People respond to Incentives

Economists normally assume that people are rational. Rational people systematically and purposefully do the best they can to achieve their objective, given the opportunities they have. As you study economics, you will encounter firms that decide how many workers to hire and how much of their product to manufacture and sell to maximize profits. You will encounter consumers who buy a bundle of goods and services to achieve the highest possible level of satisfaction subject to their incomes and the prices of those goods and services.

Rational people know that decisions in life are rarely black and white but usually involve shades of gray. At dinnertime, the decision one may face is not between fasting and eating like a pig but whether to take that extra spoonful of mashed potatoes. When exams roll around, a student’s decision is not between blowing them off or studying 24 hours a day but whether to spend an extra hour reviewing notes instead of watching TV. Economists use the term marginal changes to describe small incremental adjustments to an existing plan of action. Keep in mind that margin means “edge” so marginal changes are adjustments around the edges of what one is doing. Rational people often make decisions by comparing marginal benefits and marginal costs.

For example, consider an airline deciding how much to charge passengers who fly standby. Suppose that flying a 200-seat plane across the United States costs the airline $100,000. In the case the average cost of each seat is $100,000 /200 which is $500. One might be tempted to conclude that the airline should never sell a ticket for less than $500. In fact, however, the airlines can raise its profits by thinking at the margins. Imagine that a plane is about to take off with ten empty seats, and a standby passenger waiting at the gate will pay $300 for a seat. Should the airline sell the ticket? Of course, is should sell. If the plane has empty seats, the cost of adding more passengers is minuscule. Although the average cost of flying a Passenger is $500, the marginal cost is merely the cost of the bag of peanuts and can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal cost, selling the ticket is profitable.

Marginal decision making can help explain some otherwise puzzling economic phenomena. Here is a classic question: Why is water so cheap, while diamonds are so expensive? Humans need water to survive, while diamonds are unnecessary; but for some reasons, people are willing to pay much more for a diamond than for a cup of water. The reason is that a person’s willingness to pay for any good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit in turn depends on how many units a person already has. Although water is essential, the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large.

A rational decision maker takes an action if and only if the marginal benefits of the action exceed the marginal cost. This principle can explain why airlines are willing to sell a ticket below average cost and why people are willing to pay more for diamonds than for water. It can take some time to get used to the logic of marginal thinking, but the study of economies will give ample opportunity to practice.

An incentive is something such as the prospect of a punishment or a reward that induces a person to act. Because rational people make decisions by comparing costs and benefits, they respond to incentives. Incentives play a central role in the study of economies. One economist went so far as to suggest that the entire field could be simply summarized: people respond to incentives. The rest is commentary.

Incentives are crucial to analyzing how markets work. For example, when the price of an apple rises, people decide to eat more pears and fewer apples because the cost of buying an apple is higher. At the same time, apple orchards decide to hire more workers and harvest more apples because the benefit of selling apples is also higher. As we will see the effect of a good’s price on the behavior of buyers and sellers in a market – in this case the market for apples is crucial for understanding how the economy allocates scarce resources.

Public policymakers should never forget about incentives because many policies change the costs or benefits that people face and, therefore, alter their behavior. A tax on gasoline, for instance, encourages people to drive smaller more fuel-efficient cars. That is one reason people drive smaller cars in Europe, where gasoline taxes are high, than in the United States, where gasoline taxes are low. A gasoline tax also encourages people to take public transportation rather than drive and to live closer to where they work. If the tax were larger, more people would be driving hybrid cars, and if it were large enough, they would switch to electric cars.