Incentives, expectations and game theory

Define what an economic incentive is and classify the following as a positive or negative incentive: a double-parking fine, a discount for paying the annual gym fee in one go, and a tax credit for installing solar panels. Justify each classification.

A supermarket starts charging $\text{€}\ 0.15$ for each plastic bag, which were previously free.

1. a) What incentive does the charge create and who does it act upon?
2. b) Predict what will happen to the number of bags used and explain the mechanism.

Distinguish between monetary and non-monetary incentives, and classify the following: a medal for the best academic record, a bonus in your pay packet, the embarrassment of arriving late, and applause from the audience. Add one example of your own of each type.

The class representative proposes a points system: anyone who clears their table after finishing lunch in the canteen earns points redeemable for leaving earlier for break.

1. a) Analyse the proposed incentive: what behaviour does it respond to, and what strategic responses or unintended consequences could it generate?
2. b) Propose an improvement to the system and justify it using what you have learned about incentives.

A town council wants more recycling and is considering three options: charging a fee for each bag of non-recycled rubbish, rewarding the neighbourhood that recycles the most, and refunding $\text{€}\ 0.10$ for every container returned.

1. a) Explain the incentive each option activates and who it acts upon.
2. b) Anticipate one unintended effect of each (illegal dumping, cheating, costs).
3. c) Which would you choose, combining effectiveness and cost? Defend your design.

A city wants students to leave their cars and use public transport. Compare three policies: a free travel pass for students, a $50\ \%$ discount on the season ticket, and more speed cameras and speeding fines.

1. a) Analyse the incentive of each measure, its cost to the public purse and its foreseeable effect.
2. b) Design the combination you consider most effective and justify it using what you have learned about positive and negative incentives.

A school pays pupils $\text{€}\ 2$ for every book they read and discovers that they all choose the thinnest, simplest books. Explain what a perverse incentive is and why this reward is an example: what behaviour did it seek and what has it actually caused?

A nursery fined parents who arrived late to pick up their children and, against all expectations, lateness increased: the cheap fine turned embarrassment into a paid service.

1. a) What has gone wrong with the incentive?
2. b) What does this case teach about the difference between monetary incentives and moral or social incentives?

A regional government decides to pay a bonus to teachers whose pupils improve in external tests.

1. a) What predictable strategic responses can it provoke (teaching only to the test, inflating internal marks, dropping content that does not come up)?
2. b) Redesign the incentive so that it rewards real improvement without those effects.

After taking out fully comprehensive insurance, some cyclists leave their lock loose or park in theft-prone areas.

1. a) What is this phenomenon called (moral hazard) and what does it have to do with incentives?
2. b) Explain what insurers do to limit it (excesses, no-claims bonuses) and why these measures work.

A city subsidises each family that installs solar panels by $\text{€}\ 200$ per year. After a year, it is discovered that a company is offering "paper installations": fake panels that only serve to collect the grant.

1. a) Explain what went wrong in the design of the incentive.
2. b) Redesign the subsidy so that it is difficult to game without losing its objective.

The Government creates a rental aid scheme for young people worth $\text{€}\ 250$ a month and, the following year, rents in the areas popular with young people have risen by almost that amount.

1. a) Explain what has happened to the incentive: who has captured the aid and why (think about the supply of flats)?
2. b) What conditions should the housing market meet for the aid to reach tenants? Propose an alternative design.

Explain what expectations are in economics and why they matter. Illustrate it with this case: word spreads that petrol will go up on Monday and on Sunday queues form at petrol stations. What has driven people: today's price or the one they expect tomorrow?

The Government announces that in three months it will raise the tax on sugary drinks.

1. a) What can consumers and shops be expected to do before the increase?
2. b) Explain what role expectations play in that reaction.

Distinguish between risk and uncertainty and classify these situations, justifying each decision: buying a lottery ticket, opening an ice cream parlour in a new neighbourhood, taking out mobile phone insurance, and planting an unfamiliar crop in the face of climate change.

If all workers and firms expect prices to rise by $5\ \%$, collective agreements demand $5\ \%$ increases and firms pass them on to prices, which end up rising by $5\ \%$.

1. a) Explain in what sense the expectation has fulfilled itself.
2. b) Why are central banks so concerned about "anchoring" inflation expectations? Reason your answer.

What is a strategic decision, one in which your best option depends on what others do? Give two everyday examples (choosing the supermarket queue by looking at the others, deciding whether to leave for break early to avoid queuing at the cafeteria) and explain what you are anticipating in each one.

In game theory, a "game" has players, strategies and payoffs. Identify those three elements in this situation: two friends must choose, without agreeing beforehand, between going to the cinema or to the park, and they only truly enjoy it if they end up together.

Two food trucks must choose where to park on a one-kilometre seafront promenade. Customers go to the nearest truck and, in the event of a tie, they split between them.

1. a) Reason why, if each one chooses while thinking about the other, both end up parking together in the centre.
2. b) Is that the best outcome for the people strolling by? Relate the game to the difference between individual interest and collective outcome.

In an apartment building with $20$ neighbors, the monthly cleaning of the common areas costs $\text{€}\ 300$ in total ($\text{€}\ 15$ per apartment); the company cleans as long as most of the amount is collected, so one neighbor not paying does not cancel the service, but if almost nobody pays there is no cleaning. If the building is spotless, each family values that well-being at $\text{€}\ 25$. However, the community has left the payment to the free will of each neighbor through an unrecorded common collection box.

1. a) Analyze the individual behavior of a selfish and rational neighbor: what is their incentive if the others pay? And what if nobody pays? Predict the final outcome for the building, justifying why the free-rider problem arises.
2. b) The building manager states: "To solve this, it will be enough to put a note in the entrance hall appealing to the empathy and good faith of the neighbors." Refute their statement by applying the logic of incentives and design an institutional proposal with formal rules (monitoring and penalty mechanisms) and informal rules (reputation and repetition) that guarantees stable cooperation.

Topic challenge. Does your family act with full rationality regarding the electricity bill? Design an energy optimisation proposal for your home by applying economic decision-making models.

1. Real data and marginal analysis: Check the EirGrid or SEMOpx website (or your electricity supplier's time-of-use tariff page) for today's price per $kWh$ during peak hours ($P_{\text{peak}}$) and off-peak hours ($P_{\text{off-peak}}$). Calculate the opportunity cost and the marginal benefit of shifting a consumption of $2.5\text{ kWh}$ (for example, a washing machine or electric water heater) from the peak to the off-peak time slot.

2. Incentives and expectations: Ask two family members what they know about these tariffs. Analyse what expectations they have about future prices, what incentives they need to change their habits, and what bounded rationality biases (laziness, inertia) hinder making the optimal decision.

3. Game theory: Set up a $2 \times 2$ payoff matrix between two household members (You versus Family member; strategies: Cooperate by adapting schedules or Ignore schedules). Determine whether a Nash equilibrium exists and whether a situation similar to the prisoner's dilemma occurs.

Draft a one-page executive report with the table of marginal calculations, the game matrix, and your proposal for incentives.

Assessment criteria:

• Accuracy in the marginal analysis and opportunity cost based on real EirGrid/SEMOpx data.

• Proper formulation of the game theory matrix and identification of the Nash equilibrium.

• Critical integration of incentives, expectations, and rationality biases into the final proposal.

The figure shows the payoff matrix of a prisoner's dilemma between two rival bakeries deciding whether to lower their prices or maintain them. The first number in each cell is the profit of Aoife's Bakery and the second is that of Niamh's Bakery, in thousands of euros.

1. a) What profit does each bakery get if both maintain prices? What if both lower them?
2. b) If Aoife lowers prices and Niamh maintains them, who comes out winning and by how much?

In the prisoner's dilemma, both players end up worse off than if they had cooperated.

1. a) Explain why, despite this, each has reasons not to cooperate.
2. b) Give a real-life example (in class, sports, or among neighbours) with the same logic and analyse it in the same way.

"Norte" and "Sur" are the only two ice cream parlours on a seafront promenade. If both sell an ice cream cone for $\text{€}\ 3$, they each make $\text{€}\ 500$ per week; if one lowers the price to $\text{€}\ 2.50$ and the other does not, the one that lowers it makes $\text{€}\ 750$ and the other $\text{€}\ 200$; if both lower it, they each make $\text{€}\ 300$.

1. a) Construct the payoff matrix and analyse what each ice cream parlour will do if they cannot reach an agreement.
2. b) Compare that outcome with the one they would achieve by cooperating and explain the paradox.

Two rival private academies decide whether to run an advertising campaign. If neither does, each earns $4$ (thousands of euros); if both do, they earn $2$ each; if only one does, that one earns $5$ and the other $1$.

1. a) Construct the payoff matrix and reason what each academy will do if they cannot cooperate. Is there a prisoner's dilemma?
2. b) Explain how the analysis changes if the game is repeated every year and the academies can "punish" the one that advertises.