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Economics Dr.


Lecture Chapter 2: Incentives Matter 1. People respond to incentives Incentives _________________ our daily decisions A negative incentive can cause a person ________________ in a certain way. A positive incentive can entice a person ________________ in a certain way. incentives from parents: positive: negative: incentives from professors: positive: negative: 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 In non-market systems, personal incentives are usually NOT related to ___________________. (examples from reading)

2. Incentives and Policies Individuals, firms and governments can _______________ the costs and benefits associated with an activity in order to get you to ________________ your behavior. - when costs or benefits change, incentives change When a ____________ change results in creating incentives that are not what was intended, it is called ____________ incentives. (examples from reading) When designing ________________ from getting your kids to clean their room, to employee time-off policies, to Federal laws, it is important to think through the ______________________ of each involved party and also whether or not any perverse incentives are being created. ______________ policies both - take into account incentives - think through how individuals might respond to the policy ______________ policies either - ignore incentives - fail to anticipate how individuals might respond When we observe a negative outcome in the world, examining the incentives that lead to it is a _____________________________ before designing a policy to fix the outcome. (Simply outlawing something rarely fixes the problem.)

3. Application: Depletion of Common Resources A ____________________________ is a good that - everyone has access to - is not unlimited in quantity ex: wildlife on public land Because common resources dont belong to anyone in particular, it is _________ responsibility to see that they are used wisely. Common resources often end up ________________ or exploited. - overgrazing - deforestation - over fishing

- pollution

__________________________________________________________________________________ Experiment: Lets Go Fishing Round 1 Table:

Fisherman 1 2 3 4 5 Fish Caught Price of Fish $1000 $1000 $1000 $1000 $1000 Income

Round 2: Table
Fisherman 1 2 3 4 5 Fish Caught Price of Fish $1500 $1500 $1500 $1500 $1500 Income

In this game, what each fishermans private incentive?

Because people act according to their private incentives, what happened to the common resource?

Round 1 Table:
Fisherman 1 2 3 4 5 Fish Caught

Privatized Property Rights Rounds Round 2: Table

Price of Fish $1000 $1000 $1000 $1000 $1000 Income Fisherman 1 2 3 4 5 Fish Caught Price of Fish $1500 $1500 $1500 $1500 $1500 Income

In this game, what each fishermans private incentive?

How did the outcome of this game differ from the first time we played? 2

The Tragedy of the Commons illustrates that when ______________ incentives differ from __________ 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 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 his flock size as much as possible. However, the grazing land can only support so many sheep. When a shepherd gets a new sheep, he grazes it on the land. - he gets the ________________ benefit from the sheep - the damage to the commons is _________________ by 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.

Some potential solutions: -

Examples of the Tragedy of the Commons: Acid Rain common resource: private incentive: problem: social incentive:

Clear-Cutting of Brazilian Rainforest common resource: private incentive: problem: social incentive: 3

4. Application: Principal-Agent Problem The principal-agent problem is the arrangement that exists when one person or entity (called the agent) acts on behalf of another (called the principal); problems can arise due to a ________________ in incentives and incomplete ______________________. The arrangement works well when the principal and agent have _____________ interests and incentives. When the incentives _________________, that is when problems can come up. example: If you have a job, you are the ______________ and your employer is the ______________. While some of your interests may be in line with your employer, they arent ________ 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.

example: If you are selling your house and hire a realtor, then you are the __________ and they are the _______. 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. 5. Application: The Prisoners Dilemma Parties might have an incentive ___________ to cooperate, even if it is in their own best interest to _______________. The Classic Prisoners Dilemma:

Bonnie confess Clyde confess 5years 5years 1year 10years not confess 10years 1year 2years 2years

not confess

How does this apply to environmental situations? 4

6. Application: Taxes With regard to incentives, how can taxes alter behavior? (reading examples)

_____________________________________________________________________________ Summary: Incentives influence behavior. Effective policies take into account incentives. The Tragedy of the Commons illustrates that when private 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. The Prisoners Dilemma illustrates that incentives may cause people not to cooperate, to their detriment. Taxes cause people to change their behavior.