Principles of Economics, Principle 4: People Respond to Incentives

Principle 4: People Respond to Incentives
• An incentive is something (such as the prospect of a punishment or reward) that
induces a person to act. Because rational people make decisions by comparing costs
and benefits, they respond to incentives. You will see that incentives play a central
role in the study of economics.
• One economist went so far as to suggest that the entire field could be summarized as
simply “People respond to incentives. The rest is commentary.”
• Incentives are key to analyzing how markets work. For example, when the price of
an apple rises, people decide to eat fewer apples.
• At the same time, apple orchards decide to hire more workers and harvest more
apples. In other words, a higher price in a market provides an incentive for buyers to
consume less and an incentive for sellers to produce more.
• As we will see, the influence of prices on the behavior of consumers and producers
is crucial to how a market economy allocates scarce resources.
• When analyzing any policy, we must consider not only the direct effects but also the
less obvious indirect effects that work through incentives. If the policy changes
incentives, it will cause people to alter their behavior.