intro to economics - incentives
TRANSCRIPT
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Incentives Matter
(ch 2)
Dr. Katherine Sauer
A Citizens Guide to Economics
ECO 1040
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In your own words,
what are the main points of this chapter?
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1. People respond to incentives
Incentives influence our daily decisions
A negative incentive can cause a person to not behave in
a certain way.
Apositive incentive can entice a person to behave in a
certain way.
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incentives from parents:
positive:
negative:
incentives from professors:
positive:
negative:
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incentives from the tax code:
positive:
if you give to charity, deduct it from your taxes
negative:
if you dont purchase health insurance, you
must pay a penalty
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In non-market systems, personal incentives areusually NOT related toproductivity.
East Germany example:
India example:
North Korea example:
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2. Incentives and Policies
Individuals, firms and governments can change the
costs and benefits associated with an activity in order
to get you to change yourbehavior.
- when costs or benefits change, incentives change
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When apolicy change results in creating incentives that
are not what was intended, it is calledperverseincentives.
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Car seats on airplanes example:
Mexico City example:
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When designing any policy from
getting your kids to clean their room
to employee time-off policiesto Federal laws
it is important to think through the incentives of each
involved party and also whether or not any perverseincentives are being created.
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Goodpolicies both
- take into account incentives
- think through how individuals might respond to
the policy
Badpolicies either
- ignore incentives
- fail to anticipate how individuals might respond
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When we observe a negative outcome in the world,
examining the incentives that lead to itis a useful step
before designing a policy to fix the outcome.
(Simply outlawing something rarely fixes the problem.)
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3. Application: Depletion of Common Resources
A common resource is a good that
- everyone has access to- is not unlimited in quantity
ex: wildlife on public land
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Because common resources dont belong to anyone in
particular, it is no ones responsibility to see that they
are used wisely.
Common resources often end up overused or exploited.
- overgrazing - deforestation
- over fishing - pollution
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Experiment: Lets Go Fishing
You are a fisherman/fisherwoman. Your income dependsonly on how many fish you catch. There is a certain
number of fish currently living in the area where you like
to fish.
Since the ocean is open to anyone who wants to fish, other
fishermen/women may also fish in the spot you like. Any
fish that they catch represents money you lost out on
earning. That is, the other fishermen/women are your
competition and moreover, you dont happen to like them
very much.
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W
e will play 2 rounds.
Your objective is to maximize your income by catching
as many fish as possible.
You will fish by using your non-dominant hand.
In round 1, fish are worth $1000 each and in round 2
fish are worth $1500 each.
Fish are not replaced between rounds.
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Private Property Rights
Now, divide up the ocean and assign each person an
area.
You cant fish in anyones section but your own.
Equally divide the fish among each group members
section.
We will again fish for 2 seasons. Same values for fish
as before.
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TheT
ragedy of the Commons illustrates that whenprivate incentives differ from social incentives, people
will act in their own best interest to the detriment of
society.
- private incentive is to take as much as possible
- social incentive is to take as much as is
sustainable
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Classic Story:
In medieval Europe, shepherds would share a common
piece of land and were entitled to graze their sheep on it.
An individual shepherd had an incentive to increase hisflock size as much as possible.
However, the grazing land can only support so many
sheep.
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When a shepherd gets a new sheep, he grazes it on the
land.- he gets the entire benefitfrom the sheep
- the damage to the commons is sharedby
everyone
When individual shepherds are making economically
rational decisions, they will all try to graze as many sheep
as possible, which will destroy the commons.
When the commons are depleted, all the shepherds are
then worse off.
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Some potential solutions:
- regulations
- permits
- taxes
- privatize property rights
- social norms
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4. Application: Principal-Agent Problem
Theprincipal-agent problem is the arrangement thatexists when one person or entity (called the agent) acts
on behalf of another (called the principal);
problems can arise due to a difference in incentives and
incomplete information.
The arrangement works wellwhen the principal and
agent have similarinterests and incentives.
When the incentives differ, that is whenproblems can
come up.
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example:
If you have a job, you are the agent and your employer is
theprincipal.
While some of your interests may be in line with your
employer, they arent 100% the same.
You have an interest in showing up to work and doing
your job in order to keep your job. Your employer
wants you to work hard and do your job.
However, perhaps you take a long lunch or make a few
personal calls while at work. This behavior is hard for
the employer to spot.
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example:
If you are selling your house and hire a realtor, then you are
theprincipal and they are the agent.
While you both have an interest in selling your house, your
interests arent 100% the same.
- You want the highest price possible for your house.- Your realtor wants a high price for your house, but
balances that against the time and effort it would
take to get that price.
Lowering your asking price by $5000 is not very good for
you, but would be only a small reduction in commission for
the realtor.
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5. Application: The Prisoners Dilemma
Parties might have an incentive not to cooperate, even if
it is in their own best interestto cooperate.
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The Classic Prisoners Dilemma example:
Bonnie
Clyde
confess not confess
confess 5years5years
10years1year
not confess 1year
10years
2years
2years
*
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How does this apply to environmental situations?
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6. Application: Taxes
With regard to incentives, how can taxes alter behavior?
Bjorn Borg example:
marriage tax:
corporate taxes:
very high taxes:
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Summary:
Incentives influence behavior.
Effective policies take into account incentives.
The Tragedy of the Commons illustrates that whenprivate incentives differ from social incentives,
individuals act in their own best-interest to the
detriment of society.
The Principal-Agent Problem illustrates that when
incentives differ, problems can arise.
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The Prisoners Dilemma illustrates that incentives may
cause people not to cooperate, to their detriment.
Taxes cause people to change their behavior.
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What did you learn today?
Please explain 2 concepts from todays class.