Incentives Drive Human Behavior
Editor's Note: Below is an excerpt from Common Sense Economics: What Everyone Should Know About Wealth and Prosperity (St. Martin's Press, 2016)
All of economics rests on one simple principle: Changes in incentives influence human behavior in predictable ways. Both monetary and non- monetary factors influence incentives. If something becomes more costly, people will be less likely to choose it. Correspondingly, when an option becomes more attractive, people will be more likely to choose it. This simple idea, sometimes called the basic postulate of economics, is a powerful tool because it applies to almost everything that we do.
People will be less likely to choose an option as it becomes more costly.
Think about the implications of this proposition. When late for an appointment, a person will be less likely to take time to stop and visit with a friend. Fewer people will go picnicking on a cold and rainy day. Higher prices will reduce the number of units sold. Attendance in college classes will be below normal the day before spring break. In each case, the ex- planation is the same: As the option becomes more costly, less is chosen. Similarly, when the payoff derived from a choice increases, people will be more likely to choose it. A person will be more likely to bend over and pick up a quarter than a penny. Students will attend and pay more attention in class when the material is covered extensively on exams. Customers will buy more from stores that offer low prices, high quality service, and a convenient location. Employees will work harder and more efficiently when they are rewarded for doing so. All of these outcomes are highly predictable and they merely reflect the “incentives matter” postulate of economics.
This basic postulate explains how changes in market prices alter incentives in a manner that works to coordinate the actions of buyers and sellers. If buyers want to purchase more of an item than producers are willing (or able) to sell, its price will soon rise. As the price increases, sellers will be more willing to provide the item while buyers purchase fewer, until the higher price brings the amount demanded and the amount sup- plied into balance. At that point the price stabilizes.
What happens if it starts out the other way? If an item’s price is too high, suppliers will have to lower the price in order to sell it. The lower price will encourage people to buy more—but it will also discourage producers from producing as much, since at the new, lower price it will be less profitable to supply the product. Again, the price change works to bring the amount demanded by consumers into balance with the amount produced by suppliers. At that point there is no further pressure for a price change.
Remember the record high nominal gas prices in the summer of 2008? While a lot of people felt the pain of higher prices at the pump, there was no panic in the streets or lines at the gas pumps. Why? When the higher prices made it more costly to purchase gasoline, most consumers eliminated some less important trips. Others arranged more carpooling. With time, consumers also shifted to smaller, more fuel-efficient cars in order to reduce their gasoline bills. As buyers reacted to higher gas prices, so did sellers. The oil companies supplying gasoline increased their drilling, adopted new techniques to recover more oil from existing wells, and intensified their search for new oil fields. The higher price helped to keep the quantity supplied in line with the quantity demanded. Eventually, the prices of both crude oil and gasoline fell as supply expanded over time.
