Incentives Matter

Wednesday, November 7, 2018

Incentives Matter

First day, freshman year of college, Microeconomics 101 class. Two words were written on the white board: Incentives Matter. My professor spent the better part of that first week of class drilling this concept into the minds of a roomful of impressionable 18 year olds. Obviously it worked because it has stuck with me all these years. What I didn’t realize then was how much incentives really do matter in so many aspects of both micro and macroeconomics. The concept of incentives matter simply suggests that people respond predictably to positive and negative incentives. Pretty basic, yes, but also quite profound. Incentives are used to manipulate behavior beginning at a very young age. I tell my 6 year old son to clean his room and I hear, “No” or “I don’t want to” or “not right now.” But if I give him an incentive to clean his room, such as a quarter, or a cookie, or some screen time, suddenly his behavior changes. Economists, policy makers, and business people worldwide understand the power of incentives on human decision making and use them to drive desired outcomes.

Consider the current trade negotiations between the U.S. and China. A tariff, a tax on imports or exports between sovereign nations, is nothing more than an incentive to change consumers’ behavior. President Trump’s use of tariffs is giving manufacturers an incentive to use U.S. produced goods in place of Chinese produced goods. Let’s say a U.S. heavy equipment manufacturer formerly bought Chinese steel at $500 per ton because it was less expensive than U.S. produced steel at $575 per ton. Impose a 25% tariff on Chinese steel, and suddenly the cost of Chinese steel is $625 per ton. You have just given the manufacturer an economic incentive to purchase U.S. steel. The key is that responses to incentives are predictable because people almost always respond in their best interest. 

The most famous example of incentives matter in economics is the idea of the demand curve – when something gets more expensive, people buy less of it. This basic economic tenet is the whole reason things go “on sale” since the lower price gives consumers more incentive to buy. Convenience can also be an incentive to buy….just ask Amazon. Opponents sometimes find the idea of incentives hard to accept, especially when it comes to basic necessities. A cynic may say he still buys gasoline, even when the price goes up. He may still buy gasoline when the price goes up, but he will try to find ways to buy less. Maybe he will car pool, take public transportation, ride his bicycle or put off that road trip. If the price of gas stays high long enough, it may even be an incentive to trade that SUV for a Prius or even cause him to move closer to work.

Sports contracts are often laden with incentives in an effort to motivate players to perform. One of the more interesting sports contract incentives in recent memory involved weight goals for NFL running back Eddie Lacy. I’m not talking about how much weight he could lift, but how much he actually weighed. Following a history of weight issues during his time with the Green Bay Packers, Lacy signed with the Seattle Seahawks in 2017. Lacy’s contract with the Seahawks called for seven weigh-ins during the season, worth a total of $385,000. He simply had to step on the scale each month and collect a check for $55,000 as long as he weighed less than the amount written in his contract. Incentives can be used for good and they can also lead to poor decisions. Consider the Wells Fargo sales practice scandal where Wells Fargo employees opened accounts in customers’ names without their permission in an effort to reach sales targets. Too much of the employees pay was tied to incentives for opening new accounts. Some employees responded poorly, yet predictably, by choosing to do what was in their best interest financially. They got caught and it didn’t end well, but their behavior was driven by incentives.

Incentives are also behind the interest rate policy decisions at the Federal Reserve. In an attempt to jump start the economy amid the fallout from the 2007-2008 financial crisis, the Federal Reserve dropped the Fed funds rate to 0% to provide an incentive for individuals, corporations, and small businesses to continue to borrow and lend. It worked. People responded predictably by refinancing their homes at lower rates and buying new cars (remember Cash for Clunkers?). Corporations responded by issuing billions of dollars of new debt at record low rates. The low interest rates had the exact stimulative effect on the economy that policy makers were hoping for. Low interest rates also gave people an incentive to invest in the stock market. Where investors might have been happy to collect 4% on a CD investment prior to the financial crisis, the 0.25% CD rates following the crisis offered little incentive to keep your money in CDs, money market or savings accounts. So people responded predictably by choosing an alternative that was in their best interest….the stock market. Did 10 years of record low interest rates serve as the fuel for the current decade long bull market run? Intentionally or unintentionally, easy monetary policy most certainly has played a big part in it.

So the question now is, when do higher interest rates eliminate the incentives that are driving economic growth? The Federal Reserve in September issued another ¼ point rate increase, the third of the year and 7th overall since 2017. Two to four more rate increases are expected over the next year. At some point higher rates act as a disincentive and lead to less borrowing, fewer auto purchases, and less home buying. Higher rates will also pull money out of the stock market and back into deposit accounts as rates become more attractive.
I understand why the Fed may feel the need to raise rates, and by as much as they think they can get away with. Because when the next recession comes, they need to have some room to move….enough cushion that they can cut rates and start this whole incentive driven process over again. It’s a delicate balancing act because overly aggressive Fed tightening can be the very cause of a recession. As the Fed considers further rate hikes in an effort to find that “neutral rate” or the perfect balance between stimulative and restrictive monetary policy, here’s hoping they remember that “Incentives Matter”, and people will respond predictably.


Travis McEowen, Portfolio Manager

Investment Management solutions provided by First Merchants Private Wealth Advisors may not be FDIC insured, are not deposits of First Merchants Bank, and may lose value. Investments are not guaranteed by First Merchants Bank and are not insured by any government agency.  This material has been prepared solely for informational purposes. First Merchants shall not be liable for any errors or delays in the data or information, or for any actions taken in reliance thereon. Any views or opinions in this message are solely those of the author and do not necessarily represent those of the organization.