An incentive is something that motivates an individual to perform an action. The study of incentive structures is central to the study of all economic activities (both in terms of individual decision-making and in terms of cooperation and competition within a larger institutional structure).
Perhaps the most notable incentive in economics is price. Price acts as a signal to suppliers to produce and to consumers to buy. For example, a sale is nothing more than a store providing an incentive to potential customers to buy . The lowering of the price makes the purchase a better idea for some customers; the sale seeks to persuade individuals to change their actions (namely, to buy the product).
Sales are Incentives
Sales are incentives for consumers to buy, because firms know consumers generally respond to lower prices by purchasing more.
Similarly, the increase in price acts as an incentive to suppliers to produce more of a good. If suppliers think they can sell their products for more, they will be more inclined to produce more. The price acts, therefore, as an incentive to customers to buy and suppliers to produce.
Types of Incentives
Incentives come in many other forms, however. Broadly, most incentives can be grouped into one of four categories:
- Remunerative incentives: The incentive comes in the form of some sort of material reward – especially money – in exchange for acting in a particular way. Wages, prices, and bribery are all examples of remunerative incentives. This is the type of incentive that is typically associated with economics.
- Moral incentives: This occurs when a certain choice is widely regarded as the right thing to do, or as particularly admirable, or where the failure to act in a certain way is condemned as indecent. Societies and cultures are two main sources of moral incentives.
- Coercive incentives: The incentive is a promise of some sort of punishment if the wrong decision is made. For example, the promise of imprisonment is a coercive incentive for people to not steal.
- Natural Incentives: Things such as curiosity, mental or physical exercise, admiration, fear, anger, pain, joy, or the pursuit of truth, or the control over things in the world or people or oneself cause individuals to make certain decisions.
Economics is mainly concerned with remunerative incentives, though, when discussing government regulations, coercive incentives often come into play. By manipulating incentives, individuals (and businesses and government) hope to encourage some behaviors and discourage others.
Incentives and Performance
Companies leverage incentives-based strategies to drive performance and optimize employee decision-making and behaviors through meaningful reward systems. While there are both advantages and drawbacks to this type of approach, remunerative (financial) incentives are highly attractive options for employers in a variety of industries and businesses. Providing incentives such as variable income, where an individual can obtain more personal rewards for successfully creating a product or making a sale, often drives up production for highly motivated employees.
An example of this would be a manufacturing facility making widgets. The floor manager shifts the wage system from an hourly wage perspective to a straight piece rate system. Under this system, the more widgets a worker creates the higher his or her prospective income will be. In this situation less productive workers may stay the same but highly productive workers will increase their production as a result of this incentive system.