Glossary · Economic ideas

Incentives

An incentive is a reward or a penalty that makes people more or less likely to do something: a bonus, a price, a fine or a tax.

Also called: incentive, economic incentives, perverse incentive, cobra effect

In plain words

Your parents offer $5 for every A on your report card. Suddenly you study a bit harder. That offer is an incentive: anything that changes the payoff of a choice, and so changes what people choose.

Prices are the biggest incentives of all. When gasoline gets dear, people drive less and buy smaller cars; when a job pays more, more people train for it. Fines, taxes, bonuses, grades, prizes and even praise work the same way.

Incentives are powerful, which is exactly why they backfire when they are badly designed. People respond to what is rewarded, and that is not always what was meant.

The Hanoi rat bounty of 1902, a famous perverse incentive: the city paid for tails, not for fewer rats.

Example

The great Hanoi rat hunt

In 1902 the French rulers of Hanoi, fighting a plague of rats in the city’s new sewers, offered a bounty of 1 cent for every rat tail handed in.

At first it seemed to work: thousands of tails came in every day.
Then officials began to see rats running around without tails. Hunters were cutting off the tail and letting the rat go, to breed more future tails.
Some people even started raising rats on farms outside the city.
The bounty was dropped, and the rats stayed.

The city paid for tails, so it got tails. A good incentive rewards the result you actually want.

One level deeper

Economists sort incentives into money (wages, prices, taxes, fines), social ones (praise, shame, what the neighbors think) and moral ones (doing what feels right). They can clash. In a well-known study of day-care centers in Israel, a small fine for parents who picked up their children late increased late pickups: the fine turned a feeling of guilt into a price, and the price was cheap.

When a measure becomes a target, people chase the measure. This is known as Goodhart’s law: pay programmers per line of code and you get long code; judge a call center only on how short its calls are and customers get hung up on.

Badly aimed incentives have names of their own in this glossary: moral hazard, when being insured makes people careless, and the tragedy of the commons, when everyone’s incentive is to overuse a shared resource.

Why it matters

Nearly every economic question comes down to incentives: why people work, save, invest, take risks or cheat.

Rules, taxes and subsidies all work through incentives, and so do their side effects. A good rule asks what people will actually do, not what they are asked to do.

Incentives explain a lot of money advice too: a salesperson paid by commission has a reason to sell you something, whether or not you need it.

A common mistake

Myth: Paying people more for something always gets you more of it.

In fact: Often, but not always. A reward can crowd out people’s own motivation, and a reward for a measure gets you the measure, not necessarily the result. Incentives work best when what is rewarded is exactly what is wanted.

Questions people ask

What is an incentive in economics?

Anything that changes the costs or benefits of a choice: a price, a wage, a tax, a fine, a bonus, a grade, even praise. Economists assume people respond to incentives, though not always in the way the designer hoped.

What is a perverse incentive?

One that produces the opposite of what was intended, like Hanoi’s 1902 bounty on rat tails, which led people to breed rats. It is also called the cobra effect, after a similar but less well documented story about a bounty on snakes in colonial Delhi.

What are the main types of incentives?

Usually three: financial (money gained or lost), social (how others see you) and moral (your own sense of right and wrong). Good designs make them pull in the same direction.

About the numbers

This page explains a term. It is not investment advice.