This is probably the most important guidepost in economic thinking. It is sometimes called the basic postulate of all economics. As the personal benefits from an option increase, a person will be more likely to choose it. On the other hand, as the personal costs associated with an option increase, a person will be less likely to choose it. This guidepost also applies to groups of people, and suggests that making an option more beneficial will predictably cause more of them to choose it. Similarly, making an option more costly will cause fewer of them to choose it.
This basic idea is a powerful tool because its usefulness is practically universal. Incentives affect behavior in virtually all aspects of our lives, ranging from market decisions about what to buy to political choices concerning for whom to vote. If beef prices rise, making beef consumption more expensive relative to other goods, consumers will be less likely to buy it. The “incentives matter” postulate also explains why a person would be unlikely to vote for a political candidate who, if elected, would raise taxes to fund a new government program he or she didn’t like very much.
Most errors in economic reasoning occur because people overlook this postulate or fail to apply it consistently. With economic applications generally focusing on people trying to satisfy material desires, casual observers often argue that incentives matter only in cases of human selfishness. This view is false. People are motivated by a variety of goals, some humanitarian and some selfish, and incentives matter equally in both. Even an unselfish individual would be more likely to attempt to rescue a drowning child from a threefoot swimming pool than the rapid currents approaching Niagara Falls. Similarly, people are more likely to give a needy person their hand-me-downs rather than their favorite new clothes.
It is clear that incentives, whether monetary or nonmonetary, matter in human decision making. People will be less likely to walk down a dark alleyway than a well-lit one; they will be more likely to take a job if it has good benefits and working conditions than if it doesn’t; and they will be more likely to bend down and pick up a quarter lying on the sidewalk than they will a penny. Even a person who normally bends down to pick up pennies on the sidewalk probably would be less likely to if late for an important appointment, or on a first date.
Just how far can we push the idea that incentives matter? If asked what would happen to the number of funerals performed in your town if the price of funerals rose, how would you respond? The “incentives matter” postulate predicts that the higher cost would reduce the number of funerals. While the same number of people will still die each year, the number of funerals performed will still fall as more people choose to be cremated or buried in cemeteries in other towns. Substitutes are everywhere-even substitutes for funerals.
Posts Tagged ‘economy’
Incentives matter-choice is influenced in a predictable way by changes in incentives
July 4th, 2010The test of a theory is its ability to predict
July 9th, 2009Economic thinking is scientific. The proof of the pudding is in the eating. How useful an economic theory is depends on how well it predicts the future consequences of economic action. Economists world. Good theories are con- develop economic theories using scientific thinking based on basic principles. The idea is consistent with and help explain real-world events. Theories that are inconsistent with the to predict how incentives will affect decision makers and compare the predictions against real-world events. If the events in the real world are consistent with a theory, we say that real world are invalid and must be rejected. the theory has predictive value and is therefore valid. If it is impossible to test the theoretical relationships of a discipline, the discipline does not qualify as a science. Because economics deals with human beings who can think and respond in a variety of ways, can economic theories really be tested? The answer to this question is yes, if, on average, human beings respond in predictable and consistent ways to changes in economic conditions. The economist believes that this is the case, even though not all individuals will respond in the specified manner. Economists usually do not try to predict the behavior of a specific individual; instead, they focus on the general behavior of a large number of individuals.
In the 1950s, economists began to do laboratory experiments to test economic theories. Individuals were brought into laboratories to see how they would act in buying and selling situations, under differing rules. For example, cash rewards were given to individuals who, when an auction was conducted, were able to sell at high prices and buy at low prices, thus approximating real-world market incentives. These experiments have verified many of the important propositions of economic theory.
Laboratory experiments, however, cannot duplicate all real economic interactions. How can we test economic theory when controlled experiments are not feasible? This is a problem, but economics is no different from astronomy in this respect. Astronomers can use theories tested in physics laboratories, but they must also deal with the world as it is. They cannot change the course of the stars or planets to see what impact the change would have on the gravitational pull of Earth. Similarly, economists cannot arbitrarily change the prices of cars or unskilled-labor services in real markets just to observe the effects on quantities purchased or levels of employment. However, economic conditions (for example, prices, production costs, technology, and transportation costs), like the location of the planets, do change from time to time. As actual conditions change, an economic theory can be tested by comparing its predictions with real-world outcomes. Just as the universe is the main laboratory of the astronomer, the real-world economy is the primary laboratory of the economist.
Individuals make decisions at the margin
July 5th, 2009When making a choice between two alternatives, individuals generally focus on the difference in the costs and benefits between alternatives. Economists describe this process as marginal decision making, or “thinking at the margin.” The last time you went to eat fast food, you probably faced a decision that highlights this type of thinking. Will you get the $1.50 cheeseburger and the $1.00 medium drink, or instead get the $3.00 value meal that has the cheeseburger and drink and also comes with a medium order of fries? Naturally, individual decision making focuses on the difference between the alternatives. The value meal costs 50 cents more (its marginal cost) but will give you one extra food item-the fries (its marginal benefit). Your marginal decision is whether it is worth the extra 50 cents to have the fries. If you pay attention, you’ll notice yourself frequently thinking at the margin. Next time you find yourself asking a salesclerk “How much more is this one?” when you are choosing between two items, you are doing a marginal analysis.
Marginal choices always involve the effects of net additions to or subtractions from current conditions. In fact, the word additional is often used as a substitute for marginal. For example, a business decision maker might ask, “What is the marginal cost of producing one more, or additional, unit?’ Marginal decisions may involve large or small changes. involves additional costs and additional benefits. Given the current situation, what marginal benefits (additional sales revenues, for example) can be expected from the new factory, and what will be the marginal cost of constructing it? What is the marginal benefit versus marginal cost of purchasing a new stapler? The answers to these questions will determine whether building the new factory or buying the new stapler is a good decision.
It is important to distinguish between average and marginal. A manufacturer’s average cost of producing automobiles (which would be the total cost of production divided by the total number of cars the manufacturer produces) may be $25,000, but the marginal cost of producing an additional automobile (or an additional 1,000 automobiles) might be much lower, say, $10,000 per car. Costs associated with research, testing, design, molds, heavy equipment, and similar factors of production must be incurred whether the manufacturer is going to produce 1,000 units, 10,000 units, or 100,000 units. Such costs will clearly contribute to the average cost of an automobile, but they will change very little as additional units are produced. Thus, the marginal cost of additional units may be substantially less than the average cost. Should production be expanded or reduced? That choice should be based on marginal costs, which indicate the change in total cost due to the decision.
Confusion between marginal and total benefits or costs can also be a source of error. Almost all of the choices we make are marginal, rather than all-or-nothing decisions. For example. we don’t make decisions between eating or wearing clothes-dining well in the nude versus starving in style. Instead, we choose between having a little more food at the cost of a little less clothing, or a little less of something else. So the relevant comparison is not betkween the total value of food and the total value of clothing but between their marginal values.
People commonly ignore the implications of marginal thinking in their comments, but seldom in their actions. Thus, the concept is far better at explaining how people act than what they say. Students are often overheard telling other students that they shouldn’t skjp class because they have paid to enroll in it. Of course, the tuition is not a factor relevant at I The “one more unit” could be a new factory or a new stapler. It is marginal because it in-the margin-it will be the same whether or not the student attends class on that particular day. The only real marginal considerations are what the student will miss that day (a quiz, information for the exam, etc.) versus what he or she could do with the extra time by skipping class. This explains why even students who tell others they paid too much for the class to skip it will ignore the tuition costs when they themselves decide to skip class. When we confront a decision, the marginal benefit and marginal cost associated with the choice will determine our decision. Marginal analysis will be used extensively throughout this course. As we develop this concept further, you should pay special attention to understanding how to use it properly.