Incentives Matter

A little hobby of mine, that I have managed to get my daughter hooked on to as well, is etymology.

I’ve long held that concepts become more interesting, more relatable and therefore more memorable – in the literal sense of the term – once you’re able to tell yourself a story about the underlying concept. Look up the etymology of the word “average”, for example, and it is likely to be a story you won’t forget in a hurry. By the way, here’s a fun question the daughter asked some months ago, and I’ve been kicking myself for not having thought of it first.

So what is the etymology of the word incentive?

From Medieval Latin incentīvus (“that strikes up or sets the tune”), from incinō (“to strike up”), from in- (“in, on”) + canō (“to sing”).

I like words. I like stories that can be fashioned out of, and about, words. If you click around on the search result that I have linked to, you realize that you can go down quite a rabbit hole about the history of the word incentive. Words such as kindle, singing, and incendiary crop up, and the associations these words can conjure up in one’s mind can result in a very pleasant couple of hours. But the phrase that resonated the most with me was “sets the tune”. It fits nicely with what incentives actually do in real life – they do set the tune on which we are tempted to dance.

Now who sets the tune, for whom, and with what consequences – that’s a whole other story, and practitioners of public policy can tell this tale much better than most other folks. But even outside the always-fascinating drama that is always being staged in the theater of public policy, this story is at the heart of what plays out in applied economics. Who is incentivizing whom, towards what end, and do the incentives end up producing intended or unintended consequences, and at what cost – these are fascinating questions to answer.

My favorite story about getting incentives right comes from Marginal Revolution University:

And my favorite story about getting incentives wrong comes from Calvin and Hobbes:

And that’s the tricky thing with incentives. Getting them right is a surprisingly difficult thing to do. The reason it is a surprisingly difficult thing to do is because of a variety of reasons, but it is possible to start to think about building a framework that one might use to design incentives.

Begin by asking yourself this question: Who is designing the incentive, and for whom?

Let’s begin with a simple example. Let’s say I am designing an incentive for myself. If, I say to myself, I can finish writing the blog post you’re reading right now without taking a break, I’ll reward myself by having a cup of coffee. In this case, I am designing an incentive for myself – I am setting a tune for myself to dance to.

Note two other things about this little incentive scheme:

  1. It is a positive incentive. I am not going to punish myself if I do not finish my designated task – that would be a negative incentive. I am, instead, going to reward myself if I finish my designated task. Think of the old English phrase “the carrot and the stick” to get a sense of what a positive and negative incentive mean.
  2. It is a non-monetary incentive. I am not going to reward (or punish) myself with money. There is no prize money, nor is there a fine. There is, instead, a non-monetary reward – a nice hot steaming cup of coffee. Incentives need not always be monetary!

So, a positive, non-monetary reward to finish a task. What could possibly go wrong? Consider the opening paragraph of Ch. 6 of a lovely little book called In The Service of the Republic:

In 1902 in Hanoi, under French rule, there was a rat problem. A bounty was set—one cent per rat—which could be claimed by submitting a rat’s tail to the municipal office. But for each individual who caught a rat, it was optimal to amputate the tail of a rat, and set the rat free, so as to bolster the rat population and make it easier to catch rats in the future. In addition, on the outskirts of Hanoi, farms came up, dedicated to breeding rats. In 1906, there was an outbreak of bubonic plague that killed over 250 people.

Kelkar, Vijay; Shah, Ajay. In Service of the Republic . Penguin Random House India Private Limited. Kindle Edition.

By the way, the footnote associated with this little tale contains the link to the fuller story, and is worth reading in its entirety. It would appear that the cobra story from India doesn’t have any corroborative evidence. For those who don’t know the background, there is a very similar story from India, only involving cobras isntead of rats. (If you will permit a slight digression: I was telling both of these stories to my daughter, and her only observation was to note that the cobra story was unlikely because “won’t cobras be an example of an apex predator? They can’t grow as quickly as rats, correct?”)

But what can go wrong is what the government in Hanoi discovered – that the person for whom the incentive has been designed may well end up hearing a completely different tune than the one that the designer of the incentive intended. That is, the designer would like you to do x, but you end up doing y instead.

Teachers may set up assignments to incentivize learning, but students are playing a different game. They are looking to minimize efforts in order to maximize marks. Ditto for managers and members on a team in the corporate world. Ditto, as I and my wife have been discovering to our chagrin, for parents and kids! That last bit has been a particularly aggravating discovery, since both my wife and I are economists.

But this phenomenon of incentives not working out as envisaged has an entire “law” of its own, called Goodhart’s Law. This is what it says:

“Any measure that becomes a target stops being a measure”

You’ll find different phrasings of the same idea online, but that’s the simplest way to express the idea. If the measure (to stop the culling of the rat population) is rat’s tails that have been cut off, and you make this the target – well, they stop being a measure of the culling of the rat population!

And that’s why designing incentives is so very tricky. The Indian government found this out to its cost in the aftermath of demonetisation, for example, but rather than look for examples elsewhere, I think you learn about incentives best when you try to think of examples from your own life.

But you cannot – simply cannot – be a student of economics without appreciating both what incentives are, and how difficult it is to design and implement them. The study of this facet of economics will last for your entire life, and you will always find something interesting to learn about it, every single time.

Incentives matter.

Now, if you will remember, I had promised myself a cup of coffee if I finished writing this blog post without taking a break. Goodhart’s law would imply that I would indeed finish writing this blog post without taking a break, but presumably at the cost of either its length, or its quality, or possibly both. I leave it to you to judge if that has been the case.


I’ll go brew that cuppa.

The Higg Index and Incentives

The Higg Index is an apparel and footwear industry self-assessment standard for assessing environmental and social sustainability throughout the supply chain. Launched in 2012, it was developed by the Sustainable Apparel Coalition, a nonprofit organization founded by a group of fashion companies, the United States government Environmental Protection Agency, and other nonprofit entities.

I had no clue that such a thing existed, but it would seem that a lot of apparel stores use this index as a way to advertise the fact that the products that they’re selling have been produced in a sustainable manner.

The Higg Index is spread across three categories: product tools, facility tools and brand and retail tool.

I came across the Higg Index in a New York Times article that warns us about depending too much on an index of this sort:

An explosion in the use of inexpensive, petroleum-based materials has transformed the fashion industry, aided by the successful rebranding of synthetic materials like plastic leather (once less flatteringly referred to as “pleather”) into hip alternatives like “vegan leather,” a marketing masterstroke meant to suggest environmental virtue.
Underlying that effort has been an influential rating system assessing the environmental impact of all sorts of fabrics and materials. Named the Higg Index, the ratings system was introduced in 2011 by some of the world’s largest fashion brands and retailers, led by Walmart and Patagonia, to measure and ultimately help shrink the brands’ environmental footprints by cutting down on the water used to produce the clothes and shoes they sell, for example, or by reining in their use of harmful chemicals.
But the Higg Index also strongly favors synthetic materials made from fossil fuels over natural ones like cotton, wool or leather. Now, those ratings are coming under fire from independent experts as well as representatives from natural-fiber industries who say the Higg Index is being used to portray the increasing use of synthetics use as environmentally desirable despite questions over synthetics’ environmental toll.

I don’t know enough about the Higg Index to able to tell you about whether it ‘makes sense’ or not, but this is a good way to start to think about incentives.

When you meet an index such as this one, some simple questions are worth asking:

  • How long has this index been around?
  • Who created it?
  • Who funds it?
  • Who uses it?
  • What did it replace, and why?
  • Are there other indices that do a similar job?

Try and answer these questions for the Higg Index, for example. The NYTimes article carries a slightly sceptical tone about the Higg Index (but is, ultimately, a balanced take) – once you finish answering these questions, try giving it a read, and then reach your own conclusions about its reliability.

And as usual, the most important lesson of them all: all the other indices that you may have come across, apply the same set of questions!

Chart of the Day: Incentives Matter

Incentives matter:

The explanation is probably simple: opportunity and motive. Part of what makes dictatorships dictatorships is that questioning the official line is dangerous. At the same time, autocratic regimes have a strong incentive to report healthy growth: its absence may be taken as a sign of incompetence or weakness, which dictators can ill afford.
Autocrats’ subordinates face similar incentives. In a related study Jeremy Wallace, a researcher, found misreporting by Chinese provinces, too. As he notes, a leaked American diplomatic cable from 2007 revealed the view of Li Keqiang, the prime minister, then a provincial party secretary. He had said, with a smile, that gdp figures were “for reference only”: he relied instead on proxies, such as electricity use.

Incentives matter is the very first slide in my presentation on Principles of Economics (as it should be). But there’s always more to learn and think about where this deceptively simple idea is concerned, and this chart and the accompanying article from the Economist are a great example about the deceptive bit.

Once you understand the incentives associated with a particular entity in a particular context, you should then learn the art of being appropriately sceptical about their statements. One shouldn’t assume that they’re lying, nor should one assume that they’re telling the truth – one should understand what the incentives are of the person reporting a particular claim, and adjust one’s expectations accordingly.

Incentives matter, and understanding a person’s incentives matters at least as much, if not more.

Like their leaders, citizens in dictatorships often assume they are being lied to. Outsiders should be similarly sceptical.

I’d go one step further, and recommend that while reading, listening or viewing anything, one should keep the incentive of the creator in mind. It makes for a more interesting experience while consuming said content, and you are, at the margin, less likely to be taken for a ride.

Incentives Matter, the International Trade Edition

A chart and a paragraph from The Economist to get us started today. First, the chart:

I’ve been a student of economics for a little more than two decades, and the one thing that is quite familiar to me in this chart is how large China’s share is in US imports (that’s what the “17” at the bottom right of the chart represents. Spend some time going over the rest of the numbers on the right of this chart, and come to the realization that China is about 50% more than all of the other nations on this chart combined.)

Being a student of economics in these past two decades makes it inevitable that some notions of how the world works and functions will get deeply ingrained. And the idea that China will be much larger in everything compared to, often, the addition of all other countries performances has become a useful rule of thumb. Note that I am not advocating forming such a rule for the future – I’m simply saying this has been the case for the past two decades.

But as the Nobel Laureate said, the times, they’re a-changin’:

Yet Mr Trump’s tariffs seem to have played an important role. According to recent analysis of industry data by Chad Bown of the Peterson Institute for International Economics, a think-tank, China’s share of America’s imports rose from 36% to 39% this year in goods not covered by tariffs. For goods subject to a 7.5% tariff, however, China’s share sank from 24% to 18%. And for those hit by a whopping 25% tariff, which covers lots of it equipment, China’s share of imports fell from 16% to 10%. Overall America is now much less dependent on Chinese goods, from furniture to semiconductors. (Emphasis added)

This post isn’t about whether Trump should have imposed those tariffs or not, nor is it about whether those tariffs have been worth it. That is an important topic, but we’re going to skip over it in today’s post. Today is just a reaffirmation of a principle of economics:

When something becomes more expensive, there will be lesser demand for it.

That, of course, is just another way to state the law of demand. You can draw a curve, if you like, or you can phrase it the way I did, or you can write out a paragraph that gives an application of the law, like The Economist did. But the next time you read people opining about whether Policy X will work or not, ask yourself how the incentives have been realigned as a consequence of the new policy.

By how much will demand go down (elasticity), should this policy be implemented or not (geopolitics), and what might be the impact of this policy on China and America and other nations (international trade) are all excellent questions, and they will keep all manner of professionals busy for decades to come.

But again, that’s for another day. Today’s post is about helping you realize that the law of demand is one way to understand incentives, and (don’t stop me even if you have heard this before) it is about chanting a mantra that all economics students would do well to internalize:

Incentives Matter

Incentives Matter, and so do Externalities

In my Principles of Economics classes, I spend a lot of time explaining what I think are the six core principles of economics:

  1. Incentives Matter
  2. There Is No Such Thing As A Free Lunch
  3. Trade Matters
  4. Costs Matter
  5. Information Matters
  6. Externalities Matter

Note that the fifth point is really about prices, which are really about information.

And a recent blogpost by Gulzar Natarajan, one of my favorite bloggers from India, showcases two of these principles really well: incentives, and externalities.

When compared to the task at hand, relocating supply-chains especially from China and attracting global contract manufacturers in various sectors to establish facilities in India, the PLI scheme outlay at Rs 1.97 trillion (~$25 bn) over five years is modest. The scheme extends 4-6% subsidy on incremental sales. However, this is only a small share of the at least 18-20% cost advantage, not to speak of several other locational and supply-chain advantages, enjoyed by manufacturers in China and Vietnam. This coupled with stiff production expansion targets the inevitable bureaucratic difficulties with accessing these benefits mean that the substantive benefits from PLI Scheme are limited. In fact, a recent Bloomberg Intelligence report estimates that it would taken about 8 years to move just 10% of Apple’s production capacity out of China.

The PLI scheme incentivizes the domestic manufacture of products across fourteen sectors, by providing subsidies linked to “incremental sales from products that are manufactured in domestic units”. That quote is from the Wikipedia article about the scheme, which is a good place to begin reading more about PLI.

On the face of it, you might think that Gulzar Natarajan’s take on the PLI scheme is a negative one. Because even if the scheme is fully utilized, it still falls short of China’s 18-20% cost advantage, plus the locational and supply chain advantages enjoyed by China (and Vietnam). In fact, as he goes on to say in the blogpost, “the PLI is unlikely to be substantive enough to be a game changer for India’s manufacturing sector”.

Worse, as a Business Standard article that the author links to points out:

Global players have raised concerns on the slow and complex disbursement process, causing some of them to question whether they want to go ahead with their investment commitments under the scheme. Others are questioning the qualifying criteria. And still others are struggling with the “China factor”.

But neither the Business Standard article, nor Gulzar Natarajan’s blogpost should be construed to mean that the PLI scheme is a failure (not yet, at least). The Business Standard article points out that the silver lining to the rocky start to the PLI scheme is the willingness of the government to listen (about which more later). And Gulzar Natarajan points out that a good way to think about the PLI scheme is to think of it as a complement to marketing campaign of Make in India. If (my emphasis, not GN’s) the PLI scheme is able to “attract the critical mass of a few big contract manufacturers to establish massive manufacturing facilities in the country”, that in and of itself will be a Very, Very Good Thing.

Which brings me to the second principle of economics at play in this blogpost: externalities matter.

This is perhaps an example to avoid evaluating policies based solely on their substantive merits. The circumstances and their externalities matter, and are often more important than the policies themselves. To put this in perspective, if India’s manufacturing sector moves to the next level in scale and productivity towards the later part of the decade, I’m inclined to argue that while the PLI’s contribution by itself would be small (say, less than a tenth), it could not also have happened without the PLI Scheme.
When examining policies, researchers and commentators fail to see the larger context in which they are being implemented. They are blind to the complex theory of change associated with major policies. More often than not, transformational changes in health, education, nutrition etc are not brought about through technocratically designed and targeted policies. Instead they are brought about by community and stakeholder mobilisation, which engenders a virtuous cycle of ownership and engagement, and which can in turn be triggered by standard policies and programs which are effectively implemented. The entire process has space for improvisation and innovation to improve design and implementation quality. (emphases added)

Sure, it is entirely possible that the PLI scheme doesn’t meet its stated aims and targets. But if it acts as a catalyst in terms of better scale and productivity, thereby giving a boost to India’s manufacturing sector in the medium to long term, that would be a great start. That is, the positive externalities wrought by the scheme might end up mattering more – and that is just fine.


If you are a student of economics intending to eventually work in the realm of policy-making, you would well to focus on the phrase “community and stakeholder mobilization”. You can come up with the most well-thought-out policy in the world, but it means nothing if you don’t have a) community buy-in and b) the ability to listen to feedback and rework your policies iteratively.

In The Service of the Republic, Ajay Shah and Vijay Kelkar describe Satya Poddar’s four-step policy process:

  1. Defining the future state, or the preferred policy outcome,
  2. Preparing a blueprint for the design and specification of the future state,
  3. Defining the transition path from the current to the future state, and…
  4. Building political consensus or garnering public support for the change.

Of which, the fourth step is often ignored or downplayed, to the detriment of the whole scheme. Remember, announcing a scheme isn’t policymaking. That’s the easy bit. Making it happen is the real challenge, and that requires having a very sensitive ear to the ground at all times.

And that’s why the willingness of the government to listen matters so much, for the success of the PLI scheme depends (very much so) on our ability to tweak it as we go along.

…the success of the Scheme will depend on how nimble, flexible, and courageous are the relevant Ministries of Government of India in responding to emergent problems and trends and adapting the scheme guidelines(say, in calibrating import duties up the value chain). Policy making will have to become entrepreneurial in being able to reap gains from the PLI Scheme.

Re: the break on the blog (the last post was on the 19th of September): I just felt like taking a break, so I did. 🙂

How Might You Use Incentives in Your Own Life?

It’s all very well to dispense gyaan about incentives, but what is the TMKK?

For those of you new in these parts, TMKK stands for To Main Kya Karoon? Learning about economics for its own sake only make sense in terms of scoring marks in an examination. But a subject truly comes alive when you are able to understand its relevance and importance to your own life – preferably directly, but at the very least tangentially. Don’t get me wrong, I am not at all suggesting that intellectual pursuits for their own sake are not worth it. But I am very much suggesting that the ability to answer a TMKK for oneself makes it much more interesting.

So how should once use incentives in one’s own life?

  1. You can make museum visits less boring.
  2. You can lose weight. I cannot find the reference I’m looking for right now, but Tim Ferriss once spoke about how you can send a truly embarassing pic of yourself to a friend, with instructions to post it on social media by the end of the month – unless a certain amount of weight loss has been achieved. If pics on social media is not your thing, give an amount of money that will truly pinch you to your friend, with instructions to donate it to a cause/political outfit that you truly loathe – again, unless a certain amount of weight loss has been achieved.
  3. What is the Pomodoro technique if not an incentive mechanism? There is more to it, sure, but incentives are certainly involved, no?
  4. If you have a gym buddy, yes, that too is an incentive mechanism. There is another phrase for it – peer pressure. That simply means that it’s not so much about you missing gym, but about the pressure you feel for letting your friend down. But the underlying mechanism? Incentives! In this case, it is a non-monetary, negative incentive.
  5. In my opinion, nobody does gamification using non-monetary incentives better than Duolingo.
  6. Ask ChatGPT3 for more examples! I could have done this myself, of course, but you really should get in the habit of using ChatGPT3 as a tool to do all kinds of research – it’s what you’re going to be doing in your careers in many different ways, so the correct time to get started is yesterday.
  7. Think about examples from your own life where you’ve tried to design incentives for yourself. Ask yourself which ones worked and which ones didn’t, and then ask yourself if we humans treat positive and negative incentives the same way.
  8. Best of all, try designing incentives for somebody in your family. See how they respond to your incentive mechanism, and see if you can iterate it (the mechanism) for the better. If you’re looking for an example – what if you promise to make breakfast in bed for a family member who promises not to look at their phone after dinner throughout the week. Will this work? Try it out! (Note: not a single “I just need to do this one little thing” allowed!). Try the same experiment the next week, but this time, use a “punishment” instead. Say, a fine of a thousand rupees, payable to you, if they break the rule.
  9. If you do “run” the experiment in pt. 8 above, ask yourself if Goodhart’s Law applied.
  10. Get better with every passing week at designing incentives, refining them and implementing them, both for yourself and for others. You’ll be surprised in two regards. First, you’ll be surprised at how easy it is to design better and better incentives. And second, you’ll be surprised to learn that GoodHart’s Law is always applicable. Tricky little beasts, incentives.

Basketball’s 3 Point Line

I’ve lost count of the number of times I’ve rewatched parts of The Last Dance, the documentary on Michael Jordan, and now, in the 40th year of my life, I’ve slowly started to develop more than a passing interest in basketball.

This video, about the 3 point line in basketball, might not resonate much if you haven’t seen a single game of basketball, but I would argue it is worth thinking about how your sport has changed over time, and how players are responding to these changed (non-monetary) incentives.

On The Optimum Level of Cynicism

What level of cynicism is optimal?

What a fascinating question to be asked, and I have had a lot of fun thinking about it. Here are my notes:

  1. An absence of cynicism is certainly not ideal, and although the idea is very tempting to me, neither should one be exclusively cynical.
  2. When I say that the idea is very tempting, I am not joking. Here is the definition of cynicism, taken from Google: “an inclination to believe that people are motivated purely by self-interest; scepticism.”
    People respond to their incentives, in other words. That’s one of the building blocks of economic theory!
  3. But this is one of those cases where I think we economists would do well to think a little bit about philosophical questions, before embarking on economic theory. What are, and what should be, a person’s incentives? These are two very different questions, and economics spends far too much time on the first, and not enough on the latter.
  4. So here’s a first pass answer: given a person’s incentives, one should be a cynic. For example, politicians maximize votes. They don’t do what’s best for folks in the long run. Managers maximize short run profits. And so on.
  5. But one shouldn’t be a cynic, at all, about working towards changing incentives. Giving up on expecting politicians to do the “right” thing, given the status quo, is fine. Giving up on trying to come up with a system that incentivizes politicians better than the status quo wouldn’t be fine, as far as I am concerned.
  6. But that necessarily implies that one should be a very good (and eternal) student of getting the “right” incentives in place.
  7. And being cynical about that would be really and truly depressing 🙂

NAAC Visits and the G20

There is much angst in Pune, about how little time it took for Senapati Bapat Road to look really, really nice.

The G20 summit in Pune concluded recently, and the transformation of the surroundings near where the summit was held was a sight to behold. Neat red markings for a bicycle lane on either side of the road, immaculately painted dividers, spruced up lamp-poles, jazzed up signals, pretty little lights dangling from the many trees that line this road, lovely flowers planted along the median, and a thorough Potemkin-ization of anything deemed even remotely non-presentable – everything was achieved with a speed and efficiency that is scarcely believable.

Although as a true-blue Puneri, it gladdens my heart ever so much to realize that some things will never, ever change:

But this unbelievable improvement in efficency, I’d argue, is very familiar to students who have been in college/University when the NAAC committee has come a-visitin’. It’s the same kind of transformation, and it is equally unbelievable. Flower-pots will appear near entrances, walls will be given a fresh coat of paint, friendly signages will pop up all over campus, washrooms will positively gleam with cleanliness, and the entire campus will look brand new.

Incentives matter.

What happens if you as a citizen complain about, say, a lack of footpaths? You are issued a token, not a footpath. What happens if you as a citizen ask the PMC to repair some broken down traffic signals? You know the answer by now. What happens if those broken down signals are on a road that will be noticed by the G20 dignitaries?

It’s not so much the priority that is missing, which is the only thing I’d correct in Amit’s tweet. What’s missing is the incentive to do the best job possible – when it is the citizens that are doing the belly-aching. When it is the people holding the purse-strings, or the people who call the shots that send along gentle reminders – well, the incentive is clearly present, no?

And that’s why campuses will look their resplendent best during NAAC visits, and that’s why Senapati Bapat Road looks as pretty as it does right now.

Because, alas, incentives matter.

Old timers who have been staying in Sus village for years will regale you with stories of how roads become as smooth as silk literally overnight come the month of December, year after year. It’s the same ol’ story, with the same ol’ underlying reason: incentives matter.

Which begs the question: how can we get the incentives of the PMC to be aligned with our interests? Answering the question is easy. Implementing it? Ah, that is beyond the scope of this blog, for now.

Also, note that this has nothing to do with the BJP, or the Congress, or AAP, or indeed with any Indian political party. We aren’t unique as a nation in this regard, and no political party in our country is uniquely good (or bad) in this regard. All political parties in all nations are staffed with members of the same species that you and I belong to, and we all respond in much the same way to incentives. So please, don’t attack or defend whichever political party you have in mind.

One good thing about the principles of economics is that they work the same way on everybody, everywhere. The sooner we realize this, the better it will be for all of us.

The Big Misconception about Clean Energy

Related to this past Monday’s post (plus, a great application of incentives matter – the carrot and the stick approach):