Incentive

In economics, an incentive in anything that provides a motive for a particular course of action — that counts as a reason for preferring one choice to the alternatives. Since human beings are purposeful creatures, the study of incentive structures is central to the study of all economic activity (both in terms of individual decision-making and in terms of cooperation and competition within a larger institutional structure). Economic analysis, then, of the differences between societies (and between different organizations within a society) largely amounts to characterizing the differences in incentive structures faced by individuals involved in these collective efforts.

Incentives can be classified according to the different ways in which they motivate agents to take a particular course of action. One common and useful taxonomy divides incentives into three broad classes:

1. Remunerative incentives (or financial incentives) are said to exist where an agent can expect some form of material reward — especially money — in exchange for acting in a particular way.
2. Moral incentives are said to exist where a particular 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. A person acting on a moral incentive can expect a sense of self-esteem, and approval or even admiration from her community; a person acting against a moral incentive can expect a sense of guilt, and condemnation or even ostracism from the community.
3. Coercive incentives are said to exist where a person can expect that the failure to act in a particular way will result in physical force being used against her (or her loved ones) by others in the community — for example, by inflicting pain in punishment, or by imprisoning her, or by confiscating or destroying her possessions.

The study of economics in modern societies is mostly concerned with remunerative incentives rather than moral or coercive incentives — not because the latter two are unimportant, but rather because remunerative incentives are the main form of incentives employed in the world of business, whereas moral and coercive incentives are more characteristic of the sorts of decisions studied by political science and sociology. A classic example of the economic analysis of incentive structures is the famous Walrasian chart of supply and demand curves: economic theory predicts that the market will tend to move towards the equilibrium price because everyone in the market has a remunerative incentive to do so: by lowering a price formerly set above the equilibrium a firm can attract more customers and make more money; by raising a bid formerly set below the equilibrium a customer is more able to obtain the good or service that she wants in the quantity she desires. Similarly, the study of the effects of monopoly or perfect competition on market prices can be seen as an analysis of the different remunerative incentive structures created by different market conditions: in a monopolistic market, monopoly profits give the monopolistic firm a significant incentive to set prices above equilibrium; whereas in conditions of perfect competition there is no remunerative incentive for a customer to accept a good at a higher price than the equilibrium price (and thus there is an intense incentive for firms to sell at the equilibrium — customers have no incentive at all to buy at above the equilibrium price, so firms that set prices above the equilibrium will make no money at all).