Economic Incentives: Foundations of Free Enterprise

The Foundations of Free Enterprise
by Allen, Armstrong, and Wolken

Economic Incentives

We noted previously that all of us want to improve our own well-being. We strive to improve the quality of our lives. Businessmen seek high profits. Property owners want the highest price possible for their resources. Workers seek the highest salary possible for a given occupation. Consumers search for the lowest price for a given product. In the free enterprise system economic incentives help us determine which course of action will be most beneficial to us. Throughout life incentives encourage us to do certain things. Suppose a child’s parents offer him a certain amount of money each week to carry out the garbage. He is more likely to do it than if he were not rewarded. Nearly everything we do involves some incentive. Even something as simple as brushing our teeth. Many of us would put it off if we did not have the incentive of avoiding a painful visit to the dentist.

The desire to improve our well-being stimulates us to work efficiently and productively. We do this because efficient and productive work usually provides us with greater rewards. We can then use these rewards to live better. For example, an automobile mechanic who works quickly and efficiently can service more cars during a day’s time and so earn more than a slower, less efficient mechanic. In most instances these are money rewards in the form of increased wages. But rewards may take other forms. For example, we might receive better working conditions, a new office, an assistant, or even a promotion. Receiving these rewards indicates that we are answering the “what to produce” question properly. We are taking a scarce resource, our labor, and producing a service valued by other members of society. These rewards act as a signal to each of us in deciding how to best use our labor. But they are only signals, not commands. As mentioned earlier, we have the freedom to choose whatever job we want and how hard we want to work.

Businesses too may receive rewards. Once again, these are usually money, in the form of profit. Profit signals the business that it is properly answering the “what to produce” and “how to produce” questions. It is channeling scarce resources into a product that individuals want at a price they are willing to pay.

The system of incentives also includes punishments. We may face unpleasant consequences when we fail to do something. A painful visit to the dentist because we didn’t brush our teeth regularly is a good example. In a free enterprise system, punishments usually take the form of losses (or failure) for businesses and low salaries (or perhaps unemployment) for individuals. They indicate that the “what to produce” and/or the “how to produce” questions are not being answered properly. The business or individual is using scarce resources to provide too much of a product or one not wanted at all.

For this incentive system to operate, there must be a minimum of outside interference. Unless individuals and businesses are permitted to enjoy the fruits of their efforts, they have little reason to produce, thus reducing the potential size of the pie.

The system of incentives is an extremely important feature of free enterprise. Without incentives, we tend to sit back and let someone else do the work. The promise of rewards stimulates employees to produce more and employers to use resources efficiently. We are willing to do this because we, personally, benefit from it. Economic incentives also serve to direct scarce resources to the production of the goods and services we value the most.