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Politics & Society

Understanding Incentives in Economics

Written by MasterClass

Dec 16, 2018 • 5 min read

What inspires average people to work harder, push for more, and achieve goals? Sometimes, that inspiration comes from within. But other times, incentives can help motivate people to perform to the best of their abilities.

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What Is the Definition of Incentives?

In the most general terms, incentives are things that motivate a person to do something. However, when we’re talking about economic incentives, the definition becomes a bit narrower. Economic incentives are financial motivations for people to take certain actions.

Extrinsic vs. Intrinsic Incentives

There are two types of incentives:

Extrinsic
Intrinsic

Extrinsic incentives encompass receiving a reward or avoiding punishment. Economic incentives are extrinsic motivators, in which a reward, like money, will motivate someone to accomplish a goal or task.

In contract, intrinsic motivation is when a person is motivated to do something for its own sake, without an outside pressure or reward. It’s that feeling of personal fulfillment and satisfaction that people get from doing certain things, like learning a new skill just for the fun of it.

coins in a persons hand

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Common Types of Economic Incentives

The most common type of economic incentive system is payroll: A paycheck motivates people to go to work.

Here are five more examples of common economic incentives:

1) Tax Incentives

Tax incentives—also called “tax benefits”—are reductions in tax that the government makes in order to encourage spending in a certain area.

Tax incentives are often cited as a great way to encourage economic development. So, for example, a common individual tax exemption in the United States is the mortgage interest deduction, which makes it so money paid toward mortgage interest isn’t counted as taxable income. This incentivizes people to buy property.

An example of a corporate tax incentive is a government giving a major company tax breaks in exchange for them building an office or plant in their city. This type of special tax incentive stimulates the economy in that area by empowering the company to provide jobs as well as make goods or services available for purchase.

2) Financial Incentives

A financial incentive is a broader term that encompasses any monetary benefit given to a consumer, employer, corporation, or organization in order to incentivize them to do something they might not otherwise do.

For employees, a financial incentive might be stock options or commissions that encourage certain types of work (just think of salespeople whose commission is considered a sales incentive). For customers, an example of a financial incentive is a “discount,” like a buy-one-get-one sale which encourages more spending under the guise of saving.

3) Subsidies

Subsidies are governmental incentive programs that provide set amounts of money to businesses in order to help them grow. Agricultural subsidies are common in the United States, with the federal government giving farmers billions of dollars both to farm more of certain products and to reduce their outputs in times of surplus.

Agricultural subsidies aren’t the only type of US government subsidy, of course. Others types of government subsidies include:

Oil
Ethanol
Export
Environmental
Housing
Health care

4) Tax Rebates

Tax rebates are incentives to take certain actions, like investing in solar energy, for example. In the case of alternative energy tax rebates, the government offers a certain amount of money to consumers to purchase more environmentally-friendly ways to generate electricity. So a city might offer a check of $1,000 to a homeowner who installs solar panels, after they’ve paid for the panels themselves.

5) Negative Incentives

Negative economic incentives punish people financially for taking certain actions. So, for example, the Affordable Care Act was designed with a built-in negative economic incentive. It required that everyone have health insurance and penalized those who didn’t with a monetary fine at tax time.

a tractor on a farm which is part of the larger economy

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Understanding Incentives Within the Broader Economy

A fundamental assumption in economics is that people respond to incentives—they will (almost always) act in a way that will improve their economic standing. So, knowledge of the different types of incentives—and what incentives might exist on either side of any economic transaction—can help you understand how economies work.

The theory of wages and profit, developed by Victorian economist David Ricardo, helps explain the underlying human desire to seize opportunities for improved economic standing. Ricardo articulated his theory of wages and profit to understand how landlords and farmers negotiated rents.

David Ricardo’s Theory of Wages and Profit

Farmers want to cultivate the best possible land, where they can raise the most crops. Landlords want to charge the highest rent that farmers will be willing to pay. What then determines how much produce a farmer will have to pay to his landlord in rent and how much he will get to keep for himself? Ricardo reasoned that all farmers would get to keep an amount roughly equal to what could be produced on the worst plot of land under cultivation and any amount over would be paid in rent to the landlord.

Why? Suppose a landlord tried to charge so much rent that the farmer actually ended up with less than he could produce on the worst plot of land. In that case, the farmer could get a better deal by offering a very tiny amount to rent land that was so bad no one was currently cultivating it. The owner of that uncultivated plot isn’t receiving any rent now, so even a tiny amount of rent makes him better off. Thus the farmer leaves his old landlord and rents the uncultivated plot.

On the flip side, suppose another farmer demands that his landlord lower the rent, so that the farmer can keep more than what could be produced on the worst plot of land currently under cultivation. In that case, the landlord can threaten to evict his current farmer and rent the plot out to whoever is farming the very worst plot of land instead.

The opportunity for farmers to find a new landlord or landlord’s ability to find a new farmer keeps the income of all the farmers roughly the same. They all fall in a fairly narrow range around the amount that a farmer could produce on the worst plot of land. Neither the actual productivity nor the actual needs of any individual farmer plays much of a role in determining his income. His income is set by the quality of a plot of land that might be very far away, farmed by someone he will probably never meet.

A fundamental insight at the heart of economics is that people respond to incentives. Obvious opportunities to be better off are rarely left unexploited. While Ricardo may have named the theory, the underlying concept is a fundamentally human behavior that explains why people choose to pursue everything from fortune and fame to personal fulfillment.