We tend to think that economics is the study of the economy, and indeed this is an important application. But economics isn’t a subject matter; it’s a way of thinking. The essence of the economic way of thinking is to understand how incentives – the relationship between benefits and costs – affect people’s behaviour. Benefits are the value we get from a choice. Costs are the value we give up by making that choice. When those values change, so does our behaviour.
Therefore, incentives are the rewards and punishments that motivate behaviour:
The idea that incentives matter seems obvious but is often counterintuitive. My brother-in-law enjoys adventure and on a recent skiing trip realized that he was travelling faster than 30 mph. My parents were worried that he might hurt himself if he crashed, so they bought him a helmet. Guess what? The next day he reached 58 mph! All safety equipment has a curious potential to backfire, because it alters your incentives to take risks. Although helmets mean that you are less likely to be injured if you have an accident, they also affect the likeliness of having an accident in the first place. In the case of skiing a helmet reduces the cost of an accident. All else being equal, this makes you more willing to risk having one. This may not be a large effect, and perhaps if you wore a helmet you’d think that you’d be just as careful as without. But the helmet is incentivizing you to be more reckless, not less. Not only this, but it can affect other people’s behaviour. If you wear a helmet you also reduce the cost to other people of them crashing into you. At the margin, it could lead to more accidents.
Here are some examples of incentives at work:
I like this example of how Coldplay make sure that band members are incentivised to focus on collective achievement, rather than their own contributions to a track.
In the late 1970s, French regulation meant that you needed to hire an architect if you build a new home with more than 170m² of floor space. It should be no surprise to see a big spike in the number of houses with just under that amount.
Here is an example of how people jettison stupid beliefs if there’s money at stake.
Now, using your knowledge of incentives, consider the following examples:
In February 2023 BBC presenter Dan Walker claimed that his “helmet saved my life” after he was hit by a vehicle in Sheffield. What might have contributed to his accident?
In November 2020 F1 driver Romain Grosjean avoided serious injury despite crashing into a barrier at 137mph. According to a BBC News report, “it seems certain the halo head-protection device, introduced amid significant controversy in 2018, saved Grosjean’s life. The wishbone-shaped titanium structure that wraps around the driver’s head from the front of the cockpit looks to have taken the impact of the metal barriers.” F1 managing director Ross Brawn said, “There is absolutely no doubt the halo was the factor that saved the day – and saved Romain.” What might have contributed to the crash happening in the first place?
In 1908 the New York Times reported the story of a Newfoundland (a large breed of dog) that had saved the life of a small child that had fallen into a river on the outskirts of Paris. People were so happy they rewarded him with a juicy steak. Then, two days later, another child fell into the river, which the dog rescued. It happened on multiple occasions. What do you think caused the children to fall into the river?
Over 1.6 million Americans are allergic to sesame, therefore in 2022 a new federal law meant that any food containing sesame had to be labelled. Several restaurant chains such as Olive Garden, Wendy’s and Chick-fil-A began adding sesame to products that didn’t have it before. Why?
The corporate bonus
Imagine that a company has a policy of awarding a bonus equal to 10% of the value of every good idea initiated. An employee thinks that this is such a good idea, he helps his boss to write a book explaining why it will prompt even more good ideas. If the company believes that the value of this book is £120,000, and that it was genuinely the result of this employee’s actions (and only this employees actions), how much should he receive as a bonus? What is the corporate marginal tax rate of good ideas in this instance?
According to this topic, the goal of management is really quite simple – to change behaviour you need to change what is in people’s self-interest to pursue. You need to change incentives.
Does this mean that employees require lots of financial compensation? No!
Few of us are primarily motivated by money. The reason economists have a tendency to focus on money is simply because we are all motivated by it to some extent. Imagine offering your employees that reach specific targets a choice between the following “rewards”:
We don’t need to claim that everyone would prefer cash. It’s quite possible that some people will be more motivated by other items on the list (and indeed my own impression is that time off is the best motivational device of all). The job of a manager is to understand what motivates your employees, and chucking a £5 note at them is probably less appreciated than positive and constructive feedback. But it is difficult to know what truly motivates people, and the fact people are motivated by different things makes this even harder. In terms of incentives, money is indeed a lowest common denominator, but that’s exactly why it is so useful.