Exercises: 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 $\$3$ 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.

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 Pastelería Alba and the second is that of Pastelería Bego, in thousands of pesos.

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

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 parlor in a new neighborhood, taking out cell phone insurance, and planting an unfamiliar crop in the face of climate change.

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 neighbors) 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 $\$60$, they each make $\$10\,000$ per week; if one lowers the price to $\$50$ and the other does not, the one that lowers it makes $\$15\,000$ and the other $\$4\,000$; if both lower it, they each make $\$6\,000$.

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.

A city subsidises each family that installs solar panels by $\$4\,000$ 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 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 behavior 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.