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

INCENTIVES
It is one thing to say we all face trade-offs in the choices we make. It is quite another
to understand how individuals and firms make choices and how those choices might
change as economic circumstances change. If new technologies are developed, will
firms decide to increase or decrease the amount of labor they employ? If the price
of gasoline rises, will individuals decide to buy different types of automobiles?
When faced with a choice, people evaluate the pros and cons of the different
options. In deciding what to eat for dinner tonight, you and your roommates might
weigh the advantages and disadvantages of having a frozen pizza again over going
out for sushi. Similarly, a firm evaluates the pros and cons of its alternatives in terms
of the effects different choices will have on its profits. For example, a retail chain
deciding on the location for a new store must weigh the relative advantages of different
locations. One location might have more foot traffic but also higher rent.
Another location might be less desirable but have lower rent.
When decision makers systematically weigh the pros and cons of the alternatives
they face, we can predict how they will respond to changing economic conditions.
Higher gas prices raise the cost of driving, but the cost of driving a fuel-efficient car
rises less than the cost of driving a sports utility vehicle. Therefore, households weighing
a car purchase have a greater incentive to choose the fuel-efficient car. If a firm starts
selling more of its goods through the Internet, it will rely less on foot traffic into its
retail store. This shift reduces its incentive to pay a high rent for a good location.
Economists analyze choices by focusing on incentives. In an economic context,
incentives are benefits (including reduced costs) that motivate a decision maker in
favor of a particular choice. Many things can affect incentives, but among the most
important are prices. If the price of gasoline rises, people have a greater incentive to
drive less. If the price of MP3 players falls, people have a greater incentive to buy one.
When the price of a good rises, firms are induced to produce more of that good, in
order to increase their profits. If a resource used in production, such as labor or
equipment, becomes more expensive, firms have an incentive to find new methods
of production that economize on that resource. Incentives also are affected by the
return people expect to earn from different activities. If the income of college graduates
rises relative to that of people with only a high school diploma, people have a
greater incentive to attend college.
When economists study the behavior of people or firms, they look at the incentives
being faced. Sometimes these incentives are straightforward. Increasing the
number of courses required to major in biology reduces the incentive to pick that
major. In other circumstances, they may not be so obvious. For example, building
safer cars may create incentives to drive faster. Identifying the incentives, and disincentives,
to take different actions is one of the first things economists do when
they want to understand the choices individuals or firms make.
Decision makers respond to incentives; for understanding choices, incentives matter.
Trade-offs and Incentives in Practice: Online Music Sharing Since
1999, when Napster introduced the first file-sharing program that allowed users to
swap music files over the Internet, the practice has been embroiled in controversy.
On one side is the music industry, which views the sharing of music files as an ille-
8 ∂ CHAPTER 1 MODERN ECONOMICS