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Incentives Matter

People commit crimes because they can make outsized gains relative to the risk.
If some firms invest heavily in areas that benefit an entire industry while others in that industry abstain, a free rider
problem emerges. The firms who contribute put themselves at a cost disadvantage against their competitors. The tourism
industry which includes some agencies who contribute to conservation and others who do not suffer from a free rider

problem.
Adam Smith noted that 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. Meaning that incentives matter. When we benefit directly from our work, we

work harder.
In systems that do not rely on markets, personal incentives are usually divorced from productivity. Firms and workers are

not rewarded for innovation and hard, nor punished for sloth and inefficiency.
Government bankrolled businesses and American public education suffer from personal incentives being divorced from
productivity. The pay of teachers is not linked in any way to performance. Whereas in other areas, such as Silicon Valley, if

firms do not contribute value to the market, they fail and shut down.
The standardized pay of teachers creates a set of incentives referred to as adverse selection. The most talented teachers
are likely to be good at other professions where pay is more closely linked to productivity. Studies show that the most
talented teachers are the most likely to leave the profession early because incentive structures leads them elsewhere, the

least talented teachers incentives are just the opposite.


Perverse incentives are inadvertent incentives created when we set out to do something completely different. Also known
as the law of unintended consequences. A law in Mexico City once required cars to stay off the road once a week on a
rotating basis, using license plate numbers to decide. Policymakers did not anticipate that people would buy new cars and

hold on to older cars with poor emissions to continue driving.


Good policy directs desired behavior by using incentives while bad policy ignores incentives or fail to predict how

individuals might change their behavior to avoid being penalized.


A principal agent problem emerges when a principal (such as a firm) employs an agent (such as an employee) who has
an incentives to do things that are not necessarily in the best interest of the principal. Executives may be incentivized to
boost short term gains while she/he can exercise her stock options. The challenge is to reward good outcomes without

creating incentives for employees to game the system in ways that damage the company in the long run.
Economics teaches us how to get the incentives right.
Rational individuals acting in their own best interest can make themselves worst off. Fishermen who hunt without
constraint can deplete a fish population. The only incentive is to kill as many fish as they can when no one trusts anyone

else to practice constraint.


A market economy rewards winners and crushes losers. The steam engine, spinning wheel, and telephone put an end to

the blacksmith, seamstress and telegraph operator, respectively. In a market economy, creative destruction must happen.
Government intervention to minimize the pain inflicted by competition slows the process of creative destruction. American
automakers could have been made stronger in the long run if they faced foreign competition head-on instead of seeking

political protection from Japanese imports in the 70s and 80s.


Taxes provide incentive to avoid or reduce activity that is taxed.
Raising taxes to provide generous benefits to disadvantaged Americans can simultaneously discourage the kinds of
productive investments that might make them better off. Scandinavia has seen high marginal tax rates contribute to

growing black market economies.


Economists tend to favor taxes which are broad, simple and fair.
Deadweight loss refers to taxes which make individuals worse off without making anyone else better off.
Regressive taxes are those which fall more heavily on the poor than the rich.