Freeman

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The Economic Way of Thinking, Part 5

Incentives Explain Seemingly Irrational Human Behavior

FEBRUARY 01, 1994 by RONALD NASH

Dr. Nash, a contributing editor of The Freeman, is professor of philosophy at Reformed Theological Seminary in Orlando. His many books include Poverty and Wealth (Probe Books) and Beyond Liberation Theology (Baker Books).

We are now half-way through our eight part introduction to economics. During the course of this essay and the three to follow, we will examine four important principles of the economic way of thinking.

One of the more valuable things I’ve learned in life is the importance of viewing economics not so much as a set of doctrines or conclusions, but as a distinctive way of thinking. The principles that underlie the economic way of thinking are not difficult to grasp; they are often matters of common sense. Anyone who is unaware of these principles will not only have difficulty understanding why some things are true in economics, but also why people behave the way they do.

I will introduce the first principle of the economic way of thinking with two accounts of human behavior that don’t seem to make much sense, until analyzed in light of our first principle. I will follow my examples with a brief explanation of this principle and then show how understanding that principle can help us understand human action that at first glance appears bizarre or irrational.

How Not to Fly from California to the East Coast

A year ago, a friend and I found ourselves at the John Wayne Airport in Southern California, waiting to board planes that would take us back to our homes on the East Coast. Being a rational person, I of course would be changing planes in Dallas, en route to Orlando. I assumed that my friend would be doing the same. To my great surprise, he told me that he would be making his connecting flight in Minneapolis!

Not wishing to appear impolite I decided not to ask him why he was doing something so irrational. But I hoped my friend would make it since he would find the Minneapolis airport suffering from a midwinter blizzard.

What Not to Order for Breakfast at Bob Evans

Ordinarily, I enjoy eating breakfast at Bob Evans’s restaurants. I usually order fried eggs, over medium, with crisp bacon, wheat toast, and coffee. But on a recent Friday, I entered a Bob Evans and while waiting for the waitress, surveyed the food on the plates at adjoining tables. The lady to my left had a big stack of pancakes plus a side order of that great bacon. The fellow behind me had the bacon and eggs. But when the waitress came for my order, I requested a bowl of oatmeal. Not only that, I asked her to hold the brown sugar; I would use artificial sweetener. A bit later, the waitress noticed the tears dropping into the oatmeal and asked if my “breakfast” was all right.

A week later, I walked briskly into the same Bob Evans and without even looking at the menu ordered my bacon, eggs, toast, and coffee. There were no tears that day!

What Was Going on Here?

All of us have seen others behave in ways that seemed irregular, unusual, or even irrational. No doubt, most of us have acted in ways that other people have found peculiar; I know I have.

However, students of the Austrian school of economics know that whenever people are acting, that is, behaving in ways that reflect conscious thinking and choices, their actions are always a function of several factors: (1) the unavoidable fact of scarcity in life; we can never have everything we want. (2) the need to make choices; because we cannot have everything we want, we must choose among available options, and (3) the subjective ranking we place upon the choices open to us. Whenever people act (as opposed to simply responding to stimuli), they are always choosing the option that ranks highest in their personal scale of values at that time.

In cases where it is impossible for someone to have both A and B, a person’s choice will reflect the relative value he places upon A and B. People’s actions, then, are a reflection of their value scales. Their choices are made in order to help them secure the alternatives that accord more closely with their values.

The value that different people place upon different economic goods (such as having oatmeal for breakfast or changing planes in Minneapolis in the dead of winter) varies from person to person. I would never change planes in Minneapolis when flying from Southern California to Orlando. Possibly you would never order oatmeal in a Bob Evans restaurant. People’s value scales are personal and different. It would be highly unusual ever to find two people who ranked every economic good in precisely the same way.

What’s important to understand is that while a person’s behavior may appear strange or even irrational to someone else, that action is not irrational to that person. In some way, it makes good sense to one person to change planes in Minneapolis or to have oatmeal one day and then bacon and eggs a few days later.

All of this brings me to the major question of this little essay: Is there a principle of the economic way of thinking that explains the apparently odd behavior in our two examples? There is.

The Importance of Incentives

One principle draws attention to the importance of incentives. The greater the benefits people expect to receive from an alternative, the more people are likely to choose that option. The greater the costs expected from an alternative, the fewer people are likely to select it. If we understand what makes human beings tick, we can make general predictions as to how individuals or groups of individuals will respond to changes in their economic situation—in particular, how they will respond to new incentives.

Let’s look first at what I regard as my utterly rational selection of oatmeal for breakfast. What I didn’t state earlier was the fact that the following Friday I was scheduled for one of an ongoing series of blood tests. About a week before each of these tests, I begin altering my eating habits. Some people might think I’m simply trying to fool my doctor so he won’t prescribe new medication or perhaps give me a stern lecture. If that were true, I might well be guilty of being irrational in a different sense of the word. But my action would still be rational in the sense that I was behaving in a way to help achieve an important goal. My action a week later when I ordered my usual bacon and eggs reflected the fact that I had had my blood test and could celebrate the good results.

But what about my strange friend who changed planes in Minneapolis? As I pondered his peculiar behavior on my own flight to sunny Dallas, I remembered that he used to live in Minneapolis. Is it possible that he retains some strange obsession with Minneapolis, such that he breaks out in hives unless he visits the place every so often? I ruled that out. Were friends going to meet him for a brief visit at the airport? Since the city was suffering through a blizzard, that seemed unlikely. Then I saw the light!

During all the years he had lived in Minneapolis, the airline he had to fly most often was Northwest. A rational man such as he undoubtedly had a frequent-flyer account with Northwest. The explanation for his apparently bizarre choice was now obvious: He had to change planes in Minneapolis in order to add mileage to his Northwest account. He ranked that high enough in his personal scale of values to incur other costs, such as the possible inconvenience of bad weather in Minneapolis. Incentives matter! If you give people incentives that match their present ranking of values, they will likely select options that reflect those incentives. In my friend’s case, he chose Northwest Airlines over American or Delta. In my case, I chose oatmeal over eggs and bacon.

Are the Politicians Listening?

It seems all too apparent that American politicians do not know much about economics. It also seems obvious that they are uninformed about the principles of the economic way of thinking. In this case, they show an obstinate disregard for the importance of incentives when they frame public policy.

When our society establishes programs that provide unemployed people with benefits that approximate or even exceed what they would earn working (after taxes), one can safely predict that many of these people will choose not to work. When a welfare program provides incentives for unmarried women who become pregnant to remain unmarried, we should not be surprised when the illegitimacy rate begins to increase. When minimum wage laws give employers incentives not to hire unskilled employees, we should not be surprised when the rate of unemployment for such workers goes up.

In economics, you get what you pay for. If you give people incentives to do A rather than B, the number of people who choose A—all other things being equal—will increase. Of course, this principle holds lessons for more than just politicians. If we reflect more on what makes us tick, our own actions will become clearer to us. We’ll also gain new insight in how to have a more positive influence on the choices made by others.

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February 1994

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