Sunday, January 07, 2007

Understanding Economics: Incentives

Economics is probably the most necessary academic subject for understanding contemporary politics and the least understood.

Economics has a reputation as boring and difficult. While it may sometimes seem that way when poorly taught, it doesn't have to be. Most of what the average citizen needs to know is simple and easy to understand. The history of economics illustrates the truth that what is easy to understand is not necessarily easy to figure out.

Economics describes human use of scarce resources with alternative uses. The economic model of human behavior assumes that people are rational and self-interested. Much elaboration is possible on these concepts. For now, this basically means that people have goals and seek to achieve them as efficiently as possible.

The fundamental concept of economics is incentives. People respond rationally to changing circumstances and seek to use their resources efficiently to achieve their goals.

Penalizing some behavior, whether through taxation, criminalization, or stigmatization, will lead to less of it. Subsidizing some behavior will lead to more of it.

Incentives explain the oft-heard economic concepts of supply and demand, along with their necessary counterparts, price and quantity. In a free market, a given supply and demand determine a given price and quantity sold.

Increasing demand increases price and quantity sold. Decreasing demand decreases price and quantity sold. Increasing supply decreases price and increases quantity sold. Decreasing supply increases price and decreases quantity sold. (Take a moment to think about why these economic laws are true.)

Increasing price artificially (creating a price floor) will decrease demand or increase supply, creating a surplus. Decreasing price artificially (creating a price ceiling) will increase demand or decrease supply, creating a shortage. Try to figure out what happens when a maximum or minimum quantity produced is imposed.

Another issue to consider is that there are usually alternative means of achieving goals. Penalizing one means will increase the use of other means. Subsidizing one means will decrease the use of other means.

Yet another issue is that there is a cost associated with each action. That cost may be uncertain, that is, there may be risk. Decreasing risk will encourage a given action and increasing risk will discourage a given action.

Understanding the incentives created by various actions and policies is the key to understanding economics and much of politics. Analyzing the incentives created by a given policy makes it possible to predict its consequences. The same rules apply regardless whether the specific issue is housing, agriculture, education, or something else.

Analyzing the incentives facing for-profit business, non-profit organizations, unions, and government, and the people who interact with and are a part of them does much to explain their actions.

I will close with an example.

In the past, many well-meaning people were concerned with the problem of poverty. They proposed creating a system of welfare to alleviate it. They were specifically concerned that single mothers did not have the same income provided by a father in a married couple. To target the needy population, they established a limit on the income of people who would receive aid, and gave more aid to single mothers than to married couples.

What incentives did welfare create?

Giving money to people on the condition that they be poor created a greater incentive to be poor, and hence encouraged poverty. This seemingly counterintuitive result follows inevitably from the incentives the program created. The income limit created a disincentive to earn more than it, since that would mean sacrificing government money. Thus welfare tended to mire people in poverty.

Targeting aid specifically to single women created a disincentive to get married, since it would again mean sacrificing government money. Given the alternative means of support for a single woman of marriage and government money, welfare discouraged marriage. One of the major costs of sex outside of marriage is the risk of pregnancy. Welfare lowered the financial risk involved, and so encouraged out-of-wedlock birth. This in turn led to increased crime and many other social problems resulting from the lack of a father.

Thus a seemingly reasonable scheme to end poverty ended up causing great harm. This harm was lessened, but not eliminated, by the 1996 welfare reform. Despite the simplicity of determining the results of such a program, (and some warned of these results at the time), this simple analysis was overlooked or ignored.

This illustrates the power of economics to explain and predict human behavior. It also illustrates the necessity of analyzing incentives.

3 comments:

The Blogger formally known as Anonymous said...

What explanations exist as to why Scandinavian societies function with heavy tax burdens and massive government subsidies and welfare provision? These societies consistently ranked among the most developed and least corrupt nations in the world. What makes their cases for government provided social welfare conflict with your assertions? Certain arguments contend that poverty is higher in the United States because assistance programs are poorly target and carry extensive stigmas. While you do a good job of summarizing main-stream economic thought, your political example begs to be explained in the context of Scandinavia.

Allan said...

It is essential when making such comparisons to have good data and interpret it correctly. Most Americans don't realize that there is now a substantial difference in living standards between most Americans and most Europeans. Most European countries have GDP/person comparable to the poorest American states. (See this article: http://www.humanevents.com/article.php?id=18143) I read a while back that the average Swede has a lower standard of living than the average black American.

Poverty statistics in America are highly politicized and unreliable. The "poverty line" was created by the Johnson administration to play up the issue. One of the peculiarities of the calculation of poverty in America is that government aid is not counted as income. This guarantees that no amount of aid can "solve" poverty, at least as far as official statistics are concerned.

I don't know how poverty is measured in Scandanavia, but accurate comparisons require use of the same standard. Of course, assuming official statistics count government aid, it is possible to "end" poverty by simply shoveling enough money at people, but this does nothing to make people independant of the need for assistance, which was supposedly the original goal of such programs.

Incidentally, one of the reasons that European economies don't totally collapse despite taxes even higher than ours is that they have Value Added Taxes instead of income taxes as their primary sources of revenue. Taxes necessarily create economic incentives, and income taxes create a disincentive to productive labor and investment. Other types of taxes are not as damaging to economic growth.

The Blogger formally known as Anonymous said...

I agree it is important to have consistent figures when making such comparisons. Regarding your source, it does not correspond with several others I have seen. Without again reminding you of the distinct political bend of Human Events, I am curious to know if you have seen data not from such websites. Take a look at the Human Development Index and data available on Wikipedia regarding per capita GDP. In both sources, Norway performs better than the United States as do several other European nations. Regarding comparative poverty measures across nations, a good source of information is the Luxembourg Income Study. An article from the director of the study can be found here: http://homepages.wmich.edu/~plambert/CapitalismDemocracy/smeeding-inequality-us-comparative.pdf. These sources of information call into question your political assertion as I mentioned in my first comment. Your discussion of economic issues does cover most of the basic points; however, your political assertion does not seem to hold up that well.