Economic Incentives

A fundamental tenet of economics is that human behavior is explained by the combination of preferences and incentives. Preferences reflect the wants, needs, and desires of humans, while incentives are what actually motivates behavior. If people prefer to maximize their utility (or satisfaction) and if businesses seek to maximize profits, then those things that will result in increased utility or profits are by definition economic incentives. Economic incentives cannot be understood without taking account of preferences. For instance, people who prefer only wealth will likely respond differently to monetary rewards than people who prefer power or social status rather than wealth. When explaining and predicting human behavior, economists assume that preferences do not change. Therefore, changes in behavior are explained by changes in economic incentives. Much of economic analysis involves the study of institutional and organizational structures that give rise to and alter economic incentives.

Incentives can be either extrinsic or intrinsic. Extrinsic incentives are external to a person. These may be monetary rewards, such as cash payments, income, and profits, or they may be nonmonetary rewards, such as peer recognition and fame. In contrast, intrinsic incentives are psychological and, thus, internal to people. Knowing that you will receive a good feeling for doing something right is an intrinsic incentive. Extrinsic and intrinsic incentives often complement each other. People may be motivated to take a certain action because they are paid to do so and because they take pride in performing the work. However, many researchers have shown that extrinsic incentives often crowd out or diminish the effect of intrinsic incentives—for example, volunteerism declines when people are offered money for their services. The classic example here is donation of blood in the United States. In a 1971 book titled The Gift Relationship, Richard Titmuss contrasted the voluntary system of blood donation in Britain with the mixed commercialized and voluntary systems in the United States. He showed that paying donors resulted in a decline in voluntary blood donations and an increase in chronic and acute shortages of blood.

If incentives promote behavior, then disincentives discourage behavior. Societies use combinations of incentives and disincentives to motivate people to behave in socially desirable ways. Prizes and social accolades have the function of encouraging people to do things that are in the public interest. In contrast, fines, incarceration, and social ostracism are disincentives designed to discourage socially undesirable behavior. Similarly, feelings of guilt, shame, and regret are intrinsic disincentives for unethical behavior.

Many ethical problems can be explained by the incentives people face. Dishonesty, deception, bribery, theft, fraud, misrepresentation, plagiarism, and falsification are examples of unethical behaviors that can be [Page 648]largely explained by the incentives people face. Some scholars believe that unethical behavior in business is a response to the pressures people face in their employment. If economic incentives help explain why people in business engage in unethical behavior, then economic incentives can also be used to promote ethical behavior.