Markets, States, and the Logic of Incentives
- 19 hours ago
- 11 min read
By: Yan Xinkai (Kelly)
From the butcher in Smith’s time1 to the chatbot today, we are served not out of goodwill, but because it pays to serve. Enterprise behavior is not about intent, but about incentives. The question is not whether a firm seeks profit or serves under a public or charitable flag, but what kinds of behavior its "incentive architecture" promotes.
This essay examines the hope of profit, and its opposite: do they encourage innovation, adaptiveness and accountability? Or do they lead to complacency, rent-seeking and mis-allocation? Instead of idealizing any single ownership model, we assess which institution best links private incentives to public outcomes. On balance, the question, then, is not who owns the enterprise, but which institutional design best aligns private incentives with public goals.
I. The Case for Profit: Innovation, Adaptation, and Growth
1.1 Innovation
The hope of profit builds an incentive scheme that rewards speed and experimentation. Schumpeter's "creative destruction"2 (1942) captures this well: firms innovate because the market punishes stagnation and prizes disruption.
From AI to renewable energy, disruptive technologies like ChatGPT and Tesla's Full Self-Driving (FSD) system are driven by profit-maximizing motives: the former addresses demand for low-cost intellectual labor, while the latter targets recurring revenue streams from software subscriptions.
OECD figures show over 70% of patents come from profit-driven firms3. For instance, AI advancements (e.g., China's Manus) emerge from a commercial arms race, not public service mandates. Studies on U.S sectoral difference in R&D reveals that incentives facing firms make innovative agents naturally gravitate toward sectors with larger opportunities, especially in biomedicine and IT.
1.2 Adaption
Incentives shape not just what firms do, but how fast they do it. Profit-oriented enterprises operate under tight feedback loops: a firm that fails to adapt loses revenue. This pressure integrates agility into decision-making, making responsiveness a condition for survival.4
DeFi platforms, such as the Ethereum-based Uniswap, demonstrate such pattern by bypassing intermediaries through smart contracts: developers created value by outsmart regulators. The payoff was first-mover advantage, where code became a tool to monetize responsiveness.5
Profit-seeking firms also adjust swiftly to regulation. In China's carbon trading system (ETS), non-state firms rapidly financialized emissions strategies to capture short-term gains. Similarly, under the EU ETS, emissions fell 50% since 20056, not out of ecological commitment, but because pollution became expensive. This is the logic of Coasean incentives: when externalities have prices, firms adapt.
1.3 Growth, with jobs
Profit-seeking systems do more than reward innovation. Friedman (1962)7 argued that in free markets, the pursuit of profit leads to wealth creation and opportunity and Solow (1956)8 and Romer (1990)9 summarized this idea: sustained economic growth stems from innovation, which are incentivized by returns.
Empirical history supports this. The industrial takeoff of 19th-century Britain and the postwar rise of Hong Kong were driven not by centralized plans but by decentralized enterprises pursuing private gains. Private firms generated employment and urbanization, by serving more people10. Such logic was shown fully in the neoliberal reforms in the 1980s with waves of deregulation and privatization. Reagan's tax cut and reliance on the Laffer Curve11, for a period, showed that markets allocate resources more effectively when the rewards for doing so are direct and private.
II. The Cost of Incentives: Fragility, Exclusion, and Bias
2.1 Increasing Inequality
Profit rewards efficiency and growth, but it can also institutionalize inequality by concentrating gains in the hands of capital-owners and marginalizing labor. Marxist labor theory of value12 argued that profit inherently leads to wage suppression and surplus extraction, making inequality a feature of the capitalist system.
Modern economists sharpen this critique: Stiglitz (201213) shows that in deregulated markets, profit-seeking can induce rent-seeking, where firms invest more in political influence than productivity. Monopolistic consolidation and lobbying reshape markets in ways that preserve incumbent advantages and skew wealth distribution. The East Asian financial crisis (1997)
and the global crash of 2008 exposed that elites retained gains while systemic risks were socialized, leaving ordinary households exposed to job loss and asset loss.
Piketty (201414) quantifies the structural persistence of inequality: when the return on capital (r) consistently exceeds the growth rate of the economy (g), wealth begets more wealth, and intergenerational inequality compounds. In Latin America15 and post-Soviet states16, the rush to privatize transformed public goods into exclusionary services, eroding equity and trust with irresponsible profit-driven design.
2.2 Fraud and Sysmetic Risk
The hope of profit unexpectedly turns out to create incentives for speculation, particularly in financial markets with fragmented information. Akerlof’s theory of adverse selection (197017) warns that when sellers know more than buyers, profit-seeking may reward deception over quality.
Caruana18 and Acharya19 show that incentives during economic booms systematically reward short-term risk-taking: banks leverage aggressively20 to chase returns, assuming they will be bailed out in a downturn. When deleveraging eventually occurs, the unwinding is brutal. This played out dramatically in the 2008 crisis21: subprime mortgages were repackaged into opaque securities, and profit-maximizing firms knowingly offloaded risks onto the system. Once these bets collapsed, under-capitalized financial institutions invoked systemic importance to demand public rescue22, privatizing gains while socializing losses.
The rise of algorithmic trading in the 2020s23 makes market even more fragile. High-frequency trading distorted price signals and crowded out long-term investment, an outcome Shiller (2015) had foreseen in his critique of “irrational exuberance.”24 In crypto finance, similar trend reappears. Stablecoins like Tether promise price stability25, but incentive misalignment and lack of transparency allow speculative behavior to hide as security. As in previous cycles, profit-seeking behavior under weak regulatory oversight becomes not just risky, but contagiously so26.
III: The Case for Public and Non-Profit Enterprises: Counter-cyclicality, Equity and Mission-Oriented Innovation
3.1 Counter-cyclicality
More than anything, unlike profit-driven firms that downsize during recessions, non-profit and government entities behave countercyclically. This behavioral difference is a prime case of Keynesian economics27, that when private demand collapses, state-led spending must stabilize output and employment.
During the Great Depression, while firms laid off workers and froze investment, the U.S. federal government launched programs like the WPA and TVA, equivalent to state-owned enterprises, to inject income and rebuild infrastructure. Fishback (2017) finds that these efforts not only boosted consumption and employment, but also produced spillover gains in health and crime reduction28. The IMF (2010) echoes this, showing that public infrastructure spending during weak demand periods achieves multipliers exceeding 1.529.
3.2 Equity
State-owned firms tend to bring equity into services, notably in areas where profit-driven market tends to exclude, whether due to high costs or underserved common goods. This design puts Rawlsian ideals into practice by ensuring equal access from the start, rather than relying on redistribution as remedy.
We see this most clearly in healthcare and transportation. The founding of the UK's National Health Service in 1948 removed the link between medical care and ability to pay. As Besley and Ghatak (2003) note, this shift measurably improved equity in health access30.
A similar rationale underpins France's SNCF, which continues to operate regional rail lines at a loss, to maintain inclusion for workers in less profitable areas. Such services persist because governments deliberately subsidize them, as Estache and Fay (2007) identify that public infrastructure investment is used not only to enhance efficiency but also to promote regional equity31.
3.3 Mission-Oriented Innovation
Public and non-profit institutions frequently take the lead in what is often called "mission-oriented innovation"32, especially in areas where commercial incentives fall short.
Mazzucato (2013) draws attention to technologies like GPS, the internet, and renewable energy33: none of which would have emerged from the private sector alone, given their diffuse benefits and almost no excludability. Arrow's (1962) insight remains relevant here: firms underinvest in innovation when the results are unpredictable or difficult to patent34.
The Apollo mission and DARPA's ARPANET project are two examples of public institutions, as a "risk-taker of last resort," taking on early-stage risks and later yielded sweeping social returns: Apollo's legacy is greater than Moon landing, helping innovations in semiconductors and materials science; ARPANET, set out for national defense, evolved into the now Internet.
Today, China's AI programs (e.g. DeepSeek) rely on a hybrid model of state funding, procurement, and policy. These "Chinese Sputnik moments"35 target national capability, not short-term profit. The U.S. response, such as the AI Bill of Rights Blueprint, seeks to combine innovation with public oversight.
IV: The Cost of Non-profit: Soft Constraint, Bureaucracy and Window-dressing
4.1 Soft Constraints and Hard Costs
While the theoretical foundations of state or charity ownership come from classical ideals (e.g. Hobbes' Leviathan36 or Locke' s trustee governance37), these visions are handicapped by real-world constraints. Non-profit and public entities frequently shoe patterns of cost neglect, low innovation, and resource misallocation, symptoms Kornai (1986) described as the "soft budget constraint."
Hayek famously noted in 1945 that centralized systems underperform as they struggle to incorporate "dispersed knowledge" through price signals38. Indeed, state or charity-run entities often operate with insufficient information and delayed feedback, leading to inefficiency and cost inflation. As Easterly (2006) notes: well-intentioned projects frequently fail due to poor on-the-ground information and weak accountability39.
Recent fiscal practices also point to these institutional tensions. In China, Local Government Financing Vehicles (LGFVs) borrow with the backing of state guarantees, financing projects whose returns are often modest at best. With no real threat of default, this tendency echoes a classic account of bureaucratic behavior: when outputs are hard to quantify, officials tend to prioritize budget expansion over performance (Niskanen,197140).
4.2 Bureaucracy and Regulatory Capture
Whereas private firms must adapt or exit, public counterparts often survive by expanding bureaucracy.
This logic also goes into quasi-public sectors: In FinTech and crypto, the boundary between state and market is blurred. In the U.S., the GENIUS Act, framed as "pro-innovation", has drawn criticism for handing out subsidies to politically favored firms in under-regulated sectors. On the other side of the globe, China's leading FinTech platforms often operate with tacit state backing.
In both cases, the deeper concern of "selective favoritism" leads to what Stigler (1971)41 and Tullock (1967)42 defined as regulatory capture: when the regulated shape the rules. The "revolving door"43, where officials move between regulatory agencies and SOE boards or digital startups, may enhance technical understanding, but often weakens enforcement and erodes public trust.
4.3 Philanthropy or Window-dressing?
Charities are often seen as unselfish, yet economists like Andreoni44 and Bénabou & Tirole45 show that donations often look for reputational rewards, not social impact Media visibility tends to override local needs46: for instance, The Gates Foundation has always been critiqued for prioritizing high-profile projects like malaria pills over grassroots needs.
Lack of market feedback or accountability can render charities toward branding over impact. Generosity becomes performance, and public good risks becoming a byproduct of an elusive social goal.
V: Hybrid Governance: Where Accountability Meets Innovation
Profit drives innovation, only when checked by accountability. Meanwhile, public or charitable ownership may ensure equity, but often lacks the resource discipline. Yet, how can systems be built to combine the strengths of both?
"Hybrid governance structures"47 might offer such a solution: by guiding private-sector enterprise with transparency, clear contract, and shared risk, governments can better lead market incentives with public outcomes. Public-Private Partnerships (PPPs) illustrate this balance in practice: in infrastructure and renewable energy, they demonstrate how profit-seeking behavior can meet socially beneficial ends when appropriate institutions are in place. With ESG standards and CSR frameworks, such models could turn abstract goals into actionable, measurable governance tools.
We do not face a binary between markets and states, but a design challenge: to engineer systems where the pursuit of profit advances, not undermines, socially durable objectives. Markets will always chase incentives. The question is whether we are willing to design those incentives wisely.
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2.23.2026
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