Incentives Matter Because Knowledge is Imperfect

One of the economic arguments for government intervention into otherwise markets is that knowledge is imperfect (unlike what is represented in Econ 101 models).  This certainly is true: knowledge is imperfect.  Lemon problems do exist.  Buyers and sellers do not always have perfect information on the relative scarcity of goods and services.  That is why prices are so important.  But, given imperfect inputs, even prices can be flawed.

Does this mean that the pricing system is inherently flawed?  Perhaps, but prices are only half the equation.  The other half are incentives.

Prices convey signals on the relative scarcity of goods and services, but incentives help people decide whether to act.  Incentives act as an impetus to gather more information.  This is why having the proper incentives (that is, reducing adverse selection and moral hazard problems) is so important in economic analysis.

Even a private market system with flawed prices will allocate resources relatively more efficiently than a directed market system.  That is because people are properly incentivized  to make the best decisions.  In a private market system, the same person who reaps the benefits pays the costs.  In a directed market system, the person who reaps the benefits does not pay the costs (or not all the costs, anyway).  Therefore, the person in the private market system has a stronger incentive to get it right, even with flawed information, then the person in the directed market system, even if he has perfect information.

Incentives matter.

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