Economics 1.1: People Respond To Incentives

The video introduces the first of five core principles in economics: people respond to incentives. This principle is the foundation for understanding economic behavior and decision-making.

The speaker contrasts a market economy (where individuals make economic decisions) with a command economy (where the state controls production). Using the example of the Soviet Union's command economy, it illustrates how state-mandated production targets, specified in weight for items like glass and furniture, led to unexpected outcomes. Factory managers, incentivized by bonuses, produced excessively thick and heavy products to meet weight targets, even if impractical for use.

When planners recognized the issue with glass production, they changed the target specification from weight to area. This new incentive led managers to produce extremely thin glass that often broke during transport, demonstrating how people consistently respond to the specific incentives presented, regardless of the ultimate quality of the product.

Economists conducted an experiment with laboratory rats to observe their response to changing prices. Rats, given a limited 'income' in presses, adjusted their consumption of more desirable (but more expensive) soft drinks versus less desirable (but cheaper) tonic water when prices changed. This shows that the principle of responding to incentives, particularly price changes, extends even to animals.

Incentives are not solely material (earnings, costs). Social incentives (praise vs. criticism) and moral incentives also play a significant role. An experiment by Dan Ariely is cited, where students were less likely to cheat on a game when a Bible was present, suggesting that moral considerations, even subconscious ones, influence behavior.

Emotional incentives also motivate behavior (seeking joy, avoiding pain). The speaker then shares an anecdote from Cairo, Egypt, where many buildings have exposed rebar on their roofs. This seemingly odd architectural feature is explained by a property tax law that offers a discount if a building is 'unfinished,' with an unfinished top floor being defined by the lack of a roof. This incentivizes property owners to leave rebar sticking out to avoid higher taxes.

Another historical example from Louisiana is given, where property tax was based on the number of visible floors from the front. This led to the creation of 'camelback houses,' homes with single-story fronts but multiple stories in the back, designed to minimize visible floors and thus reduce property taxes.

Swedish researchers found that people literally postponed their death to take advantage of a reduced inheritance tax that became effective at midnight on December 31st. Data showed an unusually low number of deaths just before the tax change and a spike immediately after, highlighting the powerful influence of financial incentives.

Observing the prevalence of window washers in Kingston, the speaker, as an economist, sought the underlying incentive. Conversations revealed that window washers could earn a significant, tax-free income through tips, making it an economically viable activity, sometimes more so than formal employment.

The discussion shifts to car theft, arguing that the incentive isn't to permanently own the car, but to use it temporarily. The real question is why owners don't have a greater incentive to prevent theft. The answer lies in 'moral hazard,' where car insurance insulates owners from the full financial consequences of theft, leading to less preventative action.

The concept of moral hazard is further demonstrated with seatbelt laws. Studies suggest that when seatbelt laws are enacted, the number of accidents can increase because drivers, feeling safer, subconsciously drive more recklessly. An economist's radical proposal for safer driving (a blade in the steering wheel) humorously illustrates this point.

The speaker challenges common sayings, stating that 'crime pays' because if it didn't, people wouldn't commit it, citing examples of organized crime's earnings. Finally, the seemingly irrational act of buying lottery tickets is analyzed. The true incentive, the speaker concludes, is not the slim chance of winning money, but the 'ticket to dreams' – the brief period of hopeful fantasizing before the draw.