PRINCIPLE 4: PEOPLE RESPOND TO INCENTIVES

An incentive is something (such as the prospect of a punishment or a reward) that induces a nerson to act. Because rational people make decisions by comparing costs and benefits, they respond to incentives. You will see that incentives play a central role in the studyof economics. 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 an apple 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.

When policymakers fail to consider how their policies affect incentives, they often end up with results they did not intend. For example, consider public policy regarding auto safety. Today all cars have seat belts. but this was not true 50 years ago. In the 1960s, Ralph Nader’s book unsafe at Any Speed generated much public concern over auto safety.” Congress responded with laws requiring seat belts as standard equipment on new cars.

How does a seat belt law affect auto safety? The direct effect is obvious When a person wears a seat belt, the probability of surviving a major auto accident rises. But that’s not the end of the story because the law also affects behavior by altering incentives. The relevant behavior here is the speed and care with which drivers. operate their cars. Driving slowly and carefully is costly because it uses the driver’s time and energy. When deciding how safely to drive, rational people compare the marginal benefit from safer driving to the marginal cost. They drive more slowly and carefully when the benefit of increased safety is high. It is no surprise, for instance, that people drive more slowly and carefully when roads are icy than when roads are clear.

Consider how a seat belt law alters a driver’s cost-benefit calculation. Seat belts make accidents less costly because they reduce the likelihood of injury or death. In other words, seat belts reduce the benefits of slow and careful driving. People respond to seat belts as they would to an improvement in road conditions-by driving faster and less carefully. The end result of a seat belt law, therefore, is a larger number of accidents. The decline in safe driving has a clear, adverse impact on pedestrians, who are more likely to find themselves in an accident but (unlike the drivers) don’t have the benefit of added protection.

At first, this discussion of incentives and seat belts might seem like idle speculation. Yet in a classic 1975 study, economist Sam Peltzman showed that auto-safety laws have had many of these effects. According to Peltzrnan’s evidence, these laws produce both fewer deaths per accident and more accidents. He concluded that the net result is little change in the number of driver deaths and an increase in the number of pedestrian deaths.

Peltzrnan’s analysis of auto safety is an offbeat example of the general principle that people respond to incentives. When analyzing any policy, we must consider not only the direct effects but also the indirect and sometimes less obvious effects that work through incentives. If the policy changes incentives, it will cause people to alter their behavior.