Understanding Incentives in Economics: 5 Common Types of Economic Incentives

In the most general terms, an incentive is anything that motivates a person to do something. When we’re talking about economics, the definition becomes a bit narrower: Economic incentives are financial motivations for people to take certain actions.

There are two types of incentives that affect human decision making: intrinsic and extrinsic.

• Intrinsic incentives. Intrinsic incentives come from within. That is, a person with an intrinsic motivation wants to do something for its own sake, without an outside pressure or reward. Intrinsic incentive is that feeling of personal fulfillment and satisfaction that people get from doing certain things, like learning a new skill just for the fun of it.
• Extrinsic incentives. Extrinsic incentives involve providing a material reward (like money) for accomplishing a task, or threatening some punishment for failure to do so. By definition, all economic incentives are extrinsic motivations.

The most common type of economic incentive system is payroll: A paycheck motivates people to show up to work and perform their duties. Yet there are other types of economic incentive structures as well. Here are five common examples.

1. 1. Tax Incentives. Tax incentives—also called “tax benefits”—are reductions in tax that the government makes in order to encourage spending on certain items or activities. Tax incentives are often cited as a great way to encourage economic development. For example, a common individual tax exemption in the United States is the mortgage interest deduction, which ensures money paid toward mortgage interest isn’t counted as taxable income. This incentivizes people to buy property. An example of a corporate tax incentive is a government giving a major company tax breaks in exchange for them building an office or plant in their city. This type of tax incentive stimulates the economy in that area by empowering the company to provide jobs, as well as make goods or services available for purchase.
2. 2. Financial Incentives. A financial incentive is a broader term that encompasses any monetary benefit given to a consumer, employer, corporation, or organization in order to incentivize them to do something they might not otherwise do. For employees, a financial incentive might include stock options or commissions that encourage certain types of work (think of salespeople, whose commission is considered a sales incentive). For customers, an example of a financial incentive is a discount, like a buy-one-get-one-free sale, which encourages more spending under the guise of saving.
3. 3. Subsidies. Subsidies are government incentive programs that provide set amounts of money to businesses in order to help them grow. Agricultural subsidies are common in the United States, with the federal government giving farmers billions of dollars both to farm more of certain products and to reduce their outputs in times of surplus. Agricultural subsidies aren’t the only type of U.S. government subsidy, of course. Others types of government subsidies include: oil, ethanol, export, environmental, housing, and health care.
4. 4. Tax rebates. Tax rebates are incentives to take certain actions, like investing in solar energy, for example. In the case of renewable energy tax rebates, a state or local government offers a certain amount of money to consumers to purchase more environmentally-friendly methods to generate electricity. For instance, a city might offer any homeowner who pays to install solar panels on their roof a check for $1,000.
5. 5. Negative incentives. Negative economic incentives, or disincentives, punish people financially for taking certain actions. This is a way of encouraging specific actions without making them compulsory. For example, the Affordable Care Act was designed with a built-in negative economic incentive called the “individual mandate,” which penalizes anyone who doesn’t buy health insurance with a monetary fine at tax time.

A fundamental assumption in economics is that people will almost always act in a way that will improve their economic standing. In other words: people respond to incentives. Thus, knowledge of the different types of incentives—and what incentives might exist on either side of any economic transaction—can help you understand how economies work.

To see incentives in action in economic theory, consider the theory of wages and profit, developed by Victorian economist David Ricardo. This theory helps explain the underlying human desire to seize opportunities for improved economic standing.

• Ricardo articulated his theory of wages and profit to understand how landlords and farmers negotiated rents.
• Farmers want to cultivate the best possible land, where they can raise the most crops. Landlords want to charge the highest rent that farmers will be willing to pay. What then determines how much produce a farmer will have to pay to his landlord in rent and how much he will get to keep for himself? Ricardo reasoned that all farmers would get to keep an amount roughly equal to what could be produced on the worst plot of land under cultivation. Any amount over would be paid in rent to the landlord.
• Why? Suppose a landlord tried to charge so much rent that the farmer actually ended up with less than he could produce on the worst plot of land. In that case, the farmer could get a better deal by offering a very tiny amount to rent land that was so bad no one was currently cultivating it. The owner of that uncultivated plot isn’t receiving any rent now, so even a tiny amount of rent makes him better off. Thus, the farmer leaves his old landlord and rents the uncultivated plot.
• On the flip side, suppose another farmer demands that his landlord lower the rent, so that the farmer can keep more than what could be produced on the worst plot of land currently under cultivation. In that case, the landlord can threaten to evict his current farmer and rent the plot out to whoever is farming the very worst plot of land instead.
• The opportunity for farmers to find a new landlord or landlord’s ability to find a new farmer keeps the income of all the farmers roughly the same. They all fall in a fairly narrow range around the amount that a farmer could produce on the worst plot of land. Neither the actual productivity, nor the actual needs of any individual farmer plays much of a role in determining his income. His income is set by the quality of a plot of land that might be very far away, farmed by someone he will probably never meet.

A fundamental insight at the heart of economics is that people respond to incentives. Obvious opportunities to be better off are rarely left unexploited. While Ricardo may have named the theory, the underlying concept is a fundamental human behavior that explains why people choose to pursue everything from fortune and fame to personal fulfillment.

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