It is still very difficult for me to provide an accurate definition of financial concepts so I will make use of the ones that Linda Ghent, Alan Grant and George Lesica share in their web site The Economics of Seinfield. This will be the first, but for sure, not the last time that I will refer this interesting and recently launched web page because it illustrates economics via entertaining and wit clips of Seinfield, one of my favorite sitcom.
Today I am talking about incentives. An incentive is any factor (financial or non-financial) that enables or motivates a particular course of action, or counts as a reason for preferring one choice to the alternatives. Incentives matter, individuals and groups work in their own interest encouraged by factors that, as we have seen in previous entry, maximize utility or profits, being this self-interest what makes the world advance.
Misaligned incentives or the lack of them, bad implemented objective-based policies or even unexpected outputs to rational taken decisions can make our society worst-off. Wheelan introduces some different incentive-based cases in his chase after how “Economics teach us how to get the incentives right”:
Coordinating incentives
In our occidental, welfare and rich society it is not well understand why some countries do not better control some of their scarce natural exploitations. How is it possible not to find a case to protect endangered species like black rhino or limited fish stocks? The explanation lays in the incentives the local or the fishers have to protect these markets in the long term relative to the huge amount of money the poachers do for the rhinos' horns or fisheries do right now through the fishing. If the communities in Africa, where the black rhino lives, were given a benefit from tourism business they would probably be more interested in fight abusive hunting and control it. Meanwhile, they just try to survive and the black rhino can even be counterproductive to grow their crops and protect their families. Here, as in the case of fisheries, appears the concept of public versus private ownership incentives. It is difficult to coordinate a protection policy when nobody owns the property. “The prisoner dilemma” explains this situation: two murder suspects are caught with a mildly accusation so they are immediately separated and asked for a confession. If both confess, they will get twenty-five years in prison, if only one of them confess accusing his/her partner, the former will get 3 years in prison while the later would spend a long life in prison, if none of them talks, both will just get 5 years in prison. The best collective decision would be not to talk at all but generally, the prisoners come to the conclusion that it is better for them to accuse their partner because if the other talks, their confession saves he/she from getting life in prison and if not, he/she would only get 3 years in prison.
This model offers a insightful explanation to many situation where rational decision make an awful outcome. In the case of black rhino communities or fisheries, if one individual invests in fighting against poachers or implement a self-control fishing and the outcomes are public, others would benefit at no cost, making the former individual business more costly against competence and unsustainable. So, rationally, no one controls and everybody looses in the end. Sometimes creating private property rights is the most effective tool in the face of some scarce natural resource collapse. If a license and limit for traps is forced, the owners of the license would take care of keeping the value of their asset up to date (in this case the license) thus avoiding the stock to diminish or fished/hunt away.
In the private sector you can also find examples of incentives misalignment (Principal – Agent problems in corporations), some of them sadly known lately for having driven the financial crisis that started in 2007. Agents (CEOs/main executives) can have different incentives to principal (shareholders) best interest.
Why could be the CEO interested in strategies that damage the company in the long term? To be the CEO of bigger merged/take-over companies, more attention to himself, more power. For a time, stock options where thought the solution to align CEO/main executives incentives to shareholders benefits but it can be wrong because company executives can implement strategies that blow up company value in the short term but that damages it severely when considering a longer stretch (accounting fraud or debt default).
Financial crisis was breed by bank employees (provided with high incentives) who took huge risks at the firm expense. Then the banks packaged the reckless loans together and sell them by a lump-sum to investment firms. What we knew late is that the bankers made huge commission on buying and selling what later become “toxic assets” and they did not realize and even, if so, in the end the do not bear about the perils of the products they were trading with. The firms do. In the case of Lehman Brothers, employees lost their jobs but the responsible of this wreckage in the end didn´t have to give back their benefits. Another guilty party were the rating agencies that paid by the firms selling bond or securities being analyzed, positively rated the “toxic assets” underscoring the risk of them.
Corporates incentive problems are difficult to solve. “It is necessary to reward innovation, risk, hard work but avoiding the employees to game the system in ways that damage the company in the long run”.
When there are no incentives
The lack of incentives lead to a global inefficiency. If people are not rewarded if they work more or punish for sloth and inefficiency, the productivity will be hit. This is what happened in communist economies and in any system where the individual pay off is not linked to performance (I.e.: controversy about teachers' rewarding system in USA based on seniority not in achievement. “Since the most talented teachers are also likely to be good at other professions, they have a strong incentive to leave education for jobs in which pay is more closely linked to productivity”). So, inefficiency can also be found in capitalist economies. Other examples of inefficiency are firms owned or subsidized by government with no need to subsist by what they produce.
Incentives and competition
Wheelan makes an apart about competition and the incentives to not be thrown off business. He explains that “a market economy inspires hard work and progress not just because it rewards winners, but because it crushes losers”. It is the “creative destruction” of Schumpeter and it is easily found where a big mall or retailer opens and expels familiar and small business from market.
Creative destruction (an capitalism) is necessary for society evolution, brutal in the short term for those working in uncompetitive businesses but helping to reallocate the resources on society demand in the medium term (less farmers but more workers in technology companies than 50 years ago).
But nobody wants to be the loser so we all fight against being out of market even pushing policy trade-offs that helps to uncompetitive firms and companies even though that jeopardizes the global development and improvement process.
Incentives and public policy
On the one hand, good intentions that can lead to bad outcomes because incentives are not fully anticipated. Perverse incentives are those “unexpected incentives created when we set out to do something completely different”. As an example, during Clinton administration there was a proposal to restrain children in seats while flying, as a safety measure. This decision proved that finally it could lead to more children killed in car accidents since more families would choose to drive instead to fly to avoid paying an additional seat in the plane. Or in Mexico city where to reduce pollution they approved a policy based on cars stay off the streets one day a week on a rotating basis controlled by license plate. This lead to families, who could afford a second car, to buy a new one or kept the old one. Thus the consequences were even worse: old cars or more cars in the street with more pollution at the end.
On the other hand, good policy lies on incentives to achieve a positive end as they got in London with the established congestion fee for driving through central London during peak hours. Raising costs reduced demand and increased the flow of traffic and thus the use of public transportation become more appealing. There are some “negative effects” such less revenues than expected and retailers complaining about less people going shopping in central London but, in this case, the main objective was achieved, less traffic and pollution.
In general, taxes provide a powerful incentive to avoid or reduce the activity that is taxed. People would stop working or would embrace the underground economy based on tax rates. Some government benefits may even create perverse incentives such us unemployment benefits that diminish the incentive to work.
Since taxes incomes are necessary, economists struggle to get the more beneficial taxes. In general, economists encourage “broad, simple and fair taxes” - broad implies a small tax on a very large group, simple are those easy to understand and fair implies similar taxes to equivalent incomes. Big taxes in small groups can lead to a “deadweight loss” making individuals worst off without making anyone better off. This would be the case for taxing higher red sport cars, finally people would buy another car color so while no tax income is got the buyers would be unhappy with their car color. It would be preferable a smaller tax on all sport cars, independently of color. This example could also be applicable to tax carbon-base fuels. This would raise high revenues while create an incentive to conserve resources and avoiding pollution and CO2 emissions. But these are regressive taxes, with a heavier impact on poor households and while low load on richer households (taxes that fall more heavily on the rich than the poor are the progressive taxes, Income taxes in Spain belong to this group). As many times, economist do not get the answer to the “perfect political, social and economical tax”. They provide an analytical framework. Gasoline tax and income tax generates income but the later one could discourage work while the former one could discourage driving what may be good for the environment (the later is also applicable to tobacco, gambling, alcohol etc...). A lump-sum tax theoretically would be the broader, simpler and fairer tax among the individuals in a group but as we have seen with the example of a carbon-base fuels tax, it arises a lot of complaints as an unsocial measurement. Some other alternatives that encourage work are under study in USA, like the earned income tax credit to subsidize low incomes to raise over the poverty line.
The perfect summary I have found, also “robbed” from Wheelan's is: “good policy uses incentives to channel behavior toward some desired outcome. Bad policy either ignores incentives, or fails to anticipate how rational individuals might change their behavior to avoid being penalized”.
Time to close this chapter, please, don´t forget to watch The Andrea Doria and how your vested interests can come against you.
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