In economics, what is the most complete definition of an incentive?
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Economics · Foundations
Incentives
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An Incentive Anything that changes the costs or benefits of an action and thereby influences whether people take it. Full entry → is anything that changes the cost or benefit of an action, and one of the most reliable ideas in economics is that people respond to incentives. Rewards pull behavior toward an action; penalties push it away. Prices, taxes, subsidies, and fines all work as incentives. Because those responses are fairly predictable, incentives are the main lever behind most economic policy, from carbon taxes to bonuses. But a poorly designed incentive can reward exactly the behavior you meant to stop.
Why this matters
Almost every economic model assumes that people weigh costs and benefits and act on them, so 'people respond to incentives' is the bridge between abstract theory and real behavior. Understanding incentives lets you predict how a tax, a Subsidy A government payment or price reduction that lowers the effective cost of an activity to encourage more of it. Full entry →, a wage, or a fine will change what people actually do, not just what a policymaker hopes they will do. It also explains why good intentions sometimes backfire: if a rule rewards the wrong measurement, people optimize the measurement instead of the goal. Whether you are reading a story about carbon taxes, designing a bonus plan at work, or noticing how your own choices shift when prices change, the habit of asking 'what does this reward, and what does it punish?' is one of the most transferable tools economics offers.
The college version
What an incentive is
An incentive is anything that changes the costs or benefits of an action and, in doing so, changes how likely people are to take it. The idea rests on a simple assumption that runs through nearly all of economics: people compare what an action costs them with what it gives them, and lean toward actions whose benefits exceed their costs. Shift that balance and behavior shifts with it. Economists summarize this as a foundational principle: people respond to incentives, and they tend to do so in predictable directions. Raise the reward for doing something and you get more of it; raise the cost and you get less. This is not a claim that people are coldly calculating or always right about their own interests. It is a claim about tendencies across many people: when the payoff to an action rises, the number of people who choose it usually rises too. That regularity is what makes incentives useful for prediction. The full machinery of how people weigh one more unit of cost against one more unit of benefit belongs to marginal thinking, a neighboring topic; here the point is just that the weighing happens and that it responds to changes in the payoffs.
Positive vs negative, direct vs indirect
Incentives split along two useful lines. The first is direction. A Positive incentive A reward that makes an action more attractive, increasing how often people choose it. Full entry → is a reward that makes an action more attractive: a bonus for hitting a sales target, a subsidy for installing solar panels, a discount for buying in bulk. A Negative incentive A penalty or cost that makes an action less attractive, decreasing how often people choose it. Full entry → is a penalty that makes an action less attractive: a fine for late payment, a tax on tobacco, jail time for theft. Both change behavior, just from opposite ends: rewards pull people toward an action, penalties push them away. The second line is directness. A Direct incentive An incentive attached to the target behavior itself, such as a payment for each unit of the desired result. Full entry → targets the behavior itself, the way a bounty pays you specifically for the thing you want done. An Indirect incentive An incentive whose effect on behavior works through a chain of consequences rather than targeting the behavior directly. Full entry → works through a chain: a tax on gasoline is meant to raise government revenue or curb emissions, but along the way it also nudges people toward smaller cars, carpooling, and public transit. Much of the art of policy is anticipating those indirect, second-round responses, because people respond to the incentive as they actually experience it, not to the intention behind it.
Prices, taxes, and subsidies as incentives
In a market economy the most pervasive incentives are prices. A price is a two-sided signal: to a buyer it is a cost, and to a seller it is a reward. When a good becomes scarce and its price rises, buyers have a reason to use less of it and sellers have a reason to supply more, and the two responses push the market back toward balance without anyone coordinating them. Governments routinely use this channel on purpose. A tax raises the effective price of an activity to discourage it; a subsidy lowers the effective price to encourage it. A penalty or fine is simply a price attached to a prohibited act. Because these tools all work by changing costs and benefits, they change behavior even when compliance is voluntary. This is also why interfering directly with prices is risky: OpenStax notes that laws controlling prices change the incentives buyers and firms face, often leading to undesirable consequences such as shortages. Price controls are their own topic, but they are a clean reminder that a price is not just a number, it is an instruction that people act on.
Unintended consequences and perverse incentives
Because people respond to the incentive they actually face, a rule that rewards the wrong thing gets you more of the wrong thing. This is a Perverse incentive An incentive that produces a result opposite to what its designer intended, by rewarding a proxy or side effect instead of the goal. Full entry →: the response runs opposite to the designer's goal. The vivid label often used is the 'cobra effect,' coined by economist Horst Siebert in 2001 from a British-colonial anecdote about a bounty on dead cobras that supposedly led people to breed cobras for the reward. That particular story is historically disputed and best treated as illustrative rather than documented. A better-documented case comes from Hanoi in 1902, under French colonial rule: officials paid a bounty for each rat killed, but required only the severed tail as proof. Rat catchers, and reportedly rat farmers, then clipped tails and released the animals to breed and produce more tails, so the bounty rewarded a growing rat population rather than a shrinking one. The mechanism is general and modern: pay people per line of code and you get bloated code; reward hospitals only on a narrow metric and you may get gaming of that metric. The fix is not to abandon incentives but to tie the reward to the outcome you actually want, and to think one step ahead about how a clever person could satisfy the letter of the rule while defeating its purpose.
Eli explains
The same idea, in plain words
Explain it like I’m 10
An incentive is a reason to do something or not do it, built out of what it costs you and what you get for it. Make something more rewarding and more people do it; make it more costly or more punished and fewer people do it. Money prices are the most common incentives: a high price is a good reason for a store to sell more and a good reason for you to buy less. Grown-ups use this on purpose. A tax makes something cost more so people do less of it, and a subsidy makes something cheaper so people do more of it. The tricky part is that people follow the exact reward you set up, so if you reward the wrong thing by accident, you get more of the wrong thing.
Picture it like this
Incentives are like the point rules in a video game. Whatever the game gives you points for, that is what players end up doing all day, even if it was not what the designer secretly hoped they would do.
Where the picture stops working
The analogy breaks down because game points are the whole goal, while real incentives sit on top of many other motives people already have, like habit, ethics, and caring about other people. Real incentives also cost real money and can hurt real people when they go wrong, so getting them wrong is far more serious than losing a round of a game.
Worked example
In 2012 the U.S. Congressional Budget Office analyzed raising the federal cigarette tax. Because a tax raises the shelf price, it acts as a negative incentive to smoke. CBO summarized the evidence this way: a 10 percent rise in cigarette prices leads people under 18 to cut their smoking by roughly 5 to 15 percent, and adults over 18 to cut theirs by about 3 to 7 percent. Notice three things. First, the response is real and measurable, not just hoped for. Second, teenagers respond more strongly than adults, partly because they have less money and are not yet locked into the habit, a reminder that the same incentive lands differently on different people. Third, the tax was designed partly to raise revenue and partly to improve health, which shows one incentive doing double duty. This is the textbook shape of a policy that changes behavior through incentives: change the price, and the quantity people choose changes in a predictable direction.
Key takeaway
An incentive is anything that changes the costs or benefits of an action, and people respond to incentives in fairly predictable ways, which is why prices, taxes, and subsidies are such powerful policy levers and why a carelessly designed reward can produce exactly the behavior it was meant to prevent.
Quick check
3 questions here, of 5 in this lesson’s practice set. Answers stay hidden until you check.
A city offers residents a $500 rebate for scrapping an old, high-polluting car. How is this incentive best classified?
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Why do economists describe a market price as functioning as an incentive?
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Study tools & related lessonsYou’ll learn to · Common mistakes · Easily confused · Key vocabulary · Related
You’ll learn to
- Define an incentive in terms of the costs and benefits of an action.
- Distinguish positive from negative incentives and direct from indirect incentives.
- Explain how prices, taxes, subsidies, and penalties operate as incentives on behavior.
- Analyze a real policy that changed behavior through incentives and estimate the direction of the response.
- Identify perverse incentives and explain why a well-intentioned rule can produce the opposite of its goal.
Common mistakes
Thinking 'incentive' just means money or a bonus.
An incentive is any change in costs or benefits. Fines, taxes, social approval, time, and convenience are all incentives, not just cash rewards.
Assuming a policy achieves its stated goal just because that was the intention.
People respond to the incentive they actually face, not to the intention behind it. Always ask what behavior the rule literally rewards or punishes.
Treating the 'cobra effect' story as established history.
The cobra anecdote is disputed and best used as an illustration. The documented 1902 Hanoi rat-tail bounty is the safer historical example of a perverse incentive.
Believing everyone responds to an incentive by the same amount.
Responses vary with income, information, and habit. A cigarette tax changes teen behavior more than long-term adult smokers' behavior.
Concluding that because incentives can backfire, we should avoid using them.
The lesson of perverse incentives is to design them carefully, tying the reward to the real outcome, not to stop using incentives at all.
Easily confused
Positive incentive (reward) vs. Negative incentive (penalty)
A reward raises the benefit of an action to pull behavior toward it; a penalty raises the cost of an action to push behavior away from it.
Direct incentive vs. Indirect incentive
A direct incentive is attached to the target behavior itself; an indirect incentive changes behavior through a downstream chain of costs and benefits.
Intended consequence vs. Perverse incentive
An intended consequence is the behavior the designer wanted; a perverse incentive rewards a proxy or loophole and produces the opposite result.
Key vocabulary
- Incentive
- Anything that changes the costs or benefits of an action and thereby influences whether people take it.
- Positive incentive
- A reward that makes an action more attractive, increasing how often people choose it.
- Negative incentive
- A penalty or cost that makes an action less attractive, decreasing how often people choose it.
- Direct incentive
- An incentive attached to the target behavior itself, such as a payment for each unit of the desired result.
- Indirect incentive
- An incentive whose effect on behavior works through a chain of consequences rather than targeting the behavior directly.
- Perverse incentive
- An incentive that produces a result opposite to what its designer intended, by rewarding a proxy or side effect instead of the goal.
- Subsidy
- A government payment or price reduction that lowers the effective cost of an activity to encourage more of it.
- Price signal
- The information a price carries about scarcity and value, acting as a cost to buyers and a reward to sellers that guides their behavior.
Sources & references
- Principles of Economics 3e, 1.1 What Is Economics, and Why Is It Important? — OpenStax, Rice University
- Principles of Economics 3e, Section 3.4: Price Ceilings and Price Floors — OpenStax, Rice University
- Lesson 3: Incentives Matter — Foundation for Teaching Economics (FTE)
- Raising the Excise Tax on Cigarettes: Effects on Health and the Federal Budget — U.S. Congressional Budget Office
- Perverse incentive (Cobra effect and Hanoi rat bounty) — Wikipedia
EliExplains lessons are original prose written from the open, credible references above. See Copyright & Licensing.
Researched 2026-08-19
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