Naked Economics: Chapter 2 Vocabulary
1. Free rider: In economics, the free rider problem refers to a situation where some individuals in a
population either consume more than their fair share of a common resource, or pay less than
their fair share of the cost of a common resource. Examples: people who watch public television
and never donate money to PBS, users of parks, and missile defense system.
2. Incentives: financial or social motivators that influence human behavior.
3. Adverse Selection: a phenomenon wherein the insurer is confronted with the probability of loss
due to risk not factored in at the time of sale. Example: People who have a family history of
breast cancer are more likely to get cancer insurance.
4. Perverse Incentives: an incentive that has an unintended and undesirable result which is
contrary to the interests of the incentive makers. Perverse incentives are a type of unintended
consequence. For example: US Doctors are financially incentivized to order more procedures,
whether or not they help the patient. They are similarly dis-incentivized to provide
maintenance on chronic diseases, since they require time, effort, and are not reimbursed at a
high rate. Or, politicians are incentivized to borrow money now for policies that will make them
look good, even though it will put the county/state/country on bad financial footing later. They
likely won't even be in office then.
5. The Law of Unintended Consequences: actions of people—and especially of government—
always have effects that are unanticipated or unintended. For example: Teaching children not to
talk to strangers (e.g. the “Stranger Danger Campaign”) may be making them less safe, not more
safe. Or, the campaign to stop forest fires may put communities at a higher risk for catastrophic
forests fires.
6. Principal-Agent Problem: Conflicts of interest and moral hazard issues that arise when a
principal hires an agent to perform specific duties that are in the best interest of the principal
but may be costly, or not in the best interests of the agent. For example: Why doesn't a relator
exert some extra effort in getting a higher monthly rent or sale price for a property they're
responsible for? Because they only get a fraction of the sale/rental price in commission, so it
isn't worth their time to seek out a higher bid on a property. It is in their best interest to get
quick sale rather than a higher sale price.
7. Stock Options: a benefit in the form of an option given by a company to an employee to buy
stock in the company at a discount or at a stated fixed price. There are often restrictions on
when and how stock options can be bought or sold.
8. Boards of Directors: A group of individuals that are elected as representatives of the
stockholders to establish corporate management related policies and to make decisions on
major company issues.
9. Prisoner’s Dilemma: (in game theory) a situation in which two players each have two options
whose outcome depends crucially on the simultaneous choice made by the other. It is often
formulated in terms of two prisoners separately deciding whether to confess to a crime or stay
silent.
10. Creative Destruction: describes the "process of industrial mutation that incessantly
revolutionizes the economic structure from within, incessantly destroying the old one,
incessantly creating a new one." Example: the telegraph is replaced by the telephone. The
telephone is replaced by cellphones and email. The birth of a new industry often causes the
death of another.
11. Dead Weight Loss: The costs to society created by market inefficiency. This can take various
forms. Example: If the price of a glass of wine is $3.00 and the price of a glass of beer is $3.00, a
consumer might prefer to drink wine. If the government decides to levy a wine tax of $3.00 per
glass, the consumer might switch to beer. The excess taxation creates a loss of utility to the
consumer who decides to drink beer instead of wine, although they prefer wine. The
government also loses because they gain no tax revenue.
12. Regressive Tax: a tax that is applied uniformly. This means that it hits lower-income individuals
harder.
13. Progressive Tax: the taxing mechanism in which the taxing authority charges more taxes as the
income of the taxpayer increases.
14. Earned Income Tax Credit: a refundable tax credit for low to moderate income working
individuals and couples—particularly those with children. The amount of EITC benefit depends
on a recipient's income and number of children.