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Incentives and institutions
Incentives have a critical importance in economic theory: they determine individuals' behaviors. For instance level of development of an economy is related with the type of incentive mechanisms designed. As a result economists put a special emphasis on the designing of incentive mechanisms. Before advancing on 'divine' issues like development level, let me return to an interesting book I mentioned before. First chapter of Levitt and Dubner's Freaknomics starts with the following example:
One of the main problems facing day care centers is that parents are usually late in picking up their children from the center. This is suffered by the child who has no idea why he/she is staying late there and become anxious on the one hand and teachers who have to work overtime on the other hand. So, what can be done to prevent this?
An idea was tested with a study in Haifa, Israel. Ten day-care centers were selected and observed for the following four months. For these four weeks, on average eight late pick-ups were calculated per day-care center. At the beginning of the fifth week, it was announced that late parents will be fined: any parent more than five minutes late would pay $3 per child for each inciden.
So, what happened? The number of parents arriving late has jumped up: number of late pick up incidents per cay-care center increased from 8 to 20! So, the plan was withdrawn. To explain this issue the authors underline one important point. Before the fee based incentive system, there was a moral incentive system in effect. Many parents thought that arriving late would not be moral. But when the fee-based system was introduced, they started to think there was no need to get anxious and they could simply pay the $3 fee instead of giving up the chat with friends.
In the above example, an unsuitable incentive mechanism was designed and implemented. In the end, an exact opposite outcome is faced. The exact type or formation of the institutional structure in an economy can create 'correct' or 'wrong' incentives. Recently, the suit which was filed years ago for the cancellation of the public transportation fee rise introduced by the Ankara Municipality was concluded and the decision for the fee raise was cancelled. According to the information featured on the press, six year passed from the date the suit was filed and the date the court made its decision.
Slow judicial process is itself a significant problem. Say that you are going to establish a plant. You have agreed with a contractor to construct the plant and signed a contract to set the deadline for the operations. You have given an order for the machinery relying on the deadline. Of course, you signed other contracts too. But the contractor did not fulfill his obligations and the construction was not finished at the deadline. Say that the contract has provisions for such an incident; and the contractor has to compensate the loss.
You have initiated legal procedures. So what will happen? If you estimate that the legal process will last for years, you will keep your guard accordingly. But this implies that you will have to endure additional burden. Maybe, you will not initiate the process at all considering such problems. For instance, instead of it you can purchase foreign Treasury bills and do nothing but enjoy guaranteed returns. Why would you put yourself into trouble?
This is exactly why institutional structure is of critical importance. And judicial system is a part of the institutional structure. The exact type of not only the judicial system but the institutional structure as a whole determines the attraction of the country for investments and doing business in general. So an institutional structure that does not encourage investments and innovations put the economy at the deadlock.
This commentary was published in Radikal daily on 28.03.2010