WEBVTT NOTE Incentives in Economic Theory 1 00:00:00.000 --> 00:00:01.560 Very well. 2 00:00:01.560 --> 00:00:03.920 This presentation is based on the opening chapter 3 00:00:03.920 --> 00:00:06.260 of my dissertation, which is on the theory of moral hazard 4 00:00:06.260 --> 00:00:08.160 and its applications. 5 00:00:08.160 --> 00:00:10.640 But moral hazard is, of course, a problem of incentives. 6 00:00:10.640 --> 00:00:13.240 And so in order to get to the bottom of that problem, 7 00:00:13.240 --> 00:00:15.680 it's also necessary to take a serious look 8 00:00:15.680 --> 00:00:17.880 at the concept of incentives in economics 9 00:00:17.880 --> 00:00:22.080 and explore the role incentives play in economic theorizing. 10 00:00:22.080 --> 00:00:24.120 And although I thought this task would be quite easy, 11 00:00:24.120 --> 00:00:25.500 it led me down a difficult path. 12 00:00:25.500 --> 00:00:28.200 Because unfortunately, even though we all constantly 13 00:00:28.200 --> 00:00:29.920 use the term incentive. 14 00:00:29.920 --> 00:00:32.480 There's quite a bit of ambiguity regarding its definition 15 00:00:32.480 --> 00:00:34.440 and use, and much less is there an attempt 16 00:00:34.440 --> 00:00:37.720 to seriously investigate the proper place of incentives 17 00:00:37.720 --> 00:00:39.960 in economic reasoning. 18 00:00:39.960 --> 00:00:43.120 And this ambiguity exists even within the Austrian School. 19 00:00:43.120 --> 00:00:45.480 So to provide such a discussion of incentives 20 00:00:45.480 --> 00:00:47.920 is the goal of the first chapter of my dissertation. 21 00:00:47.920 --> 00:00:51.840 And this presentation is a portion of that research. 22 00:00:51.840 --> 00:00:54.160 It's intriguing that if we look at the great treatises 23 00:00:54.160 --> 00:00:56.880 in Austrian economics, Menger's Principles, Human Action, 24 00:00:56.880 --> 00:01:11.880 and so on. The term incentive, not necessarily the concept, but the term hardly appears at all, and when it does, it's generally in the context of discussing economic intervention and its effects, and not the pure theory of the market, with an important exception in Mises that I'll talk about in a moment. 25 00:01:11.880 --> 00:01:25.880 But what are incentives? Well, of course, this is the question. In economics, broadly speaking, there are relatively few economic definitions, and what definitions there are tend to be non-technical, often variations of the common language definition. 26 00:01:25.880 --> 00:01:27.640 definition. 27 00:01:27.640 --> 00:01:32.800 So my approach has been to look at this problem by examining the existing literature and attempting 28 00:01:32.800 --> 00:01:38.520 to distill from it the essence of incentives and to see what relevance existing theories 29 00:01:38.520 --> 00:01:45.640 of incentives have for economics which takes propulsive action as its starting point. 30 00:01:45.640 --> 00:01:49.200 So much of this relates to basic semantic issues, but these are still important because 31 00:01:49.200 --> 00:01:53.380 if we don't take proper account of the fundamentals, we can develop bad habits about how we think 32 00:01:53.380 --> 00:02:07.380 As with most other concepts in economic theory, it is useful to talk about incentives first in the context of individual action and then develop a social theory of incentives with respect to exchange, contracts, and so on. 33 00:02:07.380 --> 00:02:14.380 This is not the approach taken in the canonical literature, which usually only starts talking about incentives when it gets to agency theory. 34 00:02:14.380 --> 00:02:21.380 But as we will see, I think, what can be said about incentives in a social context can also be said about individual behavior. 35 00:02:21.380 --> 00:02:26.380 So I'll begin with the individual aspects of incentives and I'll list various approaches 36 00:02:26.380 --> 00:02:29.860 until we get to what I think is the heart of the problem and at the end I'll say a few 37 00:02:29.860 --> 00:02:34.220 things about exchange, contracts, and hopefully I get to talk a little bit about the principal 38 00:02:34.220 --> 00:02:36.840 agent problem. 39 00:02:36.840 --> 00:02:41.260 So one view of incentives is presented by Professor Kirzner, I should note that actually 40 00:02:41.260 --> 00:02:47.220 this is not Professor Kirzner's view but rather the view he presents as standard in the literature. 41 00:02:47.220 --> 00:02:51.700 And in fact, in the essay that I'm quoting from, Kirzner actually criticizes this view. 42 00:02:51.700 --> 00:02:56.380 Professor Kirzner has, of course, developed his own theory of entrepreneurial incentives, 43 00:02:56.380 --> 00:02:59.740 which I do discuss in my dissertation, but I'm not going to talk about here because this 44 00:02:59.740 --> 00:03:01.700 is a more general discussion. 45 00:03:01.700 --> 00:03:06.740 But Kirzner defines incentives as the provision of an encouragement for a decision maker to 46 00:03:06.740 --> 00:03:21.540 to Select a Particular One Out of an Array of Already Perceived Alternatives, and of course, 47 00:03:21.540 --> 00:03:25.660 Kirzner criticizes this view based on his own theory of entrepreneurship and says that 48 00:03:25.660 --> 00:03:29.260 this is too narrow because it focuses only on given opportunities and not on the process 49 00:03:29.260 --> 00:03:33.780 of perceiving new opportunities, but that's actually a little, that's already taking me 50 00:03:33.780 --> 00:03:35.820 away from what I want to talk about. 51 00:03:35.820 --> 00:03:40.380 And then there are other definitions, costs combined with the benefits of our choices, 52 00:03:40.380 --> 00:03:46.260 a device that motivates people to take action, or looking at the process more broadly, organisms 53 00:03:46.260 --> 00:03:50.300 seek information concerning what activities are rewarded, and then seek to do, or at least 54 00:03:50.300 --> 00:03:58.720 pretend to do, those things, often to the virtual exclusion of activities not rewarded. 55 00:03:58.720 --> 00:04:03.900 So the most common example of incentives that is implied by these approaches is seen in 56 00:04:03.900 --> 00:04:05.700 the simple demand curve. 57 00:04:05.700 --> 00:04:09.540 When prices rise, people find ways to reduce the quantity of a good they purchase. In this 58 00:04:09.540 --> 00:04:14.940 case, the higher price is the incentive. The incentive provides a gain to the actor associated 59 00:04:14.940 --> 00:04:20.620 with some course of action. In the case of increasing prices, reducing the quantity purchased, 60 00:04:20.620 --> 00:04:22.420 finding various methods of economizing. 61 00:04:22.420 --> 00:04:29.000 So as you can see from these definitions, the ideas of motivation, self-interest, improving 62 00:04:29.000 --> 00:04:35.260 one's welfare are the most obvious themes which unite the literature. And as usual, 63 00:04:35.260 --> 00:04:40.060 Mises had already incorporated the necessary ideas into his own work. 64 00:04:40.060 --> 00:04:45.820 Mises, in his discussion of felt uneasiness, describes uneasiness as the incentive to human 65 00:04:45.820 --> 00:04:46.820 action. 66 00:04:46.820 --> 00:04:51.660 The desire to improve his condition is the reason an actor engages in purposeful behavior, 67 00:04:51.660 --> 00:04:55.460 and more specifically the reason individuals participate in the division of labor. 68 00:04:55.460 --> 00:05:02.340 It is important, though, that this is not uneasiness, it is not uneasiness in general 69 00:05:02.340 --> 00:05:06.780 which provides an incentive, but rather a particular uneasiness, a particular want. 70 00:05:06.780 --> 00:05:09.100 Mises is sometimes confusing on this point. 71 00:05:09.100 --> 00:05:13.820 Sometimes it appears as if he uses the concept of incentives simply 72 00:05:13.820 --> 00:05:17.340 to show that action is necessary in a general sense, essentially 73 00:05:17.340 --> 00:05:21.260 equating incentives with scarcity, meaning that incentives in some sense 74 00:05:21.260 --> 00:05:22.860 cause action. 75 00:05:22.860 --> 00:05:24.260 But that is not his real meaning. 76 00:05:24.260 --> 00:05:27.140 And I think a careful reading shows that what Mises was thinking of 77 00:05:27.140 --> 00:05:31.620 was, when he discussed his incentives, is concrete choices 78 00:05:31.620 --> 00:05:35.660 and not choice as such. 79 00:05:35.660 --> 00:05:37.740 But in any case, there is some explicit agreement 80 00:05:37.740 --> 00:05:40.900 between these different approaches to incentives. 81 00:05:40.900 --> 00:05:43.620 And they do, it seems, get to the core of the issue, 82 00:05:43.620 --> 00:05:46.140 provided we take proper account of the basic principles 83 00:05:46.140 --> 00:05:47.440 of action. 84 00:05:47.440 --> 00:05:49.220 So if we modify some of these definitions, 85 00:05:49.220 --> 00:05:50.640 I think we can get a theory which 86 00:05:50.640 --> 00:05:55.060 is a bit simpler and clearer, perhaps a bit more Austrian. 87 00:05:55.060 --> 00:05:58.100 And I think the improvements we can make to these approaches 88 00:05:58.100 --> 00:06:01.260 tend to take the form of moving the theory of incentives 89 00:06:01.260 --> 00:06:06.260 away from the excessively formal aspects of agency theory and toward the more general 90 00:06:06.260 --> 00:06:08.220 theory of action. 91 00:06:08.220 --> 00:06:14.020 So I would choose to replace some of the other definitions with the following working definition. 92 00:06:14.020 --> 00:06:17.860 Incentives are the subjectively perceived gains associated with a particular action 93 00:06:17.860 --> 00:06:22.500 of the outcome of achieving a particular end. 94 00:06:22.500 --> 00:06:27.940 And we can make other distinctions about incentives too, such as between incentives and disincentives, 95 00:06:27.940 --> 00:06:32.580 with incentives being estimated increases in welfare and disincentive being estimated 96 00:06:32.580 --> 00:06:39.340 decreases in welfare, but these other distinctions are more terminological than theoretical. 97 00:06:39.340 --> 00:06:44.640 So just to clarify certain portions of this definition and their relation to other theories. 98 00:06:44.640 --> 00:06:48.500 Incentives are subjective because of course they possess economic significance in as much 99 00:06:48.500 --> 00:06:53.520 as they involve an individual's valuation. When we speak about incentives, we often imply 100 00:06:53.520 --> 00:07:04.520 Incentives provide that physical things in themselves are incentives, but of course what we really mean is that an individual derives some benefit from that thing, and that psychic benefit is what we're really concerned with. 101 00:07:04.520 --> 00:07:14.520 Incentives do often have relevance to objective conditions in the real world, but their economic meaning is dependent on how they're perceived by individuals. 102 00:07:14.520 --> 00:07:19.520 However, the thing that provides the incentive must have certain objective characteristics. 103 00:07:19.520 --> 00:07:25.520 Specifically, an incentive can only be provided by those things which are capable of being the object of action. 104 00:07:25.520 --> 00:07:32.520 Which means that, to use Menger's terminology, only those things which possess goods character can provide incentives. 105 00:07:32.520 --> 00:07:36.520 Because goods character enables things to be valued in purposeful behavior. 106 00:07:36.520 --> 00:07:40.520 This in turn means that general conditions of human action are not incentives. 107 00:07:40.520 --> 00:07:50.520 In a world without scarcity, for example, there would be no incentives, because where there is no opportunity to improve one's situation, there can be no action and no weighing of cost and benefit. 108 00:07:50.520 --> 00:07:58.520 To use the standard example, air under ordinary conditions is not an incentive, because it is not the object of action, because there is no need to economize its use. 109 00:07:58.520 --> 00:08:07.520 And likewise, goods to which an individual attaches no value cannot be incentives, because there is no question of being motivated by something which provides no benefit. 110 00:08:07.520 --> 00:08:12.520 Also, things about the existence of which we do not know cannot be incentives. 111 00:08:12.520 --> 00:08:19.520 Because without some idea of cost and benefit, one cannot form the expectation of improving one's position, which is a necessity of action. 112 00:08:19.520 --> 00:08:30.520 If an actor does not realize potential gains or losses exist, then economically they can't really be said to exercise a role in purposeful behavior. 113 00:08:30.520 --> 00:08:46.520 Back to the definition, the word perceived is included because of course uncertainty exists and so an actor may be wrong about his estimations or may be disappointed ex post, but of course what matters for action is only that an actor believes he has discovered an opportunity to improve his position. 114 00:08:46.520 --> 00:08:52.440 Now, you may notice that this definition of incentives is tied very closely to the concept 115 00:08:52.440 --> 00:08:58.760 of ends. As far as individuals are concerned, incentives are distinguishable from ends as 116 00:08:58.760 --> 00:09:02.960 much as we can distinguish between an end in itself and the benefits that the end confers 117 00:09:02.960 --> 00:09:07.920 on the actor. But it is true, though, that from the perspective of a theory which recognizes 118 00:09:07.920 --> 00:09:13.280 purposeful behavior, there's a degree of redundancy in the concept of incentives. Essentially, 119 00:09:13.280 --> 00:09:18.280 The only thing we can say about incentives we can already get using the standard terminology of praxeology. 120 00:09:21.280 --> 00:09:30.280 Now, because we're speaking about individual valuations prior to action, we can think of incentives as an essential part of the individual's value scale, arranging the order of preferences. 121 00:09:30.280 --> 00:09:38.280 But what should be clear is that in light of the value scale, what truly matters is whether an incentive results in a particular course of action being chosen. 122 00:09:38.280 --> 00:09:43.280 So in terms of effect, the most important point about incentives is whether or not they influence action. 123 00:09:43.280 --> 00:09:49.280 Whether or not the benefit offered by a particular action is valued highly enough to become the chosen action. 124 00:09:49.280 --> 00:09:56.280 And it is on this ground that we can make the historical distinction between incentives which were successful and those which were not. 125 00:09:56.280 --> 00:09:59.280 Successful incentives are demonstrated in action. 126 00:09:59.280 --> 00:10:05.280 Unsuccessful incentives are either opportunity costs or are relegated to some lower portion of the value scale, 127 00:10:05.280 --> 00:10:09.560 about which we can say basically nothing other than that it exists. 128 00:10:09.560 --> 00:10:12.600 Everything below the first items on the value scale is indeterminate 129 00:10:12.600 --> 00:10:14.880 because as Mises points out, the value scale 130 00:10:14.880 --> 00:10:17.760 is not independent of action but is expressed through it. 131 00:10:17.760 --> 00:10:20.300 We know that other rankings of things take place in some sense, 132 00:10:20.300 --> 00:10:25.040 but we can't really say anything about the order of preferences 133 00:10:25.040 --> 00:10:29.720 other than, of course, the chosen action and the opportunity cost. 134 00:10:29.720 --> 00:10:32.120 Also, if we realize that anything with goods character 135 00:10:32.120 --> 00:10:34.340 can potentially provide an incentive, 136 00:10:34.340 --> 00:10:36.380 We don't fall into any arbitrary classifications 137 00:10:36.380 --> 00:10:38.060 of different types of incentives, 138 00:10:38.060 --> 00:10:40.980 such as distinguishing between monetary and non-monetary 139 00:10:40.980 --> 00:10:42.380 incentives. 140 00:10:42.380 --> 00:10:44.420 Empirically speaking, there are, of course, 141 00:10:44.420 --> 00:10:47.280 certain things which are desired more commonly than others, 142 00:10:47.280 --> 00:10:49.540 such as money, for example, which because of its function 143 00:10:49.540 --> 00:10:53.020 as a medium of exchange, is often useful as an incentive. 144 00:10:53.020 --> 00:10:55.020 But from the perspective of pure theory, 145 00:10:55.020 --> 00:10:56.820 everything which possesses goods character 146 00:10:56.820 --> 00:10:58.500 is potentially an incentive. 147 00:10:58.500 --> 00:11:01.420 And at the same time, no thing possessing goods character 148 00:11:01.420 --> 00:11:06.860 is necessarily either an incentive or a successful incentive. 149 00:11:06.860 --> 00:11:09.020 It might be useful to compare Austrian and more standard, 150 00:11:09.020 --> 00:11:11.420 classical approaches on this point. 151 00:11:11.420 --> 00:11:13.740 Specifically, if we take seriously Mises' approach 152 00:11:13.740 --> 00:11:16.940 to rationality, then incentives become 153 00:11:16.940 --> 00:11:19.160 a much less significant problem than they 154 00:11:19.160 --> 00:11:21.260 are in the standard literature. 155 00:11:21.260 --> 00:11:23.300 Standard models of economic rationality 156 00:11:23.300 --> 00:11:25.700 make incentives deterministic in the sense 157 00:11:25.700 --> 00:11:29.620 that incentives provide known increases in costs and benefits, 158 00:11:29.620 --> 00:11:33.220 or at least known probabilities of costs and benefits 159 00:11:33.220 --> 00:11:34.780 and are therefore easily incorporated 160 00:11:34.780 --> 00:11:36.940 into utility and production functions. 161 00:11:36.940 --> 00:11:39.180 And human agents are led by the pure logic of choice 162 00:11:39.180 --> 00:11:41.980 either to accept or reject certain courses of action 163 00:11:41.980 --> 00:11:45.060 based upon the calculus of cost and benefit. 164 00:11:45.060 --> 00:11:47.300 But if we see all action as rational 165 00:11:47.300 --> 00:11:50.200 and the costs and benefits are personal and subject to change, 166 00:11:50.200 --> 00:11:52.740 that is, if we really take into consideration human action 167 00:11:52.740 --> 00:11:55.220 and not just some sort of pure logic of choice, 168 00:11:55.220 --> 00:11:57.820 then we see that incentives are not deterministic 169 00:11:57.820 --> 00:12:01.340 but are in fact an empirical consideration faced by every actor. 170 00:12:01.340 --> 00:12:05.140 Each individual evaluates various ends according to their perceived benefits 171 00:12:05.140 --> 00:12:07.860 and chooses the one which is valued most highly. 172 00:12:07.860 --> 00:12:12.860 In other words, one of the incentives wins out while the others fail. 173 00:12:12.860 --> 00:12:15.460 So inasmuch as individuals value many things, 174 00:12:15.460 --> 00:12:18.540 they always face competition between incentives with the strongest 175 00:12:18.540 --> 00:12:20.540 or most highly valued being chosen. 176 00:12:20.540 --> 00:12:24.420 So the distinction is not, as is sometimes implied by economists, 177 00:12:24.420 --> 00:12:27.220 between incentives and non-incentives, 178 00:12:27.220 --> 00:12:31.300 so much as it is between successful and unsuccessful incentives. 179 00:12:31.300 --> 00:12:34.020 We ask which particular incentive, a particular estimate 180 00:12:34.020 --> 00:12:38.100 of cost and benefit, will be sufficient to make the end more 181 00:12:38.100 --> 00:12:39.940 highly valued than all the others. 182 00:12:39.940 --> 00:12:41.740 And of course, this is an empirical problem 183 00:12:41.740 --> 00:12:45.460 depending on particular circumstances. 184 00:12:45.460 --> 00:12:47.300 So when we deal with individual action, 185 00:12:47.300 --> 00:12:50.300 incentives are really not distinct from value scales 186 00:12:50.300 --> 00:12:54.140 and the estimates of psychic profit and loss which they imply. 187 00:12:54.140 --> 00:12:55.860 But incentives take on a new significance 188 00:12:55.860 --> 00:12:59.320 when we think of them in terms of social interaction. 189 00:12:59.320 --> 00:13:01.480 In this case, we have to consider the compatibility 190 00:13:01.480 --> 00:13:06.020 of the incentives of more than one individual. 191 00:13:06.020 --> 00:13:08.220 Now, if mutually beneficial exchange is possible, 192 00:13:08.220 --> 00:13:10.180 there's really not much of a problem. 193 00:13:10.180 --> 00:13:11.680 What makes things interesting is when 194 00:13:11.680 --> 00:13:15.440 one party is not interested in making an exchange or contract, 195 00:13:15.440 --> 00:13:16.940 then some possible course of action 196 00:13:16.940 --> 00:13:19.860 must be introduced, which could provide an incentive 197 00:13:19.860 --> 00:13:24.220 for an actor to align his behavior with another's. 198 00:13:24.220 --> 00:13:28.580 Let's say there are two individuals, A and B. A desires B to behave in a certain way 199 00:13:28.580 --> 00:13:33.180 that increases A's welfare. But B does not value this course of action highly enough 200 00:13:33.180 --> 00:13:37.980 to choose it. So A attempts to provide an incentive for B. He provides something with 201 00:13:37.980 --> 00:13:43.060 goods character which he hoped will prove valuable enough to induce B to take the desired 202 00:13:43.060 --> 00:13:47.980 course of action. If he succeeds, B will choose the action and we can say that incentives 203 00:13:47.980 --> 00:13:53.960 are aligned. And this is essentially the same as any other mutually beneficial transaction. 204 00:13:53.960 --> 00:13:57.920 If the incentive is insufficient, B does not behave as A would like, and we can say that 205 00:13:57.920 --> 00:14:04.840 incentives are not aligned. Once again, incentives in some form are present for all action. So 206 00:14:04.840 --> 00:14:09.320 the situation is one of providing an additional incentive to the already existing competition 207 00:14:09.320 --> 00:14:17.640 between incentives and not adding an incentive to an otherwise incentive-less choice. 208 00:14:17.640 --> 00:14:21.640 So there's an important welfare implication of all this. Assuming voluntary action, even 209 00:14:21.640 --> 00:14:25.700 Even if A had not provided the incentive, or if he did and B still did not value the 210 00:14:25.700 --> 00:14:29.760 desired course of action highly enough to choose it, the welfare of both individuals 211 00:14:29.760 --> 00:14:32.280 is still maximized ex ante. 212 00:14:32.280 --> 00:14:36.860 So the failure to align incentives is not necessarily welfare decreasing. 213 00:14:36.860 --> 00:14:40.760 And perhaps more significantly, when incentives are aligned, what we have is essentially a 214 00:14:40.760 --> 00:14:42.760 standard exchange. 215 00:14:42.760 --> 00:14:47.960 For example, a principal provides an incentive, something he gives up which he values less 216 00:14:47.960 --> 00:14:50.960 is less highly than the results of his agent's behavior. 217 00:14:50.960 --> 00:14:54.960 And likewise, the agent exchanges his behavior which is valued less highly 218 00:14:54.960 --> 00:14:57.960 for the incentive which is provided to him. 219 00:14:57.960 --> 00:15:01.960 If, and of course this is a big if, but if incentives are aligned properly, 220 00:15:01.960 --> 00:15:07.960 there is this reverse valuation of means and ends that we see in ordinary exchange theory. 221 00:15:09.960 --> 00:15:12.960 So just to summarize, the way I think Austrians should look at incentives, 222 00:15:12.960 --> 00:15:16.960 they're inextricably bound to the notion of valuation and ends in action. 223 00:15:16.960 --> 00:15:17.920 and Action. 224 00:15:17.920 --> 00:15:19.960 The study of incentives is not, therefore, 225 00:15:19.960 --> 00:15:22.320 a branch of economic reasoning or a way 226 00:15:22.320 --> 00:15:24.320 of looking at particular problems in economics, 227 00:15:24.320 --> 00:15:26.400 as is sometimes implied. 228 00:15:26.400 --> 00:15:29.400 Incentives are actually implied in purposeful behavior. 229 00:15:29.400 --> 00:15:33.200 Without them, there could be no action, as Mises pointed out. 230 00:15:33.200 --> 00:15:35.920 Finally, economists sometimes speak of incentives 231 00:15:35.920 --> 00:15:39.560 as if their importance was the final conclusion of economics, 232 00:15:39.560 --> 00:15:42.280 when in fact, it's actually the starting point. 233 00:15:42.280 --> 00:15:43.800 So thank you for your attention.