Incentives and Policies

Capturing Externalities

It’s an economics truism that generally people respond to incentives. If you truly and deeply understand that, you know a fundamental truth about the world.

If the reward of doing something does not accrue to me, I will not be likely to work hard at it. This does not mean that there are no altruists or that everyone is a selfish clod who only cares about himself. It only means that most people will not do something which is good for society but which does not fully compensate them for their personal costs. In economist speak, if the personal costs cannot be compensated for by capturing at least some part of the positive externalities, the agent will not expend the effort.

Let me put it in concrete but hypothetical terms. Suppose I can do project X, at a personal cost PC, and a social cost SC, which will have the social benefit SB. Assume that SB >> (PC + SC). In other words, assume that total benefits are much much greater than the total costs. Suppose further that I can gather at most PB (personal benefit) from the SB. As a self-interested economic agent, only if PB > PC, I will undertake X, otherwise not.

Good Policy is Expensive

Good policies help with development. It is rarely that one does not really know or cannot tell good policies from bad ones. So why is it that bad policies usually trump good policies? (I take it as a given that in the case of all under-developed economies, that bad policies win more often than good policies. If it were otherwise, they would not be under-developed economies.)

Making good policy is personally expensive, its beneficial effects take a long time, and those benefits cannot be sufficiently captured to compensate for the personal cost incurred. Good policy requires hard work, is often politically unpopular, and by the time your dedication is recognized, you would have shuffled off this mortal coil.

That is why good policies are not made in India. Let’s note that the success of an economy is critically dependent on the quality of its policies. What policies do is prioritize activities and allocate resources accordingly. Prioritizing is important because sequencing of activities matter. You have to have the foundation built first, for instance. Or that primary education is a prerequisite for higher education.


Time is the reason that we have to sequence our actions. As the wise man said, time is nature’s way of preventing everything from occurring all at once. Time is the binding constraint. But there’s a less important but equally binding constraint: resources. Choices have to be made. You cannot have your cake and eat it too.[1]

As in any individual’s case, society also has a large set of things that need done. Prioritizing is not trivial because they can be ranked along multiple dimensions, all of which are ultimately value judgments. Different people have different values and therefore their orderings differ. So in this regard as least, the individual has it easier than an economy: unless one is suffering from an extreme case of multiple personality disorder, he or she does not have the problem of aggregating the preferences of a large number of individuals to solve the ranking of things to be done.

Total Orderings

In any case, total orderings of things to be done is not possible. Most are incommensurable due to dimensionality issues and therefore the best one can do is partial orderings. How does one choose between two projects that differ in their importance and their urgency? What weighing mechanism should one use to rank them properly?

In the case of an individual, the consequence of the choices are usually limited to the individual. One makes ones bed and is forced to lie in it. But in the case of public choice, the people who do the choosing are merely agents acting on behalf of the collective, the principal. The standard principal-agent problems arise. The agents can and often do suffer from moral hazard: they choose to avoid actions that are costly for them but which would have been beneficial for the principal.

Bad Choices are Cheap

Now we can get back to the problem of why good policies are not chosen. It is assumed that good policies are within the feasible set. There would be no point in discussing whether or not to do something if that something was impossible to do. Moreover, it is not just that the feasible set is non-empty but also that it has more than one element. One has to choose between alternatives.

My conjecture is that good policies are not chosen by policy makers because the rewards for doing so are less than the rewards for choosing bad policies. Consider the issue of caste and religion based reservations in higher education. It is a bad policy but the rewards to the policymakers (politicians) is electoral success. Another religion related bad policy: subsidizing haj visits and madrassa education for Muslims instead of allocating those resources for a progressive secular education. Once again these bad policies provide immediate rewards at low personal cost but have immensely harmful effect on society in the long run. By the time society suffers the consequences of these harmful choices, the policy makers would have gone to meet their makers.

Choice Matters

Success is a series of good choices. That’s true as much for an individual as for a collective such as a large economy. In the case of collectives, the choosers are called policy makers. Policy makers are politicians, and in most cases are guided by a bureaucracy. Bureaucracies have their own objectives, their agenda, which is independent of and more persistent than the tenure of politicians. It is hard to tell whether it is the bureaucracy or the politicians who actually make the decisions. Most likely it is some complex strategic game that determines the outcome. But what occurs behind the scenes is not as important as the outcome. Generally, the result is not pretty and the evidence is all around us to see. The poverty of nations is never a pretty sight.

Prosperity and poverty are outcomes of a long series of apparently small choices, not something random falling from the heavens like gentle rain. Whether to spend scarce resources (and resources are always scarce) on sending probes to the moon is a trivially small matter when considered in the larger context. But trivially small matters add up eventually. As the poem reminds us, “little drops of water, little grains of sand, make the mighty ocean and the pleasant land.”



I have always found that saying to be confused. Every time I hear it, I think, “That’s really stupid. You have to have your cake before you can eat it. Only that you cannot eat your cake and have it as well because when you are done with eating it, you don’t have the cake any more.” But I have a more general point that I want to make. You can also eat your cake and have it too — provided you have lots of cake. Then you proceed to eat as much of it as you like and then you will have sufficient leftover to have later.

I would re-state that saying as: “You cannot eat all of your cake and have it too. But if you have so much cake that you cannot possibly eat it in one go, then you can eat as much as you can and have it too. So the trick is to get so much cake that you can eat your cake and have it too. The ultimate goal for the economy is that it produce so much cake that everyone can eat their fill and have leftovers for maƱana.” [Return.]

2 thoughts on “Incentives and Policies

  1. Some food for thought for you. Perhaps a post too! How can we incentivize our elected representatives, both at the state levels and at the center to do their primary job, which is to legislate after debate? The executive function seems to completely dominate our democracy and badly needed legislative work is not being attended to.


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