The Economic Way of Thinking and Incentives

The Fundamental Core of Economic Thought

Summary Sentence: The entire economic way of thinking can be distilled into a single, four-word sentence: "People respond to incentives."
Explanatory Power: This simple phrase is powerful enough to explain virtually all observed human behavior and societal phenomena.
Framework for Behavior: Understanding that people respond to incentives allows for a structured evaluation of how individuals make choices.

The Economizing and Optimizing Framework

Definition of Economizing/Optimizing: Individuals' choices are governed by a process where they compare the anticipated outcomes of their decisions.
The Decision Rule: People evaluate decisions based on two primary factors: * Expected Additional Benefit ( $EAB$ ): The additional gain or utility anticipated from an action. * Expected Additional Cost ( $EAC$ ): The additional loss, sacrifice, or expenditure anticipated from an action.
The Inequality Condition: Individuals choose to take actions only when the following condition holds: $\text{Expected Additional Benefit} \geq \text{Expected Additional Cost}$
Logic of the Choice: * By following this rule, a person ensures they are doing better (or at least not worse) because the benefit is at least as high as the cost. * Choosing an action where \text{EAB} < \text{EAC} is described as "shooting yourself in the foot," as it represents a net loss in utility or well-being.

Re-evaluating Previous Case Studies Through the Framework

The Cobra Effect (Bounty Incentives): * The Setup: A bounty was offered for dead cobras. * The Incentive Mechanism: The bounty (expected additional benefit) was higher than the actual cost of breeding and raising a cobra (expected additional cost). * Resulting Behavior: Because \text{EAB}_{\text{breeding}} > \text{EAC}_{\text{breeding}}, individuals responded logically by breeding snakes to collect the bounty, leading to an eventual increase in the snake population.
Seat Belt Laws and Risky Driving: * The Shift in Cost: By legally requiring seat belts, the state forces drivers to be safer. This reduction in physical risk translates to a decrease in the $\text{Expected Additional Cost}$ of driving fast or recklessly. * The Optimization Shift: Before the law, a driver might have balanced $\text{EAB}$ and $\text{EAC}$ at a moderate speed. With the seat belt, the $\text{EAC}$ of risky driving drops, tipping the inequality toward $\text{EAB}$ . * Resulting Behavior: The lower $\text{EAC}$ of risk leads people to drive faster and take more risks.
The Spikes-in-the-Steering-Wheel Thought Experiment (Counterexample): * Scenario A (Spikes): Imagine replacing a car's airbags with super-sharp, lethal spikes. * Effect: This would massively increase the $\text{Expected Additional Cost}$ of even a minor collision. * Result: People would drive much more cautiously or choose not to drive at all. * Scenario B (Airbags): Replacing spikes with airbags reduces the $\text{EAC}$ . * Result: People feel comfortable driving faster and getting into cars more readily. * Conclusion: This experiment proves that when you reduce the cost of a behavior (driving fast), people engage in more of that behavior.

Evaluating Policy: Intent vs. Incentives

The "Economic Superpower": The most critical skill in economics is learning to evaluate policies based on the incentives they create rather than their intent or objectives.
The Pitfall of Noble Intentions: Many policies have noble goals (e.g., getting rid of snakes or saving lives via seat belts), but they fail or backfire because they create "bad" or perverse incentives.
Counter-Intentional Behavior: When lawmakers fail to think like economists, they implement rules that cause people to behave in ways that actively work against the policy's original goal.
Institutions as the "Rules of the Game": * In economics, institutions (laws, property rights, and social rules) are viewed as the "rules of the game." * These institutions are significant specifically because they set the incentive structures that influence individual choices.

Example 3: Mexico City’s Pollution Reduction Scheme

Historical Context: Mexico City in $1988$ suffered from extreme air pollution, largely driven by heavy commuter traffic.
The Policy (Hoy No Circula): Translated as "No Circulation Today," the plan banned specific cars from driving between $5\,AM$ and $10\,PM$ based on their license plate numbers. * Specifics: On Mondays, plates ending in $5$ or $6$ were banned; on Tuesdays, plates ending in $7$ or $8$ were banned, and so on.
Intended Goal: To take tens of thousands of vehicles off the road to reduce air pollution.
Unintended Consequences (The Failures): The policy actually made air pollution worse due to shifting incentives: 1. Shifted Hours: Drivers increased their driving significantly during unrestricted hours (between $10\,PM$ and $5\,AM$ ). 2. Purchase of Second Cars: Because the law applied to specific cars/plates rather than specific people, individuals responded to the high cost of not being able to drive by buying a second vehicle. 3. Qualitative Decline in Vehicles: People did not buy high-quality second cars. They bought cheaper, older, more pollution-intensive, and less fuel-efficient vehicles (e.g., an old Jeep) to use on the days their primary, cleaner car (e.g., a RAV4) was banned.

Example 4: California’s Three Strikes Laws

The Policy Definition: A law that substantially increases prison sentences for individuals convicted of a felony if they have two or more prior convictions for violent crimes or serious felonies.
The "Third Strike" Trigger: A third conviction—even for a relatively minor felony like illegal substance possession—can result in a life sentence.
The Comparison of Punishments: Under this law, the punishment for a non-violent third strike becomes equivalent to the punishment for murder.
Intended Goal: To disincentivize crime by making repeat offenses increasingly expensive ( $\text{EAC}$ ) for the criminal.
Unintended Consequence: The introduction of these laws led to an increase in murder rates.
Economic Analysis Prompt (Assignment): Students are tasked with explaining this phenomenon using the $\text{EAB}$ vs. $\text{EAC}$ framework. * Hint derived from the lecture: If the marginal cost of committing a murder is the same as the marginal cost of a minor third-strike felony (since both result in life in prison), the incentive to avoid murder while committing the third crime is significantly reduced.