04 April 2011

Incentives

MW asks:
You talk about the economic vs. engineering side - engineers have solutions like drip irrigation, but a lack of incentives to ensure they are implemented - thus the economic picture. But in my line of work (energy efficiency) it is acknowledged that humans often do not work in their economic or other rational self interest, especially if it involves doing or learning something new. We are often primarily motivated by emotion (maybe more so at an individual consumer level and less at a business or government level - but organizations are a sum of their parts and getting schools or businesses to be more energy efficient, even when cost effective, can be just as hard if it is not part of the mindset of the decision maker already ).

So even though most people could make numerous economically sound energy efficiency improvements in their lives (more insulation in the attic, etc), most of these opportunities go untaken (yes, some of this barrier is still economic - like the split incentive of the landlord tenant relationship - who makes the improvement and who gets the $ benefit??).

A recent example: electricity is subsidized for some rural Alaskans by the state such that the residential consumer gets the first x kWhs per month for $.18/kwh, then after that the rate jumps dramatically (to $.55/kwh or so) (some for cheap, pay for more). Apparently, many consumers are not aware of this or fail to take it in to consideration and routinely are hit with huge bills - cases where a 20% higher usage means a bill over twice as much. These are not people that can afford to blow the money.

Twenty percent reductions in energy use, of course, are within the realm of easy energy efficiency or conservation measures. This points to the education/information barrier to adopting even economically advantageous options, but there are other barriers as well - the emotional nature of making decisions mean that people want to do what is popular, fun, easy, etc.[1]

So you are an economist, and of course your job is to think about that side of things, but do you have thoughts on the 'beyond economics' part of motivating behavior change? People selling things do it by manipulating the price of their goods, but then also by advertising to appeal to the emotional decision making part of people.[2]

How big does an economic advantage need to be to motivate conservation, and what is the nature of the correlation between economic signal and conservation, especially compared to other factors like ease of use, habit, etc? And then maybe with water auctions you get the benefit of people irrationally being more interested in getting paid than avoiding a loss of the same amount?

Here in Alaska we generally have to bribe folks with partial rebates to get them to make energy efficient choices that would pay back anyway.[3]

Anyway, all I'm saying is that it seems to me that as getting a behavior change or use change, technology isn't the whole picture, but neither is economic incentive, and I'm curious about your feedback on this.
This is an excellent question that comes up often. Here are a few thoughts:
  1. Barriers: getting off the couch (transaction cost) plus data on use (information cost). These are incorporated into economics. Emotion ("I don't care about the cost") is still a valid argument for inaction in economics. We just redefine the problem (or people's happiness) to include BOTH financial and emotional components...

  2. Those are both economic actions. Price is *on* the demand curve; advertising shifts the curve in and out ("change of tastes")

  3. That's a good question. It's possible to raise prices EVEN HIGHER (e.g., $4/gal gas) so that people take notice. OTOH, it's possible to help people who DO care to make $ off people who don't. Thus, an energy audit consultant can get paid with 50% of the savings that clients accrue for taking action. Other than that, I think that coersion to act can either backfire or turn out to be misguided (grandma economics -- "what grandma used to do" -- is often sound)

  4. Technology is what's chosen. Narrow economic incentives do not do it all. A broader definition (to include happiness, community belonging, the children, etc.) of economic incentives has the answer in there, somewhere (Read this). I'm not trying to redefine the question, but merely to point out that you're right AND that the answer is there, within an expansion of the definition of incentive :)
Bottom Line: People respond to different incentives. Economists try to include and reconcile these incentives to explain choices and outcomes, but it's not easy to design an incentive system that delivers a targeted result.

3 comments:

  1. I spent forty years designing incentives to accomplish specific goals. It just ain't that hard, unless of course, you are the former head of Obama's economic policy committee.

    And it's not just me. Tens of thousands of people are designing incentive systems right now. Here is a simple example from a sales promotion program. You want a specific, identified, group of people to take a certain action by a specific date. It just ain't hard. You communicate an incentive that they are interested in and bingo. It works every time.

    Substitute advertising for sales promotion and you get the same result. However, it will be a little messier because it is harder to control the advertising.

    Anyway, churches do it every day. The Smile Train does it everyday. And on, and on, and on.

    But then I am sure it doesn't work in macroeconomic mathematical models, but then nothing much does.

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  2. I like your responses to MW, especially the inclusion of the often overlooked concept of happiness. However, I would also like to respond to this quote: "Here in Alaska we generally have to bribe folks with partial rebates to get them to make energy efficient choices that would pay back anyway." The problem is that these types of choices don't really pay back in part because opportunity costs and time aren't taken into account. So, investing $1000 in something that will conserve energy or water and save you $100 a year is not necessarily a great deal, because the question is what else could you do with $1000 for 10 years?

    In this regard, I would like to suggest that financial options present an opportunity to perhaps more accurately model these types of investments, as they take into account net present value, opportunity costs and the risk profile of those considering such "green" investments.

    As someone who has looked into solar energy for the home, and found that the capital costs are still far too great, it seems to me that the "investment" aspect of these things is overrated. With regard to water, for a long time I had an old toilet that functioned fine but of course used more water per flush. It wasn't until my toilet began leaking, and the water constantly running, that the capital cost of investing in a new toilet really could be repaid from the cash flows of reduced water costs.

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  3. Regarding #3, it seems the price signal is often mistimed. If it isn't delivered at the moment of decision-making, it's not going to be effective. Rebates are particularly susceptible, because they deliver long after the decision has been taken. When you are cold, and considering whether to turn the heater up or put a coat on, the possibility of a rebate coming to you 3 months later just isn't very compelling compared to the prospect of a warm house. I'm sure this is "in economics" as well.

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