Reading: Lesson 4 – Incentives Matter

Description:

Incentives influence human behavior and motivate people to act in predictable ways. Institutions such as laws, customs, and culture provide incentives that instruct and guide people’s behavior. The market also provides incentives as people interact through prices, profits, and losses. These market incentives communicate valuable information and promote social harmony.

In this lesson, students will watch and discuss a video “Incentives Matter” by Professor Angela Dills. Next students will read and discuss an article “The Power of Incentives” by Dwight Lee. Students also complete the “Candy Cartel” activity that teaches how incentives influence behavior.

 

Time Required:

45 min

 

Required Materials:

Internet connection, writing instrument, bag of individually wrapped candy, chocolate, or other small prizes. 

 

Prerequisites:

None

6.4.A – Watch and discuss the following video using the questions below to guide your discussion [15 min]:

Video: (Learn Liberty, 2:15 min)

“According to Prof. Angela Dills, incentives are important and help economists predict individual behavior. Recognizing that incentives matter is fairly straightforward. What’s difficult is determining all the different ways a policy might affect people’s incentives and change people’s behavior. A good economist looks not only at the obvious incentives created by a particular policy but also looks for the less obvious effects.”

Discussion Questions: Incentives Matter

1. Why is it important to understand incentives?

1. The idea that incentives matter is one of the most fundamental and most important principles in all of economics. Incentives influence people’s behavior in predictable ways based on the costs and the benefits associated with the decisions people make. All other things equal, if something becomes more costly, people will choose less of it. If something becomes more beneficial, people will choose more of it.
2. An understanding of incentives is important for understanding and predicting human behavior.

 

6.4.B - Read the following article using the questions below to guide your discussion [15 min]:

Article: The Power of Incentives by Dwight Lee (FEE.org)

“The market economy is the ultimate example of how a set of rules can create a setting in which private incentives motivate social cooperation. Market economies don’t create incentives directly. Indeed, in a literal sense, markets don’t create incentives at all. The most important incentives come from the subjective desires of individuals: the incentive to find love, to earn respect, to make the world a better place, to provide for their families. Markets are the rules of conduct that harmonize these various incentives by making it possible for people to communicate their desires to others. The prices, profits, and losses commonly referred to as market incentives, are created by people’s interacting with one another. These incentives, which can be communicated only through markets, contain information that promotes social cooperation.”

Discussion Questions: The Power of Incentives

1.  According to the author, what role do incentives play in influencing behavior?

1. Incentives are an effective way to encourage people to behave in certain ways.
2. The author explains “The surest way to get people to behave in desirable ways is to reward them for doing so – in other words provide them with incentives. This is so obvious that you might think it hardly deserves mention. But it does.”
3. The two important functions of incentives are: (1) to communicate information on the best things to do and (2) to motivate people to do them.

2. What are some of the challenges with trying to design incentives to get people to behave in desirable ways?

1. The author explains “Even when you acknowledge that incentives are necessary, it is not obvious how to establish the ones that motivate desirable action.”
2. Furthermore, “…in most cases the type of behavior we desire requires subtly balancing competing objectives. In such cases, creating a direct incentive to do one thing can be too effective because it causes people to ignore other things.”

 

3. “When the objective is to motivate people to cooperate, desirable results can rarely be realized by directly establishing incentives.” What are some ways or examples showing how to incentivize people indirectly?

1. Incentives are often established indirectly through a set of general rules that allow them to emerge from social interaction.
2. “These incentives, which can be communicated only through markets, contain information that promotes social cooperation.”
3. One example the author uses is traffic. Traffic is a perfect example of hundreds of people cooperating spontaneously in order for everyone to get to their destination safely and in as little time as possible. Drivers all follow the same rules and guidelines.
4. “The market economy is the ultimate example of how a set of rules can create a setting in which private incentives motivate social cooperation.”
5. “The most important incentives come from the subjective desires of individuals: the incentive to find love, to earn respect, to make the world a better place, to provide for their families.”
6. “The prices, profits, and losses commonly referred to as market incentives, are created by people’s interacting with one another. These incentives, which can be communicated only through markets, contain information that promotes social cooperation.”

 

6.4.C - Complete the following activity about incentives [20 min]:

Activity:  Candy Cartel

A cartel is an association of producers or suppliers who collude together for the purpose of restricting competition and maintaining prices at an artificially high level. In this activity, students will attempt to form a cartel and will learn about the power of incentives to influence behavior.

 

Required Materials:

Bag of individually wrapped candy, chocolate, or other small prizes.

 

Directions:

1. Tell the group that you are forming a candy cartel and will be asking them to join you. Hold up the bag of candy to show the potential gains.
2. Inform the group that each person will have the opportunity to vote whether or not to be a part of the cartel. They will choose from two options:

• Option 1: Students can vote to collude and join the candy cartel.
• Option 2: Students can chose to defect and not join the candy cartel. 

1. Explain the rules of the cartel agreement as follows:

• If everyone in the room votes to collude and join the cartel, then everyone will receive several pieces of candy split evenly across the room.
• If there is one (and only one) person who defects, then that person will get a $25 gift card, and no other students receive candy.

Teacher Tip: You do not need to actually buy a gift card. For groups of 20 or more, it is highly unlikely that only 1 person will defect. For smaller groups, teachers may want to adjust the prices in the off-chance there is only one person who defects.

However, if there are two or more people who defect, then no one gets either the candy or the gift card. 

1. Using a secret ballot, tell student to cast their vote by writing their name and decision on a piece of paper. Everyone must vote for one of the two below. Each person can only vote once.

• #1 - “Join candy cartel and receive the candy”
• #2 – “Defect for a $25 gift card”

1. Share the results of the vote with the class. It is unlikely there will be fewer than two people who defect, so no one will get candy or a gift card.

Discussion Questions

1. Why did you vote the way you did? What motivated you? How did the incentives of the scenario play into your decision?

1. People act in their own self-interest, which is why cartels are unsustainable over the long run if members are not forced to participate.
2. If members of the group attempt to collude to keep prices high, then others have incentive to undercut the group for personal gain.

 

2.  Did you trust others in your group to vote in a way that would be in your best interest?

 

3.  Did you vote in a way that was in the best interest of others in your group?

 

4.  Did you vote in a way that was in your best interest? Why or why not?

 

5.  If you were trying to make an agreement that was in your best interest and the best interest of others in the class, and did not want others to defect, what kinds of things would help build trust?

 

6.  How does this activity relate to similar to incentives you face in the real world? How is it different?

 

Teacher Tip: Some students may interpret this game as indicating that everyone is worse off when people follow their own interests. This, of course, is not true. The purpose of this game is to explain how incentives influence behavior. It is not self-interest that makes people worse off, it is the incentive structure the system provides.

Lesson Recap

 

• “Institutions are the “rules of the game” that influence choices. Laws, customs, moral principles, superstitions, and cultural values influence people’s choices. These basic institutions controlling behavior set out and establish the incentive structure and the basic design of the economic system.”

 

• Incentives are “factors that motivate and influence human behavior”

 

• “People respond to incentives in predictable ways. Choices are influenced by incentives, the rewards that encourage and the punishments that discourage actions. When incentives change, behavior changes in predictable ways.”

 

• Incentives are communicated via markets which contain the information that promotes cooperation.

 

• The prices, profits, and losses commonly referred to as market incentives, are created by people’s interacting with one another. These incentives, which can be communicated only through markets, contain information that promotes social cooperation.”

 

• “The market economy is the ultimate example of how a set of rules can create a setting in which private incentives motivate social cooperation.”

  

Additional Resources

Podcast: Daniel Pink on Drive, Motivation, and Incentives EconTalk (1:19:04 min)

“Daniel Pink, author of Drive, talks with EconTalk host Russ Roberts about drive, motivation, compensation, and incentives. Pink discusses the implications of using monetary rewards as compensation in business and education. Much of the conversation focuses on the research underlying the book, Drive, research from behavioral psychology that challenges traditional claims by economists on the power of monetary and other types of incentive. The last part of the conversation turns toward education and the role of incentives in motivating or demotivating students.”

 

Article: Incentives Matter by Russell Roberts (Library of Economics and Liberty)

“Incentives matter. The most famous example in economics is the idea of the demand curve – when something gets more expensive, people buy less of it. When it gets less expensive, people buy more of it.”

 

Podcast: Luigi Zingales on Incentives and the Potential Capture of Economists by Special Interests EconTalk (1:02:06 min)

“Luigi Zingales of the University of Chicago’s Booth School of Business talks with EconTalk host Russ Roberts about Zingales’s essay, “Preventing Economists’ Capture.” Zingales argues that just as regulators become swayed by the implicit incentives of dealing with industry executives, so too with economists who study business: supporting business interests can be financially and professionally rewarding. Zingales outlines the different ways that economists benefit from supporting business interests and ways that economists might work to prevent that influence or at least be aware of it.”