LECTURE 2

SOCIAL PREFERENCES

309ECN Dr. Alexandros Karakostas

“Economic decisions can only be taken as the result of

animal spirits – a spontaneous urge to action rather

than inaction, and not as the outcome of a weighted

average of quantitative benefits multiplied by

quantitative probabilities” (Keynes, 1973 [1936]: 150)

Intended Learning Outcomes

Appreciate some of the recent empirical evidence from experimental economics on the failure of the narrow self interest hypothesis (in some cases) to explain economic behaviour.

Introduce the Trust, Ultimatum and Dictator games; see what these games can tell us about economic decision making and peoples preferences.

Introduce social preferences and the inequity aversion model of Fehr and Schmidt (1999).

Apply the Fehr and Schmidt model to explain behaviour in the Trust, Ultimatum and Dictator games

Last Week..

Last week Jon introduced how optimal incentivecontracts are derived.

participation constraint

i.e. the principal must pay the agent hisopportunity cost/ outside option.

Incentive compatibility constraint

i.e the principal need to monetarily incentivise theagent to exert the effort level that is profitmaximising to himself.

That is where C(e)’=P(e)’

Incentives work…

Causal Evidence: Pole dancers, taxi drivers, hairdressers

etc..

Andrew et al. (1997): Farmers in Philippines if paid a

piece rate versus a fixed wage exert more calories (i.e.

effort).

Haley (2003) Tree cutters under piece rate increased

productivity by 50%.

The chronicles of a firefight..

In December 2001Boston’s fire department terminates its policy of unlimited paid sick days…

As a result the number of firefighters who were ill on Christmas and New Years Eve increased tenfold.

The Fire Commissioner retaliated by cancelling their holiday bonuses.

Next year the firefighters claimed 13.431 sick days up from 6,432.

EXERCISE 3(LOOK AT THE END OF THE LECTURE NOTES)

…But not always the way we predict!

More parents were late after a fine was introduced for

parents who arrive late to pick up their childern from a

kindergarden (Gneezy and Rustichini, 2000a).

When students were paid (little) for answering correctly

on an IQ test the scores decreased(Gneezy and

Rustichini, 2000b).

When students were paid for volunteering work effort

decreased (Gneezy and Rustichini, 2000b)

TRUST GAME

Trust Game

Think the following questions

What is the optimal incentive contract in the trust game?

When you where the proposer/owner why you decided to sent

the amount you sent?

How did you expect the responder/investor to behave?

Why? How did you respond as a responder?

If that was a repeated game how would that affect behaviour?

Round 1 Round 2

Investme

nt (I)

Return

(R)

Investment

(I)

Return

Results From the Game

The Trust Game

The Trust Game (Berg et al. 1995)

The Trust game (Berg et al, 1995)

Experimental Design

64 subjects

One-shot game, double blind

Endowment: $10

Results

Proposer:

Most send money

Responder:

Some return money, increasing in amount sent

On average, proposers neither win or lose!

Assuming that both the Principal and the Agent are profit maximisers, then backward induction suggests the Principal should send nothing! (That is because the agent will

always return nothing.)

However, we know that people tend to try to trust each other.

And some studies suggest that there is even a self fulfilling prophecy of trust (Bacharach et al. 2007).

We could claim that the agent returned out of reciprocity or altruism.

What about the proposer?

The Trust Game

Ultimatum Game (Guth et al. 1983)

Two players bargain (anonymously) to divide a fixed

amount between them.

P1 (proposer) offers a division of the “pie”

P2 (responder) decides whether to accept it

If accepted both players get their agreed upon shares

If rejected both players receive nothing.

Ultimatum Game (Guth et al. 1982)

Güth, Schmittberger, Schwarze (1983)

They did the first experimental study on this game.

The mean offer was 37% of the “pie”

Since then several other studies has been conducted to examine this gap between experiment and theory (Camerer, 2003).

Almost all show that humans disregard the rational solution in favor of some notion of fairness

The modal offer is 50%

The average offers are in the region of 40-50% of the pie

About half of the responders reject offers below 30%

Ultimatum Game

Ultimatum game

When a proposer makes high offer it is either because:

A taste for fairness

Fear of rejection

Both

When a responder decides about an offer, he faces a

trade-off between:

The utility gained from the monetary payment (narrow

self interest)

Anger (self interest/ desire to express negative

reciprocity) and desire to punish (altruistic punishment).

The Drunken Ultimatum (Morewedge et al., 2013)

Drunkeness doesn’t fuzz up judgment so much as cause the drinker to overly focus on the most prominent cue in his environment (sounds familiar?).

Morewedge et al. (2013) visited some bars and asked drunk people to play the ultimatum game

They found that:

Proposers offers were the same between drunk and sober participants

Rejections where higher by drunk people

Suggesting that main motive behind behavior is self interest in the sense that participants prominent cue is expressing their anger rather than strategic or altruistic punishment.

Dictator Game (Forsythe et al., 1994)

P1 (dictator/proposer) offers a division of the “pie”

P2 (receiver/responder) is bound to accept it

The receiver has no bargaining power over the division of the pie.

In this setup the dictator has no fear of his offer being rejected

Any positive amount offered can only be explained out of pure altruism (or demand effects but we are not going to look

at this in this course)

The mean offer is around 20% and the distribution of offers is bimodal (Camerer, 2003)!

The Self-Interest Hypothesis

In economics we have been traditionally assuming that individuals are narrow self interested.

That they only care about monetary payoffs and that our preferences are independent of each other.

There are two key reasons behind this assumption:

Simplicity: which leads to clear predictions

In many cases strong predictive power (eg. auctions!)

In recent years experimental economists have shown that the narrow self interest assumption in many cases fails to predict behaviour and as a result the literature in social preferences have been developed.

Social Preferences

Social Preferences relax the self-interest hypothesis and

allow for interdependent preferences.

As a result models of social preferences often account

that an individual’s utility function depends on the utility

of others.

Examples

Altruism, Spite

Reciprocity

Fairness

Beliefs, Intentions

Types of Social Preferences

Distributive Preferences: Preferences over the final

distribution, eg. Equity, efficiency, altruism; related to

consequences or outcomes

Reciprocal Preferences: Desire to reward or punish other

beyond mere consequences, e.g., being “more than fair”

to someone who has been fair to you; related to

intentions or types of agents

Models of Social Preferences

Among the most well known models on Social Preferences

1. Inequality Aversion (Fehr and Schmidt 1999; Bolton and

Ockenfels, 2000)

2. Intention based reciprocity (Rabin, 1993; Dufwenberg and

Kirchsteiger, 1998)

3. Hybrid models (Falk and Fischbacher, 1999; Charness and

Rabin, 2002)

We will focus on the most popular and simplest of these

models i.e. Inequality aversion model of Fehr and Schmidt,

1999.

Inequality Aversion (Fehr and Schmidt, 1999)

Inequality Aversion (Fehr and Schmidt, 1999)

Say you have two players: Alex (A) and Jon (J) with payoffs πΑand πJ respectively

Jon is narrow self interested. He only cares about his own

material payoff. Hence his utility function is given by:

Alex is inequity averse, he cares about his own material payoff,

but he also cares about not earning less than Jon, he also claims

that he cares a little bit for Jon and he would be less happy if he

earned more than Jon. Hence his utility function is given by:

I am clearly more complicated. Let me explain

I care about earnings the same way Jon does πΑ.

But I also care about disadvantageous inequality:

– αA max (πJ –πΑ,0) (i.e. If Jon earns more than me it makes me

unhappy)

But I also care about advantageous inequality:

– βA max (πΑ–πJ,0) (i.e. If Jon earns less than me it also makes me

unhappy)

– αA stands for how much I care about disadvantageous inequality

– βA and how much I care about disadvantageous inequality

The model assumes that αA > βA and 0≤ βA ≤1

Inequality Aversion (continued)

UA(π)= πΑ – αA max (πJ –πΑ,0) – βA max (πΑ–πJ,0)

You can also write the equation the following way:

If πΑ = πJ Then, UA(π)= πΑ

If πΑ < πJ Then, UA(π)= πΑ – αA (πJ –πΑ)

If πΑ > πJ Then, UA(π)= πΑ – βA max (πΑ–πJ,0)

EXERCISE 4(LOOK AT THE END OF THE LECTURE NOTES)

All else given, i prefer j’s income to equal his; i’s utility declines in their income difference, more so if i himself is worst off.

i’s utility as a

function of j’s

income, for a

given xi

Note xi xj stands for 𝜋𝐴, 𝜋𝐽 respectively

UA(π)= πΑ – αA max (πJ –πΑ,0) – βA max (πΑ–πJ,0)

Back to the Trust Game

0.5 1

send return πA πP β α Uagent

10 0 40 0 20 20

10 5 35 5 15 20

10 15 25 15 10 15

10 20 20 20 0 0 20

10 25 15 25 10 15

10 30 10 30 20 10

Lets assume that the Proposer decides to send 10 what

would be the optimal response for an inequity averse

agent?

Intended Learning Outcomes

Appreciate some of the recent empirical evidence from experimental economics on the failure of the narrow self interest hypothesis (in some cases) to explain economic behaviour.

Introduce the Trust, Ultimatum and Dictator games; see what these games can tell us about economic decision making and peoples preferences.

Introduce social preferences and the inequity aversion model of Fehr and Schmidt (1999).

Apply the Fehr and Schmidt model to explain behaviour in the Trust, Ultimatum and Dictator games

Expected reading

Berg, Joyce, John Dickhaut, and Kevin McCabe. "Trust, reciprocity, and

social history." Games and Economic Behavior 10.1 (1995): 122-142.

Falk, A., Kosfeld, M., 2006. The Hidden Costs of Control. American

Economic Review 96, 1611-1630.

Fehr, E., Falk, A., 2002. Psychological Foundations of Incentives,

European Economic Review 46, 687-724

Fehr, Ernst, and Klaus M. Schmidt. "A theory of fairness, competition,

and cooperation." The quarterly journal of economics 114.3 (1999):

817-868.

Forsythe, R., Horowitz, J. L., Savin, N. E., & Sefton, M. (1994). Fairness

in simple bargaining experiments. Games and Economic behavior, 6(3),

347-369.

Expected reading

Gneezy, U., Rustichini, A., 2000a. A Fine is a price. Journal of Legal

Studies 29, 1–17.

Gneezy, U., Rustichini, A., 2000b. Pay enough or don’t pay at all.

Quarterly Journal of Economics 115 (2), 791–810.

Güth, W., Schmittberger, R., & Schwarze, B. (1982). An experimental

analysis of ultimatum bargaining. Journal of Economic Behavior &

Organization, 3(4), 367-388.

Fehr, Ernst, Georg Kirchsteiger, and Arno Riedl. "Gift exchange and

reciprocity in competitive experimental markets." European Economic

Review 42.1 (1998): 1-34.

Recommended Reading

Fehr, E., Kirchler, E., Weichbold, A., & Gächter, S. (1998). When social norms overpower competition: Gift exchange in experimental labormarkets. Journal of Labor economics, 16(2), 324-351.

Fehr, E., & List, J. A. (2004). The hidden costs and returns of incentives—trust and trustworthiness among CEOs. Journal of the European Economic Association, 2(5), 743-771.

Gneezy, U. (2003). The W effect of incentives. University of Chicago Graduate School of Business.

Hossain, T., and List, J.A. (2009) The behavioralist visits the factory: Increasing productivity using simple framing manipulations, NBER working paper 15623

Morewedge, C. K., Krishnamurti, T., & Ariely, D. (2013). Focused on Fairness: Alcohol Intoxication Increases the Costly Rejection of Inequitable Rewards. Journal of Experimental Social Psychology.

Slonim, R., & Roth, A. E. (1998). Learning in high stakes ultimatum games: An experiment in the Slovak Republic. Econometrica, 569-596.

Additional Material

Bacharach, Michael, Gerardo Guerra, and Daniel John Zizzo. "The

self-fulfilling property of trust: An experimental study." Theory and

Decision 63.4 (2007): 349-388.

Camerer, Colin. Behavioral game theory: Experiments in strategic

interaction. Princeton University Press, 2003.

Fehr, E., & Schmidt, K. (2001). Theories of fairness and reciprocity-

evidence and economic applications.

Roth, A. E., & Kagel, J. H. (1995). The handbook of experimental

economics(Vol. 1). Princeton: Princeton university press.