The importance of economic incentives, problems and economics

Welcome to Finance and Fury. A few weeks ago we did an episode on the Manifesto of Equals – got me thinking more about the nature of humans and how we respond to incentives – and how this can be really good for us, or be highjacked at our detriment – this is all food for thought – you can agree or disagree and that is perfect – how social discourse should occur – but in this episode we will look at economic incentives and human nature – and how incentives are our best and worst quality at the same time – large topic that will take a bit to explain, so probably will be in two parts – so bear with me

What are incentives – and how does this relate to economics?

1. At the core of all of Economics is incentive – this is everything – because it is how people respond to conditions, or inputs
   1. Economics is really a social science that studies the production, distribution, and consumption of goods and services – but to do this it focuses on the behaviours and interactions of economic agents – those economic agents are you and I, companies, governments and any participant in the buying or selling of goods
   2. At its core, incentives are always the key behind human behaviour – nobody starts a company and produces a good without an incentive – i.e. profit, or providing an altruistic service, and nobody buys these goods without an incentive, i.e. some marginal gain in utility – i.e. the money you spend is less than the benefit that the good provides you – think about food as a core good – you will pay for your groceries as it is a question of producing your own food, sourcing food from another source or not eating – so the gain in eating food that someone else produces is more than the cost of the food –
2. When taking incentives into account – What is forgotten in economics is that there is no perfect solution – only trade-offs – and that Homo economicus, or the economic man, doesn’t exist in practice, only theory – which is the rational person that only responds to incentives in a rational way based around the assumptions of economic models – this is why most models fail to predict human behaviours – due to the vast differentials between each person – not everyone responds in the same way
   1. Some people are more responsive to monetary gain, some are more responsive to human interactions
   2. Everyone has different responses to induvial incentives – which is the hard part for economics – how do you create a policy to influence incentives based around individuals that have vastly different incentives?
3. But it is also important to remember that there is no one perfect solution to the problems that people respond to through incentives
   1. Problems are simply an issue or event that we respond to – based around our incentives to solve them
      1. Some problems are small and there is little incentive to respond – or the effort is worth more than the problem being fixed – like a light bulb being out in our home – which we can directly control – people will respond differently, some may get in the car then and there to get a new bulb, others may delay for months, as this is not a high priority
         1. Sometimes, the incentive to solve a problem can be so little that we don’t respond at all
      2. Others problems may have a greater level of perceived importance in our own lives –
         1. Like a broken arm – due to the input of pain, you are likely to respond quickly to this

• Our response to problems all depends on how we view this problem – as a big deal or not a big deal, along with the effort on our behalf to solve the problem
  1. If the problem is large, and the effort to solve is little – then we are more likely to take action rather than having a small problem, that would take a large amount of effort to solve

4. this is where our incentives can be hijacked – especially if the actions to solve this problem are being promised form external sources – i.e. someone else promises to solve what you perceive as a big problem – more on this later

How incentives influence decisions –

1. To understand this, it helps to fist look at Human nature and incentives – we are hard wired to respond to positive outcomes from incitive inputs – it may seem crass to say, but think of humans as Pavlov’s dogs – which were conditioned to salivate at the ring of a bell that conditioned these dogs to understand that the ring of this bell meant food was on offer
   1. If these scientists were the only source of food and every time before these dogs were fed, the scientists rang a bell, who can blame these canines from becoming conditioned to believe that food was on the table each time they heard this bell ring?
   2. But we are not dogs, right? Well, we are not, but as mammals, what behavioural scientists have found over the last 100 years is that whilst we are not canines, our responses are not that different to Pavlov’s dogs
   3. This may be a hard truth to swallow – but under the right conditions, we can easily be conditioned to respond in certain ways to events – without us knowing it
   4. The interesting point here is that this conditioning wears off over time – this is where constant reinforcement is required to condition a behaviour, or response to an input – or problem
2. Without going too in depth about this certain point – We as the human race are the apex specie – but whilst as a race we are the apex specie, we are not immune to conditioning around the belief that there is higher authority than ourselves to solve problems on our behalf – this is the argument from authority
   1. To help explain this further – look at a specific problem – How to solve world problems such as hunger and poverty?
      1. If someone in power, or who we are told is an expert in this topic told us that the perfect solution for you and I would be to be to have a higher authority to provide all of our food for free, i.e. no monetary cost or labour cost if you are growing it yourself – then many people may take this solution at face value – but this is where the trade-off occurs – as in reality, some input is required to feed people – both in labour and financial resources for the tools and equipment required for modern farming
      2. If all food is meant to be free – who would get into the business of providing food? No farmer is going to sell their produce for free, given their costs involved to produce the food – so what you end up with is no supply – so whilst food may be free, there is no food – the incentive for a farmer to farm is not just because they love it, but to at least make some money to cover their costs to produce food along with making a profit – this profit in many cases is not to become stinking rich, but to build up a reserve for years in which there are non-optimal conditions to grow or produce food – in this instance, their stored reserves of profits are depleted to subsidise their own enterprises – to make sure we still have food to eat
   2. This is where different economic theories are based around the assumptions that are given to incentives –
      1. every economic model treats human nature and our natural incentives differently – and people will fall into different camps of economic models based around how they treat human nature and respond to incentives
      2. For myself, I know that I am more drawn to Austrian economics – but this is not a consensus – others may be drawn to the idea that what other work for should be owned by the collective – which is communism
   3. You have different forms, ranging from anarchism, socialism, communism, Big to small government – all have different promised incentives for the population that live under them – but whilst they all offer different incentives, it doesn’t mean that any of them actually fulfil their promises
3. This brings up a greater point – which can be found through looking at the trade-offs between bigger government and incentives that they provide, versus individual incentives
   1. Individuals will have incentives to respond to solve problems in their own lives – again, based off how large the problem is and how much effort it will take to solve the problem
   2. but if there is a higher authority that promises to solve these problems on their behalf – then the incentive to take any action to solve their own problems is diminished – someone else has promised to solve it for you
      1. So you take no action – but what happens if this problem isn’t solved?
   3. The biggest component to this, and the one word that can sum this up better than any other is Entitlements – believing oneself to be inherently deserving of privileges or special treatment – for which different government system promise different levels of entitlement on
      1. “From each according to his ability, to each according to his needs” – This is Karl Marx’s statement around each member of a communist state to both be able to produce and then receive their needs to live – all determined by the state – if you didn’t work though, then there was no social welfare under this ideology – this may be a shock to some people who idealise a communist state – as you are forced to work in a role the state tells you to, to receive back benefits – often just at a subsistence level to keep you alive – but you can never rise beyond this point
         1. The state owns everything – what you are granted is a gift, but only a gift you are entitled to if you give back into the system by producing a good that others may need – this diminishes your individual incentive to produce beyond a quota – as anything extra you provide to the economy is a bonus to the state, but you gain nothing extra in your quota of rations – so why work yourself to the bone to get nothing extra back?
         2. The old communist saying: we pretend to work and they pretend to pay us – beyond the nature of central planning, this form of incentive system fails to provide any abundance or incentive of development
      2. Throughout history – there has been an incentive to work together and to build a better society – which has happened indirectly though individuals wanting to better their own individuals live – this is each of our incentives – but when you look at society – this is built up of individuals – so when you have most people working towards a common goal of betterment for their own individual lives, this translates into a society that can progress, collective sum is greater than the individual parts – but if you have a collective society focused not on the betterment of their own lives, but being reliance on what other can provide, a period of extraction occurs, lowering the potential output of a nations potential
         1. If there is no welfare or guaranteed safety net – then the incentive to provide for yourself in retirement increases
            1. This doesn’t mean that there was a safety net prior to a government scheme existing – but it wasn’t guaranteed, it was instead reserved for those really determined to be in need by religious institutions or charity organisations – both of which has seen a significant reduction in their contributions to so society as the government has replaced them
         2. by actually building a better society by being interdependent, not by the goal of building a better society, but one that naturally occurs when everyone in the society increases their own personal capacity – but as the incentives to do so have been decreased by the welfare state
      3. The conditions to do so need to also be in place though – it is all well and good for people to want to better their own lives, but if there is no infrastructure or mechanisms to do so, then this incentive, or desire goes to waste
         1. We need laws or a common understanding in place to help facilitate human natures desire for betterment
         2. Many economists who point to welfare in the modern age to that of the turn of the century point out the destitute nature of those living under the poverty line
            1. But even the upper middle class was living below the poverty line when compared to the modern age – struggling to buy food
            2. Technology and capacity to save for retirement were completely different over 100 years ago – there wasn’t a modern banking system, and the nature of employment was also completely different – along with the costs of goods – Around 45% was spent on food alone in the early 1900s – compared to between 10% to 15% on average now – it wasn’t the government that solved this problem, but technological advancements, as 100 years ago around 30% of the population was involved in food production, whilst today it is between 2-4%
         3. Then the state comes in – it can either help to create an environment for human nature to flourish in response to incentives, or curtail those incentives
         4. This is the fine balancing act – as history has shown, the more power or control over human actions the government has, the less people are free to take action in response to their own incentives
            1. This is where government policy can switch natural our incentives – rather than the state being dependent on us – we now become dependent on the state – What does this do to previous incentives? – turns them on their heads –
            2. Do you need to know your neighbours, give to your local community, as one day you may need to rely on this is a government promises that they will now provide for you?

• What economic incentives have government policies influenced – anything that changes the natural incentives that we have – and we will start working through some of the major ones currently occurring in next weeks episode

7. This has been a bit of an introduction – next episode will go through how to spot when the government is hijacking your incentives – and the solutions