By Jonny Lupsha, Wondrium Staff Writer
America’s gross domestic product (GDP) is continuing on a steady rate of growth. Adjusted for inflation, the GDP increased by 2.9% at the end of 2022. How does human behavior affect economic growth?
Spending habits are often shaped by major societal events. For example, due to the coronavirus pandemic, the American economy had a disastrous 2020 before bouncing back strong in 2021. However, human behavior also shapes financial patterns. After the first half of 2022 saw some shrinkage, which led many to fear a looming recession, the second half of the year showed considerable growth.
In the fourth quarter of 2022, America’s gross domestic product (GDP) grew at an annual rate of 2.9%, largely in part to a strong job market and cooling inflation. However, this success also owes partially to consumer confidence. In his video series Why Economies Rise or Fall, Dr. Peter Rodriguez, Associate Dean for International Affairs and Associate Professor at the Darden School of Business at the University of Virginia, looks at the surprising role that human behaviors like trust play in the economy.
What Drives Economic Behavior Change?
A seemingly simple and obvious question to spur economic growth is “When the economy isn’t growing, how do we change people’s behaviors in ways that lead to economic growth?” The answer, which is more complex, lies in incentivizing products or services.
“People respond to incentives, and that’s what makes economic behavior and that ultimately is what leads to the differences between successes and failures,” Dr. Rodriguez said. “But […] people don’t always respond the way you think they will, and that’s a big problem for economics. People do respond to incentives, but often very differently and not always the way that you think they will.”
In this sense, the free market is just another story of incentives. As Dr. Rodriguez pointed out, in the free market, you reap all the benefits of your actions, but also incur all the costs of your actions. Of course, this is when the market works ideally.
“The reaping of the benefits and the incurring of the costs are exactly the incentive structure we face, and that’s the magic behind free markets,” he said. “Free markets really take our naturally self-interested behavior and, the idea is, channel our greed toward something that is productive and socially beneficial. In free and open markets, there is no safety net, and that means all the more incentive to be very productive.”
When Does the Free Market Fail?
The less of a safety net there is to protect someone who fails, the stronger their incentive should be to succeed, because there’s a greater risk. However, the free market makes a lot of assumptions about human behavior and criminal law that don’t always ring true.
“For free markets to work, for that system of incentives to be really successful, this has to be true: Productive behavior, that is economically productive behavior, has to be more profitable than the alternatives,” Dr. Rodriguez said. “What are the alternatives, you might ask? There’s fraud, theft, corruption.”
The world is rife with socially unproductive behavior that is nevertheless profitable. People can get rich and live well without providing better goods or services to the market. Additionally, people must be unafraid of risk. Without a safety net for failure, entrepreneurs have to have a high tolerance for the risks they’re taking. If they don’t have that, they don’t begin their ventures. With no new ventures, behavior isn’t productive, leading to a stagnation of incentive.
Trust and confidence must also be present.
“People must have trust or confidence in the rules of the game, and, hence, in the other players and in their activities,” Dr. Rodriguez said. “Without trust, without confidence in the rules of the game, a free-market story, as elegant and as beautiful as it is […] can break down.”
Why Economies Rise or Fall is now available to stream on Wondrium.