Economics, 3rd Edition

Principle 4: People Respond to Incentives

Because people make decisions by comparing costs and benefits, their behaviour may change when 

the costs or benefits change. That is, people respond to incentives. When the price of an apple rises, for 

instance, people decide to eat more pears and fewer apples because the cost of buying an apple is higher. 

At the same time, apple farmers decide to hire more workers and harvest more apples, because the benefit 

of selling an apple is also higher. As we shall see, the effect of price on the behaviour of buyers and sellers 

in a market – in this case, the market for apples – is crucial for understanding how the economy works.

Public policymakers should never forget about incentives, because many policies change the costs or 

benefits that people face and, therefore, alter behaviour. A tax on petrol, for instance, encourages people 

to drive smaller, more fuel efficient cars. It also encourages people to switch and use public transport 

rather than drive, or to move closer to where they work. When policymakers fail to consider how their 

policies affect incentives, they often end up with results they did not intend. For example, the UK govern-

ment provided tax relief on business premises that were not being used as an incentive to the owners to 

find new uses or owners for the buildings. The government decided to remove the tax relief and sugges-

ted that in doing so there would now be an incentive for owners of premises to get them back into use 

as quickly as possible so that they avoided losing the tax relief. Unfortunately, as the new policy came 

into being the economy was going through a severe recession. It was not easy for owners of premises to 

find new tenants let alone get new businesses created in these empty properties. Some property owners 

decided that rather than have to pay tax on these properties it was cheaper to demolish them. Is this the 

outcome the government wanted? Almost certainly not.

This is an example of the general principle that people respond to incentives. Many incentives that 

economists study are straightforward and others more complex. No one is surprised, for example, that 

people might switch to driving smaller cars where petrol taxes and thus the price of fuel is relatively high. 

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6  PART 1  INTRODUCTION TO ECONOMICS 

Yet, as the example of the removal of tax allowances on empty business premises shows, policies can 

have effects that are not obvious in advance. When analysing any policy, we must consider not only the 

direct effects but also the indirect effects that work through incentives. If the policy changes incentives, it 

will cause people to alter their behaviour.

SELF TEST 

Many people across the EU are without work and claiming benefits. Governments throughout the 

EU are trying to cut spending but find themselves having to spend more on welfare benefits for the unemployed. 

What sort of incentives might governments put in place to encourage workers off welfare and into work? What 

might be the unintended consequences of the incentives you identify?