Incentives in Economic Theory

0:00Very well. This presentation is based on the opening chapter of my dissertation, which is on the theory of moral hazard and its applications. But moral hazard is, of course, a problem of incentives. And so in order to get to the bottom of that problem, it's also necessary to take a serious look at the concept of incentives in economics and explore the role incentives play in economic theorizing. And although I thought this task would be quite easy, it led me down a difficult path. Because unfortunately, even though we all constantly use the term incentive. There's quite a bit of ambiguity regarding its definition and use, and much less is there an attempt to seriously investigate the proper place of incentives in economic reasoning. And this ambiguity exists even within the Austrian School. So to provide such a discussion of incentives is the goal of the first chapter of my dissertation.

0:47And this presentation is a portion of that research. It's intriguing that if we look at the great treatises in Austrian economics, Menger's Principles, Human Action, 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. 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. definition. So my approach has been to look at this problem by examining the existing literature and attempting to distill from it the essence of incentives and to see what relevance existing theories of incentives have for economics which takes propulsive action as its starting point.

1:45So much of this relates to basic semantic issues, but these are still important because if we don't take proper account of the fundamentals, we can develop bad habits about how we think 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. This is not the approach taken in the canonical literature, which usually only starts talking about incentives when it gets to agency theory. But as we will see, I think, what can be said about incentives in a social context can also be said about individual behavior. So I'll begin with the individual aspects of incentives and I'll list various approaches until we get to what I think is the heart of the problem and at the end I'll say a few things about exchange, contracts, and hopefully I get to talk a little bit about the principal agent problem.

2:36So one view of incentives is presented by Professor Kirzner, I should note that actually this is not Professor Kirzner's view but rather the view he presents as standard in the literature. And in fact, in the essay that I'm quoting from, Kirzner actually criticizes this view. Professor Kirzner has, of course, developed his own theory of entrepreneurial incentives, which I do discuss in my dissertation, but I'm not going to talk about here because this is a more general discussion. But Kirzner defines incentives as the provision of an encouragement for a decision maker to to Select a Particular One Out of an Array of Already Perceived Alternatives, and of course, Kirzner criticizes this view based on his own theory of entrepreneurship and says that this is too narrow because it focuses only on given opportunities and not on the process of perceiving new opportunities, but that's actually a little, that's already taking me away from what I want to talk about.

3:35And then there are other definitions, costs combined with the benefits of our choices, a device that motivates people to take action, or looking at the process more broadly, organisms seek information concerning what activities are rewarded, and then seek to do, or at least pretend to do, those things, often to the virtual exclusion of activities not rewarded. So the most common example of incentives that is implied by these approaches is seen in the simple demand curve. When prices rise, people find ways to reduce the quantity of a good they purchase. In this case, the higher price is the incentive. The incentive provides a gain to the actor associated with some course of action. In the case of increasing prices, reducing the quantity purchased, finding various methods of economizing.

4:22So as you can see from these definitions, the ideas of motivation, self-interest, improving one's welfare are the most obvious themes which unite the literature. And as usual, Mises had already incorporated the necessary ideas into his own work. Mises, in his discussion of felt uneasiness, describes uneasiness as the incentive to human action. The desire to improve his condition is the reason an actor engages in purposeful behavior, and more specifically the reason individuals participate in the division of labor. It is important, though, that this is not uneasiness, it is not uneasiness in general which provides an incentive, but rather a particular uneasiness, a particular want. Mises is sometimes confusing on this point.

5:09Sometimes it appears as if he uses the concept of incentives simply to show that action is necessary in a general sense, essentially equating incentives with scarcity, meaning that incentives in some sense cause action. But that is not his real meaning. And I think a careful reading shows that what Mises was thinking of was, when he discussed his incentives, is concrete choices and not choice as such. But in any case, there is some explicit agreement between these different approaches to incentives. And they do, it seems, get to the core of the issue, provided we take proper account of the basic principles of action. So if we modify some of these definitions, I think we can get a theory which is a bit simpler and clearer, perhaps a bit more Austrian.

5:55And I think the improvements we can make to these approaches tend to take the form of moving the theory of incentives away from the excessively formal aspects of agency theory and toward the more general theory of action. So I would choose to replace some of the other definitions with the following working definition. Incentives are the subjectively perceived gains associated with a particular action of the outcome of achieving a particular end. And we can make other distinctions about incentives too, such as between incentives and disincentives, with incentives being estimated increases in welfare and disincentive being estimated decreases in welfare, but these other distinctions are more terminological than theoretical. So just to clarify certain portions of this definition and their relation to other theories.

6:44Incentives are subjective because of course they possess economic significance in as much as they involve an individual's valuation. When we speak about incentives, we often imply 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. 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. However, the thing that provides the incentive must have certain objective characteristics. Specifically, an incentive can only be provided by those things which are capable of being the object of action. Which means that, to use Menger's terminology, only those things which possess goods character can provide incentives.

7:32Because goods character enables things to be valued in purposeful behavior. This in turn means that general conditions of human action are not incentives. 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. 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. 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. Also, things about the existence of which we do not know cannot be incentives. Because without some idea of cost and benefit, one cannot form the expectation of improving one's position, which is a necessity of action.

8:19If 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. 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. Now, you may notice that this definition of incentives is tied very closely to the concept of ends. As far as individuals are concerned, incentives are distinguishable from ends as much as we can distinguish between an end in itself and the benefits that the end confers on the actor. But it is true, though, that from the perspective of a theory which recognizes purposeful behavior, there's a degree of redundancy in the concept of incentives. Essentially, The only thing we can say about incentives we can already get using the standard terminology of praxeology.

9:21Now, 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. 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. So in terms of effect, the most important point about incentives is whether or not they influence action. Whether or not the benefit offered by a particular action is valued highly enough to become the chosen action. And it is on this ground that we can make the historical distinction between incentives which were successful and those which were not. Successful incentives are demonstrated in action. Unsuccessful incentives are either opportunity costs or are relegated to some lower portion of the value scale, about which we can say basically nothing other than that it exists.

10:09Everything below the first items on the value scale is indeterminate because as Mises points out, the value scale is not independent of action but is expressed through it. We know that other rankings of things take place in some sense, but we can't really say anything about the order of preferences other than, of course, the chosen action and the opportunity cost. Also, if we realize that anything with goods character can potentially provide an incentive, We don't fall into any arbitrary classifications of different types of incentives, such as distinguishing between monetary and non-monetary incentives. Empirically speaking, there are, of course, certain things which are desired more commonly than others, such as money, for example, which because of its function as a medium of exchange, is often useful as an incentive. But from the perspective of pure theory, everything which possesses goods character is potentially an incentive.

10:58And at the same time, no thing possessing goods character is necessarily either an incentive or a successful incentive. It might be useful to compare Austrian and more standard, classical approaches on this point. Specifically, if we take seriously Mises' approach to rationality, then incentives become a much less significant problem than they are in the standard literature. Standard models of economic rationality make incentives deterministic in the sense that incentives provide known increases in costs and benefits, or at least known probabilities of costs and benefits and are therefore easily incorporated into utility and production functions. And human agents are led by the pure logic of choice either to accept or reject certain courses of action based upon the calculus of cost and benefit.

11:45But if we see all action as rational and the costs and benefits are personal and subject to change, that is, if we really take into consideration human action and not just some sort of pure logic of choice, then we see that incentives are not deterministic but are in fact an empirical consideration faced by every actor. Each individual evaluates various ends according to their perceived benefits and chooses the one which is valued most highly. In other words, one of the incentives wins out while the others fail. So inasmuch as individuals value many things, they always face competition between incentives with the strongest or most highly valued being chosen. So the distinction is not, as is sometimes implied by economists, between incentives and non-incentives, so much as it is between successful and unsuccessful incentives.

12:31We ask which particular incentive, a particular estimate of cost and benefit, will be sufficient to make the end more highly valued than all the others. And of course, this is an empirical problem depending on particular circumstances. So when we deal with individual action, incentives are really not distinct from value scales and the estimates of psychic profit and loss which they imply. But incentives take on a new significance when we think of them in terms of social interaction. In this case, we have to consider the compatibility of the incentives of more than one individual. Now, if mutually beneficial exchange is possible, there's really not much of a problem. What makes things interesting is when one party is not interested in making an exchange or contract, then some possible course of action must be introduced, which could provide an incentive for an actor to align his behavior with another's.

13:24Let's say there are two individuals, A and B. A desires B to behave in a certain way that increases A's welfare. But B does not value this course of action highly enough to choose it. So A attempts to provide an incentive for B. He provides something with goods character which he hoped will prove valuable enough to induce B to take the desired course of action. If he succeeds, B will choose the action and we can say that incentives are aligned. And this is essentially the same as any other mutually beneficial transaction. If the incentive is insufficient, B does not behave as A would like, and we can say that incentives are not aligned. Once again, incentives in some form are present for all action. So the situation is one of providing an additional incentive to the already existing competition between incentives and not adding an incentive to an otherwise incentive-less choice.

14:17So there's an important welfare implication of all this. Assuming voluntary action, even Even if A had not provided the incentive, or if he did and B still did not value the desired course of action highly enough to choose it, the welfare of both individuals is still maximized ex ante. So the failure to align incentives is not necessarily welfare decreasing. And perhaps more significantly, when incentives are aligned, what we have is essentially a standard exchange. For example, a principal provides an incentive, something he gives up which he values less is less highly than the results of his agent's behavior. And likewise, the agent exchanges his behavior which is valued less highly for the incentive which is provided to him. If, and of course this is a big if, but if incentives are aligned properly, there is this reverse valuation of means and ends that we see in ordinary exchange theory.

15:09So just to summarize, the way I think Austrians should look at incentives, they're inextricably bound to the notion of valuation and ends in action. and Action. The study of incentives is not, therefore, a branch of economic reasoning or a way of looking at particular problems in economics, as is sometimes implied. Incentives are actually implied in purposeful behavior. Without them, there could be no action, as Mises pointed out. Finally, economists sometimes speak of incentives as if their importance was the final conclusion of economics, when in fact, it's actually the starting point. So thank you for your attention.