Principle #4: People Usually Respond to Incentives, Exploiting Opportunities to Make Themselves Better Off

One day, while listening to the morning financial news, the authors heard a great tip about how to park cheaply in Manhattan. Garages in the Wall Street area charge as much as $30 per day. But according to this news report, some people had found a better way: instead of parking in a garage, they had their oil changed at the Manhattan Jiffy Lube, where it costs $19.95 to change your oil—and they keep your car all day!

It’s a great story, but unfortunately it turned out not to be true—in fact, there is no Jiffy Lube in Manhattan. But if there were, you can be sure there would be a lot of oil changes there. Why? Because when people are offered opportunities to make themselves better off, they normally take them—and if they could find a way to park their car all day for $19.95 rather than $30, they would.

An incentive is anything that offers rewards to people who change their behavior.

In this example economists say that people are responding to an incentive—an opportunity to make themselves better off. We can now state our fourth principle of individual choice:

People usually respond to incentives, exploiting opportunities to make themselves better off.

When you try to predict how individuals will behave in an economic situation, it is a very good bet that they will respond to incentives—that is, exploit opportunities to make themselves better off. Furthermore, individuals will continue to exploit these opportunities until they have been fully exhausted. If there really were a Manhattan Jiffy Lube and an oil change really were a cheap way to park your car, we can safely predict that before long the waiting list for oil changes would be weeks, if not months.

In fact, the principle that people will exploit opportunities to make themselves better off is the basis of all predictions by economists about individual behavior. If the earnings of those who get MBAs soar while the earnings of those who get law degrees decline, we can expect more students to go to business school and fewer to go to law school. If the price of gasoline rises and stays high for an extended period of time, we can expect people to buy smaller cars with higher gas mileage—making themselves better off in the presence of higher gas prices by driving more fuel-efficient cars.

One last point: economists tend to be skeptical of any attempt to change people’s behavior that doesn’t change their incentives. For example, a plan that calls on manufacturers to reduce pollution voluntarily probably won’t be effective because it hasn’t changed manufacturers’ incentives. In contrast, a plan that gives them a financial reward to reduce pollution is a lot more likely to work because it has changed their incentives.

FOR INQUIRING MINDS: Cashing In At School

The true reward for learning is, of course, the learning itself. Many students, however, struggle with their motivation to study and work hard. Teachers and policy makers have been particularly challenged to help students from disadvantaged backgrounds, who often have poor school attendance, high dropout rates, and low standardized test scores.

Two studies, a 2009 study by Harvard economist Roland Fryer Jr. and a 2011 study by University of Chicago economist Steve Levitt along with others, found that monetary incentives—cash rewards—could improve students’ academic performance in schools in economically disadvantaged areas. How cash incentives work, however, is both surprising and predictable.

In the Fryer study, research was conducted in four different school districts, employing a different set of incentives and a different measure of performance in each. In New York, students were paid according to their scores on standardized tests; in Chicago, they were paid according to their grades; in Washington, D.C., they were paid according to attendance and good behavior as well as their grades; in Dallas, second-graders were paid each time they read a book.

Fryer evaluated the results by comparing the performance of students who were in the program to other students in the same school who were not.

In New York, the program had no perceptible effect on test scores. In Chicago, students in the program got better grades and attended class more. In Washington, the program boosted the outcomes of the kids who are normally the hardest to reach, those with serious behavioral problems, raising their test scores by an amount equivalent to attending five extra months of school.

The most dramatic results occurred in Dallas, where students significantly boosted their reading-comprehension test scores; results continued into the next year, after the cash rewards had ended.

So what explains the various results?

To motivate students with cash rewards, Fryer found that students had to believe that they could have a significant effect on the performance measure. So in Chicago, Washington, and Dallas—where students had a significant amount of control over outcomes such as grades, attendance, behavior, and the number of books read—the program produced significant results.

But because New York students had little idea how to affect their score on a standardized test, the prospect of a reward had little influence on their behavior. Also, the timing of the reward matters: a $1 reward has more effect on behavior if performance is measured at shorter intervals and the reward is delivered soon after.

The Levitt study, involving 7,000 students in the Chicago area, confirmed these results: monetary incentives lead to an increase in standardized test scores equivalent to five or six months of studying for the test. In addition, the Levitt survey found that offering more money ($20) resulted in significantly higher scores than offering less ($10). And, like Fryer, Levitt and his co-authors found that delaying the reward to a month after the test had no impact on scores.

Cash incentives have been shown to improve student performance.
Blend Images/Superstock

These two experiments reveal critical insights about how to motivate behavior with incentives. How incentives are designed is very important: the relationship between effort and outcome, as well as the speed of reward, matters a lot. Moreover, the design of incentives may depend quite a lot on the characteristics of the people you are trying to motivate: what motivates a student from an economically privileged background may not motivate a student from an economically disadvantaged one.

Fryer’s insights give teachers and policy makers an important new tool for helping disadvantaged students succeed in school.

So are we ready to do economics? Not yet—because most of the interesting things that happen in the economy are the result not merely of individual choices but of the way in which individual choices interact.

!worldview! ECONOMICS in Action: Boy or Girl? It Depends on the Cost

Boy or Girl? It Depends on the Cost

One fact about China is indisputable: it’s a big country with lots of people. As of 2012, the population of China was 1,354,040,000. That’s right: over one billion three hundred and fifty million.

The cost of China’s “one-child policy” was a generation of “disappeared” daughters—a phenomenon that itself is disappearing as economic conditions change.
Tan Ming Tung/Getty Images

In 1978, the government of China introduced the “one-child policy” to address the economic and demographic challenges presented by China’s large population. China was very, very poor in 1978, and its leaders worried that the country could not afford to adequately educate and care for its growing population. The average Chinese woman in the 1970s was giving birth to more than five children during her lifetime. So the government restricted most couples, particularly those in urban areas, to one child, imposing penalties on those who defied the mandate. As a result, by 2011 the average number of births for a woman in China was only 1.6.

But the one-child policy had an unfortunate unintended consequence. Because China is an overwhelmingly rural country and sons can perform the manual labor of farming, families had a strong preference for sons over daughters. In addition, tradition dictates that brides become part of their husbands’ families and that sons take care of their elderly parents. As a result of the one-child policy, China soon had too many “unwanted girls.” Some were given up for adoption abroad, but many simply “disappeared” during the first year of life, the victims of neglect and mistreatment.

India, another highly rural poor country with high demographic pressures, also has a significant problem with “disappearing girls.” In 1990, Amartya Sen, an Indian-born British economist who would go on to win the Nobel Prize in 1998, estimated that there were up to 100 million “missing women” in Asia. (The exact figure is in dispute, but it is clear that Sen identified a real and pervasive problem.)

Demographers have recently noted a distinct turn of events in China, which is quickly urbanizing. In all but one of the provinces with urban centers, the gender imbalance between boys and girls peaked in 1995 and has steadily fallen toward the biologically natural ratio since then.

Many believe that the source of the change is China’s strong economic growth and increasing urbanization. As people move to cities to take advantage of job growth there, they don’t need sons to work the fields. Moreover, land prices in Chinese cities are skyrocketing, making the custom of parents buying an apartment for a son before he can marry unaffordable for many.

To be sure, sons are still preferred in the rural areas. But as a sure mark of how times have changed, websites have popped up advising couples on how to have a girl rather than a boy.

Quick Review

  • All economic activities involve individual choice.

  • People must make choices because resources are scarce.

  • The real cost of something is its opportunity cost—what you must give up to get it. All costs are opportunity costs. Monetary costs are sometimes a good indicator of opportunity costs, but not always.

  • Many choices involve not whether to do something but how much of it to do. “How much” choices call for making a trade-off at the margin. The study of marginal decisions is known as marginal analysis.

  • Because people usually exploit opportunities to make themselves better off, incentives can change people’s behavior.

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  1. Question 1.1

    Explain how each of the following situations illustrates one of the four principles of individual choice.

    1. You are on your third trip to a restaurant’s all-you-can-eat dessert buffet and are feeling very full. Although it would cost you no additional money, you forgo a slice of coconut cream pie but have a slice of chocolate cake.

    2. Even if there were more resources in the world, there would still be scarcity.

    3. Different teaching assistants teach several Economics 101 tutorials. Those taught by the teaching assistants with the best reputations fill up quickly, with spaces left unfilled in the ones taught by assistants with poor reputations.

    4. To decide how many hours per week to exercise, you compare the health benefits of one more hour of exercise to the effect on your grades of one fewer hour spent studying.

  2. Question 1.2

    You make $45,000 per year at your current job with Whiz Kids Consultants. You are considering a job offer from Brainiacs, Inc., that will pay you $50,000 per year. Which of the following are elements of the opportunity cost of accepting the new job at Brainiacs, Inc.?

    1. The increased time spent commuting to your new job

    2. The $45,000 salary from your old job

    3. The more spacious office at your new job

Solutions appear at back of book.