People respond to incentives

Steven Landsburg begins his book Armchair Economist with the statement, "Most of economics can be summarized in four words: 'People respond to incentives.' The rest is commentary."

That seems a rather different beginning than that given in most introductory textbooks, which stresses that economics is about scarcity and choice. However, on closer examination, Landsburg's statement may tell us more and at the same time incorporate the insights of the scarcity-choice definition.

When economists talk about incentives, they are thinking that people respond to costs and benefits. When the cost of something rises, people use or do less of it, while when the benefit of something rises, people use or do more of it. Rational people should not act if the benefit of acting is less than the cost, and they should act if the benefit of acting is greater than the cost.

A benefit is something that makes a person better off. How do we decide if something makes a person better off? Economists take an Aristotelian approach on this question. They assume that people have goals, though unlike Aristotle, they do not spend much time trying to evaluate whether those goals are desirable or not. Actions that move a person closer to achieving their goals are benefits.

Notice that it is the individual who decides what his or her goals are, not some authority. Economics assumes that people know what is best for themselves, that is, that people should be allowed to choose for themselves what their goals are. This is not an assumption that everyone makes. In addition, by assuming that people are goal-seeking, we are also implicitly making the assumption that people are self-interested. You might think that someone could decide that their goal was to do whatever was best for humanity, and they might. But the limits to our knowledge and ability to process information make this a goal beyond the capability of anyone to actually put into practice.

What about costs? The cost of anything is what you have to give up to get it. Often this is measured in money. When we say that something costs $5.00, that means that when you spend $5.00 to get the item, you cannot use that $5.00 to purchase some other item. Often cost includes time. If to get an item one must pay $5.00 plus wait fifteen minutes, the cost of the item includes both money and time.

Why is there any cost at all? In a world without cost, we would not need to give up anything, and there would be no need to make choices. In a world without choice, there would be no incentives. This world without incentives is the world of abundance, a world without scarcity. And this insight brings us back to the traditional definition of economics, which is that it is the study of how people make choices in a world of scarcity.