Economic Incentives Definition Example Pros And Cons

Economic Incentives Definition

Economic incentives can be intrinsic or extrinsic based on the source of motivation. It has huge macro-economic effects, like stimulating commercial activity and increasing people’s participation. It allows the government to keep control of the economy and helps businesses increase sales. Common incentives include salaries, subsidies, tax credits and rebates, discounts, etc.

Key Takeaways

Economic incentives are rewards that influence the citizens’ or consumers’ behavior by delivering financial motivation. It can be anything related to cash like discounts, cash back, etc., or a move with an indirect monetary value like selling complementary products or extra quantity for free.There are two types of economic incentives- intrinsic and extrinsic. The former is related to an individual and their beliefs, whereas the latter is concrete and comes from outside, like money.Incentives are extremely beneficial to the economy but have their downsides, too, like increased tax burden on people, difficulty in ascertaining effectiveness, etc.

Economic Incentives Explained

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Economic incentives approach is a common practice adopted by governments and businesses. It is a strategy through which financial impetus is provided to the general public to stimulate the desired action.

For example, consider a company ABC, which introduces a new printer model. As a pre-launch offer, it decides to provide 40% cashback to the first 100,000 customers. It is an attractive offer, and customers buy the printer. Here, the cashback is the incentive or the reward.

But it doesn’t mean that economic incentives always have to be financial rewards, it just needs to have a significant monetary value. Like, in the example mentioned above, if the company decides to offer ink cartridges for free with every printer, that too will be sufficient to encourage purchases because the two items are complementary, and again the cartridges have a monetary value.

Similarly, take the case of a country X, which deals with population issues. On average, every couple has three kids in the country. With the growing population, the government encourages the single-child policy by taking up the child’s educational expenses until under-graduation. It assures parents about the security of their child.

Economic Incentives from the government

Economic incentives are largely associated with the government and its activities. For example, the government often provides subsidies to citizens to take up a certain course of action they recommend. For instance, governments incentivize manufacturing firms that use renewable energy sources.

As a result of this motivation, people are interested in adopting the measures suggested by the government. There are economic incentives for environmental protection, agriculture, renewable energy alternatives, electric vehicles, etc., provided by the government. Some countries even give incentives to a single girl child.

But the government is not just involved in propelling economic activity; sometimes, it restricts activity too. It is done through economic disincentives, which discourage consumption or production. For example, suppose the country has high inflation, and the government increases the interest rate on borrowings to reduce public consumption.

Economic incentives may not always be positive. Sometimes the government or organizations can also punish people in a certain way for their choices. Fines and penalties like those implemented for carbon emissions are an example.

Example

Consider the following example of economic incentives to understand the concept better.

This is a real-life example of economic incentives for environmental protection. The high installation and maintenance costs of solar panels and batteries discourage many users from adopting the technology. So, the United States government provides tax credit facilities to citizens who install solar power systems at home.

With tax credits, a percentage of income tax is credited to the citizens, which reduces the total tax amount. As a result, it can serve as a major push for prospective consumers to install solar panels. According to Forbes estimates, in 2023, consumers can expect a tax credit rate of 22 – 26%. In 2021, the discount rate was averaged at 26%.

Advantages and Disadvantages

Economic incentives can be largely beneficial to society. It helps manage the economy and keep it under control. Incentives by businesses can be advantageous to both the consumers and firms. Government subsidies encourage people’s participation in the economy and reduce inequality by supporting the needy.

However, that is just one side of the coin. Incentives have negative implications too. Firstly, it increases government expenditure considerably, which leads to increased taxation and national debt. Secondly, the efficiency of transferring these incentives to the people in developing and under-developed countries is debatable. Thirdly, businesses that offer incentives might exploit people and reap profits.

It is also rather complex to measure the extent of success of incentivizing national goals. In some cases, it might even lead to monetary loss for the government. Consider the example discussed above. A couple, Jane and John, are parents to a single child, Kate. For the past ten years, they have been receiving subsidies from the government. But recently, they found out that they were expecting another child. Here, the incentives provided for the last ten years would be a loss for the government, as it couldn’t reach its goal.

Economic Incentives backfiring

Lastly, incentives can backfire. But to understand how this happens, it is important to be familiar with the two types of economic incentives – intrinsic and extrinsic. Intrinsic incentives are internal to a person and deal with an individual’s philosophy and beliefs. For example, charity is a type of intrinsic incentive purely motivated by a person’s mindset or belief system. On the other hand, extrinsic incentives come from outside sources and often have huge monetary value, motivating people through offers, discounts, etc.

According to Harvard Business Review, extrinsic incentives backfire when it conflicts with intrinsic incentives. Let’s consider the example provided by social researcher Richard Titmuss. People donate blood because it makes them feel valuable and of service to society. However, if the government puts a price tag on it and subsidizes people who donate blood, some would lose their motivation to do so, as it is against their ethics or because they do not want others to believe that they did it for the money. Hence, the effort to motivate becomes the villain here.