barrier to forming the internet is that companies thought consumers would never be able to adapt so quickly.
We understand that due to incentives that people will change their habits overnight if it suits their interests. This incentive is probably the most dramatic example of responding to incentives.

Jason Br. said...

I think the critique that economists focus on too much on material incentives is sometimes valid but mostly off-target.

Much, probably most, economic analysis applies to material and non-material goods, and in that sense the critique is wrong. People will respond to whatever incentives they happen to care about. If you care about love first and money second, you'll use money as a means to love (given appropriate situations in which to do so). If it's the other way around, you'll behave that other way. Economic-style analysis covers this sort of situation all the time and handles it well.

Sometimes, though, I have seen a hesitancy to specify whether a specific analysis or analytical tool deals with only a particular subset of goods or with all goods. This weakness in specification manifests itself in a lot of hand-waving and either (1) assertions that non-material goods are covered by an analysis or (2) an admission that they are not covered. Particularly in general equilibrium analyses, which typically requires that all goods be tradeable (and actually traded? and priced in dollars?), am I skeptical that non-material goods are taken into account. Macroeconomic data (e.g., computation of GDP) is also very sketchy on how non-material goods are handled.

Steven Horwitz said...

I think you missed a chance here David. You're right that the issue is size/complexity, but the answer is as old as Adam Smith: in face-to-face societies, we know each other's interests and preferences well enough to identify and serve collective needs without being "incentivized."

However, in a world of anonymity, we don't have this knowledge in front of us (paraphrasing Smith: life is such that we only get to know a scarce number of people very well). Not knowing what others want, directly, and how best to satisfy that, directly, we have to rely on processes like the market that provide us both the knowledge and incentives necessary to act in ways that improve the lives of others.

The belief that we can achieve coordination and cooperation in anonymity without the incentives and the knowledge that prices and markets provide is but a version of the atavism that Hayek criticizes in The Fatal Conceit.

mthomas1776 said...

The second and third comments above are helpful for my understanding. So, arguendo, we do understand that people value different things, short of trying to understand this diversity - we look to some other way of proxy, the pecuniary market.
I am missing the compelling argument for the minority to accept the market's weight of their values. In fact there is a non-pecuniary market which doesn't seem to tip in GMU's favor, evidence these last two posts. It is my fear that others are more skilled with understanding the way this “other” market works. Is it that American University students will be won over by the power of our logic? I believe that you are right in what you say, but these other students have beliefs as well. What is the specific tool we use to reconcile our discontent with each other? I believe diversity is well championed and supported through a free market, this much has been proven, but I am not convinced that reform always works along such neat lines. There is more for me to witness and understand in this regard.

David said...

I don't really see it as a missed opportunity (at least not as much as you might, Steve). Trust me: if I could have given a lecture as to why we need to learn to live in two different worlds, I would have included the role of knowledge when it came to incentives.

Sadly, casual discussions are far more suited (in my experience) for targeted critiques rather than complete analysis (due to the back-and-forth nature) so I chose to focus on the actual incentive structure while talking about why incentives always matter. Even then, my analysis here is much more thorough than what I was able to pass on at the bar.