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Bulletin of the ERI, 2008/09 no. 1

Contents: November 2008

Incentives

    People respond to incentives. The current credit crisis, for example, has a lot to do with regulators and firms providing inadequate or badly designed incentives to financial sector employees. Until recently, policy makers did not recognize this or chose to ignore it. The financial regulations and institutional framework shape the incentive structure that "players" in financial markets face. These now need to be redesigned.

    While economics is concerned with the allocation of scarce resources, it is equally about incentives. Laws, regulations, norms, and institutions create incentives for people to behave in one way rather than in some other way. Economists study the positive question of what incentives are created by different rules, norms, and institutions.

    Economists also study the normative question of what rules, norms, and institutions can provide "good" incentives that lead people to behave in ways that are desirable. For example, divorce rates have increased in several countries. To address this problem, economists study how divorce legislation and social policies shape incentives for couples to seek divorce rather than make a marriage work. Of course, this problem is about more than just incentives, but incentives have a big role to play.

    The world faces serious problems such as poverty and deprivation, poor health and education, economic and social backwardness, violence and political instability. All require careful design of the laws, regulations, and institutions that create incentives for the various players – politicians, bureaucrats, managers, employees, firms, and NGOs – to behave well.

    In addition, we should not forget that incentives that are provided to some people may affect how they provide incentives to others. For example, the bonuses that rewarded bank employees for selling mortgages to people who have turned out to be unable to afford them were shaped by the encouragement that politicians and regulators gave to bank executives to undervalue the risks in the housing market.

    In sum, incentives matter. Much of economics is about incentives. The current disarray in the world economy shows we need better understanding of how incentives work, how they are established, and how they are passed on in regulated markets and organizations.

    Abhinay Muthoo

    Abhinay Muthoo is director of the Economic Research Institute and chair of the Department of Economics.