Incentives

An employee of a drug dealer decided to make off with one million dollars of the profits. The dealer and his assistant chased the man down to a small town in Mexico. The employee only spoke Spanish, a language the dealer didn’t know but which his assistant did. The drug dealer pulled out his gun and threatened the would-be thief. “Tell me where you hid the money or you’re a dead man.” The assistant translated. The man, fearful for his life, said in Spanish, “It’s under the bridge down by the river.” “What did he say?” the dealer asked his assistant. The assistant hesitated for a minute and then said, “He says he’ll never tell you.”

It’s all a matter of incentives. The assistant realized that his boss wouldn’t know what the thief had said. So by changing the man’s response he got a million dollars. His costs were very low and his benefits very high.

In the world of economics incentives pay a central role. In fact they play the central role. The reason socialism collapsed was that it provided the wrong incentives. Marx said his system of economics was based on the principle, “from each according to his ability, to each according to his need”.

Notice what such a system would do. Those with ability pay out. In other words they are punished for having ability. Meanwhile, those in need are rewarded for being needy. The Marxist system of economics was one guaranteed to destroy ability and increase need. Now such policies may work for a limited time in a wealthy country. But as a long-term policy it’s doomed to failure.

With each year that passes those with ability reduce their productivity or simply stop producing all together. The “needy” meanwhile realize that if they start producing they may not keep more than a very small share of what they produce. So they have no incentive to become productive. Thus the number of “needy” continuously grows while the level of ability continuously declines. And incentives don’t rely on intentions. So even if the people proposing socialist solutions have the best possible intentions nothing will change. The incentives will still remain what they were – non-existent – and the system will eventually collapse. Good intentions aren’t important but good incentives are.

In the world of capitalism the intentions of the capitalist are also irrelevant. The businessman who only cares about his own profit still has to satisfy customers. His main intention may be to increase his own profits. But the way he makes those profits is by selling his product or services to willing customers. And the customers won’t purchase from him unless he keeps them satisfied. His incentive is to produce a good or service that meets the need of others. He doesn’t do it because he enjoys satisfying other people, but by doing it he increases his own well-being. In a free market, he can’t stop competitors. And so he knows that if he doesn’t satisfy his customers, someone else will.

One of the great paradoxes is that the two primary economic systems each produce results that seem in conflict with their moral premises. The socialists want to meet the needs of the most needy yet the result is a system that increases poverty and misery. The capitalists, concerned with their own self-interest, produce greater wealth and prosperity for all.

Extract from The Liberal Tide: From tyranny to Liberty, edited by Jim Peron.

FMF Policy Bulletin/ 5 July 2012