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Economic Incentives: Definition, Examples & Quiz

Instructor: Shawn Grimsley

What motivates people to work or start a business? In this lesson, you'll learn about economic incentives, related concepts and be provided some examples along the way. You'll also have a chance to reinforce your knowledge with a short quiz.

We also recommend watching Automatic Stabilizers in Economics: Definition & Examples and Expansionary Monetary Policy: Helping the Economy Grow

Definition

Economic incentives are what motivates you to behave in a certain way. Preferences are your needs, wants and desires. Economic incentives provide the motivation to pursue your preferences. Let's look at a basic example. Let's say you want wealth. You are motivated to work because you will be paid, which will help you achieve your preference for accumulating wealth. Of course, economic disincentives discourage behavior. Taxes are a prime example of disincentives because they make products and services more expensive.

Intrinsic Incentives and Extrinsic Incentives

Extrinsic incentives come from outside of a person. These are the typical economic incentives that you probably think about all of the time. Extrinsic incentives include cash rewards, bonuses, income, and profits. However, it's not all about money. External incentives can include such things as peer recognition, fame, social status and power. Some of these incentives will work better than others depending upon your preferences. Someone may care more about social status, for example, than money.

Intrinsic incentives are psychological incentives and are internal to the person. Getting satisfaction from work is an intrinsic incentive. The feeling of making a difference in the world is also an intrinsic motivation - regardless of whether you actually make a difference or not. Sometimes extrinsic motivations will trump intrinsic motivations. For example, the idea of building a home for the poor makes you feel good, but you will gladly accept pay to do it, which ends your spirit of volunteering.

Keep in mind that extrinsic and intrinsic incentives are not mutually exclusive. They can work together. For example, you may not care much about money, but you do tend to enjoy power. You also want to change the world. These two incentives motivate you to pursue a political career - for the power and to do good.

Institutional Use of Economic Incentives

Businesses and governments structure economic incentives to encourage certain behavior. Let's look at government first. For example, the government has decided to tax investment income lower than earned income because it wants to encourage investment and saving. The government also wants to encourage 'family farms,' and have provided subsidies to family farms as an incentive to keep families farming. A city may want to encourage businesses to revitalize its downtown district and offers attractive tax benefits if they locate downtown. Finally, central banks will act affect interests rates to encourage or discourage borrowing.

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