Describe what we mean in economics by the word incentive. Provide examples of perverse incentives and discuss their impact on the economy.

The government giving subsidies to farmers allows them to manage their cost of production and gives them the ability to present their goods at a reasonable price in the market to attract consumers. This would create an incentive for them to develop their methods of production and attempt to raise the efficiency of it so that they soon don’t have to rely on the government as a supplement to run their agriculture. This government intervention is vital as without it there would be market failure in the sense that these farmers wouldn’t be able to produce these goods that create positive externalities due the incapability of them entering the market where they are required to compete against other farmers from more economically stable countries. The farmers would be able compete internationally as the subsidies would compensate for such low prices and gain consumers along with revenue. This would give them the incentive to increase their production levels and allow them to work within economies of scale which would substantially decrease their costs of production and make them more productive. This would result in a rise in equity to these farmers as they are able to increase their standard of living and well-being through this subsidy, which is politically popular and does target specific activities. However these benefits do come at a cost which is the financial impact it has on the government’s budget as it does cost a lot to subsidise these farmers and it raises the question of opportunity cost as the government could well be spending that money elsewhere on healthcare and education which may have more of an impact. It can be argued whether providing the subsidy is worthwhile compared to other responsibilities the government has where the funds can be used but it all depends on many factors which decide the effects it has on the economy.

The problem is that firms that pollute create a cost to society but not to themselves and due to the firm not having an accurate view of its cost of production, it’s unable to set its production at the level that maximises efficiency in the economy. Tradable pollution permits are a free market solution to the problems caused by negative externalities, and involves firms to be given licenses to pollute at a specific level where firms can purchase, sell and trade these permits onto the market. This creates an incentive to these firms to pollute as little as possible as then they are able to sell their permits. This could be achieved by firms being encouraged to change their production methods to one that involves creating less pollution which would mean that they aren’t as restricted to maximise their production levels in the fear that they have limited pollution permits. This would allow these firms to maximise efficiency in the economy and create less of a cost to society as they are controlling their pollution levels and this would give them the incentive to become more environmental friendly. This would result in these firms attracting more consumers due to their reputation improving and being known as a firm that creates low levels of pollution and doesn’t harm society. The government implementing tradable pollution permits does create incentives for the firms and reduces the negative externalities that are created by firms. However in the long run, some firms may pollute heavily, and others may not, resulting in some areas of the world becoming highly polluted and others being relatively clean. Also it is difficult to measure exactly how much a firm is polluting and what pollution level is acceptable in the eyes of the government along with the administrative costs of controlling and monitoring the pollution levels of these firms.

pointless. This would result in the consumption of the economy falling as less people are spending their money in the time of such high interest rates and therefore consumption would contribute less to aggregate demand. This would slow down the multiplier effect and therefore decrease GDP as expenditure falling would result in national income also falling meaning that real national output would also decrease as they are all equal.

Incentives are crucial in economics as without it individuals would have no intention of making the decisions and performing the actions they do subconsciously. They all have different impacts on the economy as some incentives are stronger than others and hence are more influential.