Econ 101
This post comes under the sub-section Econ 101. Under Econ 101 I try to cover some basic economics concepts that will come handy in public policy discussions. We won't cover economic theory exhaustively, there are many textbooks that can do this better. We will be focussed on developing an economic way of looking at the world.
Incentives are Everywhere
I recently had a surgery. Before the surgery, I had to wait for hours in the ICU. As the hours passed, the seriousness of the procedure started slowly hitting me. I thought to myself, I have paid all the money for the surgery already, they have taken consent signatures from me and the doctor who is going to operate me is going to get paid for the job regardless of the outcome. If that is the case, then what is in it for the doctor to do a good job with the surgery?
Too late to have these questions one would say. I mean, I had ran out of things to think about lying in the ICU doing nothing for hours.
The question that I was asking myself was one of incentives. Is there an incentive for the doctor to do a good job with the surgery? Or is he just incentivised to get it done with and move on to the next one, to clock his numbers for the day?
Think about this, what if the payment mechanism in the hospital was different? What if I only had to pay after the surgery was done and only if it was done well? Well, in such a case, the incentive for the surgeon changes in some ways. He will have to prove to me that the surgery was done well, if he needs to get paid.
If we actually start looking, we could ask such questions about so many things around us. You find incentives everywhere. By incentives, we mean rewards and penalties that motivate behaviour.
When you walk into your local bakery, you find freshly baked bread stocked in the shelf. The shop owner bought the bread from a baker, who prepared it with materials he sourced from farmers, who grew the wheat several months ago. All of them worked to get you that bread. Why do you think so many people work for our benefit? In his 1776 classic, The Wealth of Nations, Adam Smith explained:
It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.
Self interest
This is one of the biggest lessons of economics. That we are all self interested individuals (not be read as selfish) who respond in predictable ways to incentives of all kinds. The shop owner gets bread in his shelf because of his self interest, the baker bakes bread out his self interest, etc. When all your self interests align, everybody gets paid and you get your bread.
You might be telling yourself right now, 'I'm not self-interested all the times'! Of course not. We give up, sacrifice and let go for loved ones, like many around us. But, generally speaking, we all do respond in predicatable ways to incentives. Mind you, money isn't the only incentive. Time, reputation, fame, concience, love, sex, even patriotism can act as incentives.
But money is a common and reliable incentive. That's why your employer gives you a salary at the end of the month, and not a warm hug. And this predictability of human behaviour wrt incentives, especially financial, is a very useful and important tool in policymaking.
Demand & Supply Curve
One of the most important examples of incentives in economics is the demand and supply curve. When the price of a product goes down, the quantity demanded increases and vice versa (demand curve). This is because, when price reduces, people have an incentive to buy that product. But when the price of something increases, people are incentivised to look for other alternatives. For example, if the price of wheat increases for some reason, our consumption of rice or millet in our diet might increase. In other words, we are incentivised to find alternatives to wheat. The demand for wheat goes down. We are not doing this for the benefit of rice and millet farmers out of our goodwill. We are acting in our own self-interest since we don't want to pay more than a particular amount for wheat.
Incentive Compatibility
When it came to my surgery, I was worried if my surgeon's self-interest (assuming it's the money he makes from a surgery) aligned with my self interest (to get the best surgery possible). I can't blame the surgeon for wanting to make money from his profession and I am not wrong in expecting the surgeon to do his best job possible. But unless, both our self-interests align, either one of us will be unhappy with the transaction. Economists call such aligning of self-interests as incentive compatibility. Incentive compatible transactions produce the best results for everyone involved.
How do we ensure incentive compatibility in every transaction? Now, this is a question that must bother a policymaker. How can we structure incentives in the healthcare sector so that everyone is better off? Sometimes when policemen tend to be corrupt, or teachers tend to not show up in government schools, we question their ethics. But have we thought about restructuring the incentive mechanisms of the institutions they are part of?
If not, it is time for you to put on the hat of an economist and start thinking about incentives. Because incentives matter, they are powerful and they are all around you.
Homework:
1. Read this example to see how incentive mechanisms can go wrong. Get a taste of a framework we will soon explore called Unintended Consequences.
2. Here is a summary of Adam Smith's classic work, Wealth of Nations.
3. If you are not familiar with the demand curve and supply curve, watch these videos: Demand, Supply.
I would like to hear from you. Write to me at onepolicyconceptaweek@gmail.com.