People are motivated by incentives. As a student of economics, I live and breathe by this principle. If prices are lowered for a product, utility-maximizing individuals will buy more of that product. If wages are higher in one sector, more people will compete for jobs in that sector. If the government raises taxes on a good, the higher prices will make me shift my preferences away from that good.

Some incentives are stronger than others. If the price of heroin doubles, heroin addicts might not change their consumption habits too much (what economists would call inelastic). On the other hand, if Miller Lite doubles its price for a bottle of beer my consumption of Miller Lite will change a lot (elastic demand). But sometimes people overstate the inelasticity of a good or discount the incentive-mechanism all together.

Libertarians will cry foul when taxes are raised on a good (saying it will be horrible for business) but understate the role of incentives in the case of welfare or public education for increasing immigration. Progressives are happy to point to the role of incentives when taxing gasoline to reduce driving but seem to forget that increasing welfare benefits can be counter-productive by increasing the incentive to be on welfare. Similarly, conservatives will say a porn tax will lower the demand for porn but they won’t admit that a gasoline tax could be good for the environment.

Along these same lines, people forget the role of incentives when talking about caps on executive pay. The caps are obviously understandable, as Gary Becker writes:

I sympathize with all the people who are upset by the very large bonuses, stock options, and other compensation received by heads of some financial institutions that ran their companies into the ground through bad investments.

The fact that we bailed these people out is even more disgusting. But capping executive pay might not be the answer.

The generous bonuses and stock options received by financial executives may often have been unwarranted, but they are being used as a scapegoat for other more crucial factors. Financial institutions underrated the systemic risks of the more exotic assets, and apparently so too did the Fed and other regulators of financial institutions. In addition, large financial institutions may have recognized that they were “too big to fail”, and that they would be rescued by taxpayer monies if they were on the verge of bankruptcy because they took on excessively risky assets.

Executive pay is being used an easy scapegoat for politicians and voters to vent their frustration with the economic climate. And putting caps won’t do anything. Ben & Jerry’s, everyone’s favorite hippie ice cream company, once made a promise that it would not pay any executive more than five times its lowest paid employee. What happened? All of their management was low-quality. With lower pay, the incentives for the best executives in the industry were with other firms. Eventually, Ben & Jerry’s was tanking and eventually got bought out by British conglomerate Unilever.

It might seem like an overstated case. After all, look at how great these bankers did with their huge bonuses, why do we need them to fix it? But we can’t discount the role of incentives and how important management is in these huge institutions. Cap pay, you take away the incentives. Take away the incentives, you get poorer quality management. Poorer quality management, the problem might not get fixed.

But more fundamentally, the government capping executive pay and deciding what people deserve is a frightening thought to me. We bailed out these banks, sure. Those guys deserve nothing. But governments on principle shouldn’t be deciding what people are entitled to. That’s what voluntary exchange is for.