[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

The Incentive Problem
Providing incentives that motivate individuals to make the best choices is one of the
central economic problems. The central problem of incentives, in turn, is that individuals
do not bear the full consequences of their actions. The multibillion-dollar
collapse of many savings and loan associations in the 1980s—though fraud may have
played a part—is attributable largely to incorrect incentives. Because S & L deposits
were guaranteed by the government, depositors had no incentives to check on what
the S & Ls were doing. For the same reason, the owners of many S & Ls had an incentive
to take high risks. If they were successful, they kept the gains. If they failed, the
government picked up the loss.
When there is a misalignment of incentives such as occurred in the S & Ls, we say
there is a problem of moral hazard. The term originated in the insurance industry.
Individuals who purchased insurance had an inadequate incentive to avoid the insuredagainst
event—indeed, if they were insured for more than 100 percent of the loss, they
would have an incentive to bring it about. Though the term was originally associated
with insurance fraud, its use by economists today has no ethical overtones. For example,
an individual who has fire insurance has less of an incentive to avoid a fire. The
benefit to her, for instance, of putting in a sprinkler system may not be worth the
cost—because she need not take into account the expected cost to the fire insurance
company. Thus the fire insurance company is likely to require a sprinkler system; or
it may change her calculations by offering a discount on the premiums of individuals
with such systems, so that it would pay for her to have a sprinkler installed.
In the basic competitive model of Part Two, private property and prices provide
incentives. Individuals are rewarded for performing particular tasks. Incentive problems
arise when individuals are not rewarded for what they do, or when they do not have
to pay the full costs for what they do. In our economy, such problems are pervasive.
In product markets, firms must be given the incentive to produce quality products,
and here, too, information is an important part of the picture. If customers
could always tell the quality of the product they were getting, firms that produced
higher-quality products would always be able to charge a higher price, and no
company could get away with producing shoddy goods.
MARKET SOLUTIONS
In simple transactions, incentive problems can be solved by stipulating penalties
and rewards. For example, many companies need to have goods delivered. They
contract with trucking firms, promising to pay a certain amount if the goods are
delivered safely and on time to their destination. The contract might stipulate how
much will be deducted from the total payment for each day the goods are late or
for any damage that occurs while they are in the truck. The agreement thus has
built-in incentives for the trucking firm to perform adequately.
But most transactions, even relatively simple ones, are more complex than this one.
The more complicated the transaction, the more difficult it is to solve the incentive
problem. Say you want your grass mowed, and your neighbor’s twelve-year-old son
THE INCENTIVE PROBLEM ∂ 337