Incentives matter. We decide how to use our limited time and limited resources based on what we believe will most satisfy our needs, desires, and preferences. Regardless of whether or not we realize it, humans are constantly making countless economic calculations to rank values in terms of subjectively determined costs and benefits. This is the basic process that drives all voluntary human action; from ordering a pizza, to watching a play, to reading a blog. Economics is the science of human decision making – the science of purposeful human action.

In Part 1 we described how items do not and cannot have value apart from an individual's subjective valuation. It is important to remember that
specific items have specific value to a specific individual at a specific point in time.

Since we know that we value goods as specific units in relation to our needs and desires, we can see why we don't have to make sweeping 'all or nothing' decisions. We don't have to choose between, say all the hamburgers in the world or all the lemonade in the world. The extent to which an individual subjectively values a particular good is defined at the margin
. This means the value of a single unit of a particular good is determined by the value of the good's least preferred use. An explanation similar to the one presented by Thomas Taylor in an Introduction to Austrian Economics may help:

  • Let's say I have ten gallons of water at my house. I might want to use two for drinking, three for cooking, four for watering the flowers, and one for making water balloons. To me, the value of my tenth gallon of water is equal to an arsenal of water balloons. If I was making a trip through the desert with ten gallons of water, I might value the water for drink over the enjoyment of a water balloon fight.

  • Similarly, if I have ten gallons of water at my house with the same preferred uses as above and encounter a man selling delicious hamburgers for the bargain price of one hamburger for one gallon of water, I may very well be willing to make a trade. My cost for giving up my tenth gallon of water is the cost of the foregone alternative: the water balloons. It might even make sense for me to give up a few gallons of water depending how much my flowers need to be watered and how tasty his burgers are. In the desert scenario, depending on the length of my journey and the status of my supplies, exchanging a few gallons of water for hamburgers may be the difference between life and death.

This is an extreme example, but it shows that all individual human decision makers perform a cost benefit analysis at the margin.

Here is a great article on Health Care Incentives from the Freeman Online.

I also suggest reading this article from - Our perverse government’s perverse actions lead to perverse incentives.

If you are looking for something slightly more advanced, this is an excellent article: The Political Economy of Moral Hazard by Jörg Guido Hülsmann

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