An incentive is something that motivates or drives one to do something or behave in a certain way.[1] There are two type of incentives that affect human decision making. These are: intrinsic and extrinsic incentives. Intrinsic incentives are those that motivate a person to do something out of their own self interest or desires, without any outside pressure or  promised reward.[2] However, extrinsic incentives are motivated by rewards such as an increase in pay for achieving a certain result; or avoiding punishments such as disciplinary action or criticism as a result of not doing something.[1][2]  

A florist offers a "buy one, get one free" incentive to encourage purchase of a certain flower.

Some examples of extrinsic incentives are letter grades in the formal school system, monetary bonuses for increased productivity or withholding of pay for underperforming in the workplace.[2] Examples of intrinsic incentives include wanting to learn a new language to be able to speak to locals in a foreign country or learning how to paint for self enjoyment.

In the context of economics, incentives are most studied in the area of personnel economics where human resources management practices focus on how firms manage employee incentives such as pay and career concerns, compensation and performance evaluation.[3]


Classified by David Callahan, the types of incentives can be further broken down into three broad classes according to the different ways in which they motivate agents to take a particular course of action:[4] [5]

Class Definition
Remunerative incentives exist where an agent can expect some form of a material reward like money in exchange for acting in a particular way.[5]
Moral incentives exist where a particular choice is widely regarded as the right thing to do or is particularly admirable among others.[5] An agent acting on a moral incentive can expect a sense of positive self-esteem, and praise or admiration from their community. However, an agent acting against a moral incentive can expect a sense of guilt, condemnation or even ostracism from the community.[5]
Coercive incentives exist where an agent can expect that the failure to act in a specific way will result in physical force being used against them by others – for example, by inflicting pain, or by imprisonment, or by confiscating or destroying their possessions.[5]

Incentives in economic contextEdit

The economic analysis of incentives focuses on the systems that dictate the incentives needed for an agent to achieve a desired outcome. [6] When a firm wants their employees to produce a certain amount of output, it must be prepare a offer a compensation scheme such as a monetary bonus to influence the employees to reach the target output.[6]

In cases with asymmetric information where one user knows some relevant fact about another, principal-agent theory is the guiding framework in optimizing incentive of choice. The classic example for a situation for asymmetric information can be that of a manager and worker, where manager may want a certain level of output from the worker. The manager does not know the capabilities of the worker, and to achieve the best outcome, an optimal scheme of incentive may be chosen to motivate the worker to give their best performance.[7]

An optimal incentive is one that accomplishes the stated goal.[8] If the goal is to maximize profits, then an optimal incentive will be one that encourages workers to balance the risk imposed by the employee for poor performance and the marginal disutility of effort. A weak incentive is any incentive below this level.[9]

Regulation in the utilities sectorEdit

Incentive-based regulation can be defined as the conscious use of rewards and penalties to encourage good performance in the utility sector.

Incentives can be used in several contexts. For example, policymakers in the United States used a quid pro quo incentive when some of the U.S. incumbent local telephone companies were allowed to enter long distance markets only if they first cooperated in opening their local markets to competition.

Incentive regulation is often used to regulate the overall price level of utilities. There are four primary approaches: return (or cost of service) regulation, price cap regulation, revenue cap regulation, and benchmarking (or yardstick) regulation.

With benchmarking, for example, the operator's performance is compared to other operators' performance and penalties or awards are assessed based on the operator's relative performance. For instance, the regulator might identify a number of comparable operators and compare their cost efficiency. The most efficient operators would be rewarded with extra profits and the least efficient operators would be penalized. Because the operators are actually in different markets, it is important to make sure that the operators' situations are similar so that the comparison is valid, and to use statistical techniques to adjust for any quantifiable differences the operators have no control over.

Generally, regulators use a combination of these basic forms of regulation. Combining forms of regulation is called hybrid regulation. For example, U.K. regulators (e.g. Ofgem) combine elements of rate of return regulation and price cap regulation to create their form of RPI - X regulation.[10]

Incentive rates are also prevalent in the utility sector, under any of the utility regulatory frameworks noted. Incentive rates are a vehicle for the utility to induce large commercial or industrial customers to locate or maintain a facility in the utility service territory. The incentive is provided in the form of a discount from the utility's standard tariff rates, terms or conditions. In the U.S., incentive rates (also known as Economic Development Rates and/or Load Retention Rates)[11] are a common component of the utility strategy for supporting the economic development efforts of a particular geographic region or political entity.

Potential issuesEdit

Incentive structures, however, are notoriously more tricky than they might appear to people who set them up. Incentives do not only increase motivation, they also contribute to the self-selection of individuals, as different people are attracted by different incentive schemes depending on their attitudes towards risk, uncertainty, competitiveness.[12] Human beings are both finite and creative; that means that the people offering incentives are often unable to predict all of the ways that people will respond to them. While the promotion of intrinsic morality is sometimes employed to avoid this uncertainty, using short term incentives can yield similar results.

For example, decision-makers in for-profit firms often must decide what incentives they will offer to employees and managers to encourage them to act in ways beneficial to the firm. But many corporate policies – especially of the "extreme incentive" variant popular during the 1990s – that aimed to encourage productivity have, in some cases, led to failures as a result of unintended consequences. For example, stock options were intended to boost CEO productivity by offering a remunerative incentive (profits from rising stock prices) for CEOs to improve company performance. But CEOs could get profits from rising stock prices either (1) by making sound decisions and reaping the rewards of a long-term price increase, or (2) by fudging or fabricating accounting information to give the illusion of economic success, and reaping profits from the short-term price increase by selling before the truth came out and prices tanked. The perverse incentives created by the availability of option (2) have been blamed for many of the falsified earnings reports and public statements in the late 1990s and early 2000s.

See alsoEdit


  1. ^ a b Armstrong, Michael (2015) [2005]. Armstrong's handbook of reward management practice: improving performance through reward (5th ed.). London; Philadelphia: Kogan Page. ISBN 9780749473891. OCLC 910859327.
  2. ^ a b c Krugman, Paul (2 October 2020). "Understanding Incentives in Economics: 5 Common Types of Economic Incentives". MasterClass. Retrieved 18 October 2020.
  3. ^ Lazear, Edward. P; Shaw, Kathryn. L (2007). "Personnel Economics: The Economist's View of Human Resources". Journal of Economic Perspectives. 21: 91–114.
  4. ^ Callahan, David (2004). The cheating culture: Why more Americans are doing wrong to get ahead. Harcourt. ISBN 9780156030052.
  5. ^ a b c d e Dalkir, Kimiz (2011). Knowledge Management in Theory and Practice (Second ed.). The MIT Press. ISBN 9780262015080.
  6. ^ a b Neilson, William.S (2007). Personnel Economics. Pearson Education Inc. p. 11. ISBN 9780131488564.
  7. ^ "LectAgent Problem" (PDF). Archived from the original (PDF) on 2015-11-23.
  8. ^ EconTerms website, accessed February 7, 2008 Archived January 16, 2009, at the Wayback Machine
  9. ^ EconTerms website, acce, 2008 Archived January 16, 2009, at the Wayback Machine
  10. ^ Body of Knowledge on Infrastructure Regulation
  11. ^ "Load Retention Rates: A Framework For Regulatory Evaluation". Archived from the original on 2012-01-31. Retrieved 2011-12-05.
  12. ^ Chiappori; Salanié (2003). M. Dewatripont; L. Hansen; S. Turnovsky (eds.). "Testing contract theory: a survey of some recent work". Advances in economics and econometrics. Cambridge: Cambridge University Press. 1.