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Economics Dr.

Katie Sauer

Chapter 2 Reading Guide: Incentives Matter I. Communal Resources Technical definition: A common resource is a resource that anyone can have access to but the resource is finite. Ex: wildlife, environment Black Rhino Example: Why do people kill black rhinos?

Why will this market not correct itself?

Contrast communal property with private property. Explain what this has to do with the black rhinos endangerment.

Technical definition: A free-rider problem happens when people consume a common resource without paying for it, the resource tends to be overused. In the case of a produced good or service, if people can use it without paying, the good is likely to be under-produced. Explain the free rider problem as it applies to the black rhino.

Explain a free rider problem that you may have faced in your own life.

What are some possible solutions to the black rhino problem?

II. Incentives Matter People respond to incentives. A negative incentive can cause a person to NOT behave in a certain way. A positive incentive can entice a person to behave in a certain way. From your own life, give an example of a negative incentive that you faced: positive incentive that you faced: 1

Economics Dr. Katie Sauer

In non-market systems, personal incentives are usually NOT related to productivity. East Germany example:

India example:

North Korea example:

III. Incentives and Policy In the United States, how can incentives be used to help design energy/environmental policy?

In the United States, how does the uniform pay scale for teachers affect incentives?

Many types of policies can result in unintended consequences. Technical definition: perverse incentives / unintended consequences are unintended and undesirable results which are contrary the intended behavior that the incentive was designed to promote. Car seats on airplanes example:

Mexico City example:

Good policies will take into account incentives and think through how individuals might respond to the policy. Bad policies either ignore incentives or fail to anticipate how individuals might respond. London example:

Economics Dr. Katie Sauer

IV. The Principal-Agent Problem Technical definition: The principal-agent problem happens when a principal hires an agent to act on the principals behalf; problems can arise due to a difference in incentives and incomplete information. Burger King receipt example: potential problem


CEO/Shareholder example: potential problem

stock options solution

Explain how incentives and the principal-agent problem came into play in the financial crisis.

Real-estate agent / Home seller example:

V. The Prisoners Dilemma Technical definition: A prisoners dilemma is a fundamental problem in game theory that demonstrates why two parties might not cooperate even if it is in both their best interests to do so. Explain the story of the classic prisoners dilemma:

Economics Dr. Katie Sauer

Explain how this situation applies to environmental situations.

Explain how a different outcome can be reached.

VI. Creative Destruction Using Wal-Mart as an example, explain some of the benefits and costs of creative destruction.

What would happen if all creative destruction were prevented?

VII. Taxes & Government Benefits With regard to incentives, how can taxes alter behavior?

Bjorn Borg example:

marriage tax:

corporate taxes:

Economics Dr. Katie Sauer

very high taxes:

government benefits:

Economists favor taxes that are broad, simple and fair. A broad tax means:

A simple tax:

A fair tax:

Different types of taxes affect taxpayers differently. A regressive tax:

A progressive tax:

How does the EITC work? How does it take into account incentives?

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.