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Fairness and social preferences.

(ch 10 + articles)

Social preferences are a type of preference studied in

behavioral and experimental economics and social

psychology. These preferences include interpersonal

altruism, fairness, reciprocity, and inequity aversion.

When people exhibit social preferences it means that they are not solely motivated by material self-interest but also care positively or negatively for the material pay-offs of other individuals.

These other individuals are called relevant reference agents, and vary depending on the situation. They may be work colleagues, relatives, trading partners, neighbors etc. It is important to keep in mind that in different domains a person may have different reference agents.

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The Standard Economic Model (SEM).

• SEM often referred to as the self interest model is linked to the rationality assumption

• Pure self-interest models assume that an individual maximizes her own utility, the

function of which is unaffected by the utility

of others. Behavioral models extend the utility

function and allow it to incorporate the utility

(or pay-offs) of others.

Anomalies (deviation from the established rule; in this case SEM) can for example relate to behavior that are altruistic or spiteful.

• altruistic: one definition: behavior that is beneficial to others –but involves a cost to the person who behaves in this manner- donation for example.

• Spiteful behavior: behavior that imposes a cost or damage to the receiver at a cost to the originator-yelling at someone that throws litter for example.

Both types of behavior involve non-material benefits.

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Many anomalies are observed in real life and experiments

that refute the SEM’s assumption for example:

- Tipping waiters

- Giving to charity

- Monopolies not raising prices in shortages

- Companies that lay off workers rather than cut wages

- Punishing free riders even at a cost to the punisher

- Co-operation in prisoner dilemma games

Etc…

Why altruistic or spiteful? There may be many differentreasons- one theory put forward is group selection:

The group selection idea, which originates from Darwin, states that groups with internal cooperation will be more successful than other groups, and that this may cause altruistic behavior. This implies that the individual will make sacrifices for the common good of the group, so that the group may survive and prosper.

Similarly, this theory extends to punishment for those who do not adhere to group rules , so punishment (even at a cost to the punisher) may be seen as a way to uphold and enforce societies norms.

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• SEM assumes 1) people are motivated solely by self interest,

2) people are unboundedly rational

3) no time lags.

• BGT (Behavioral game theory) relaxes all these 3 assumptions.

Fairness

The nature of fairness

• there is no objective measure of fairness. What is considered fair varies over time and between societies.

• We will begin by considering the factors that determine peoples’ judgment of fairness in general terms based on the paper by Daniel Kahneman, Jack L. Knetsch, Richard H. Thaler1986 in American Economic Review. Fairness as a Constraint on Profit Seeking: Entitlements in the Market.

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Kahneman, Knetsch, Thaler 1986; AER, Fairness as a

Constraint on Profit Seeking: Entitlements in the Market.

The paper considers in turn three determinants of fairness

judgments:

1. the reference transaction

2. the outcomes to the transactors

3. Circumstances of changing transaction terms.

The study was concerned with scenarios that involve a firm

(merchant, landlord, or employer) making a pricing or wage-

setting decision that affects the outcomes of one or more

transactors (customers, tenants, or employees)

key concept: Dual entitlement; both parties in

a transaction are entitled to certain

consideration.

Transactors have an entitlement to the terms of

the reference transaction and firms are

entitled to their reference profit.

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1. Reference Transactions • A central concept in analyzing the fairness

of actions in which a firm sets the terms of future exchanges is the reference transaction

The reference transaction is a relevant precedent (standard) that is characterized by a reference price or wage, and by a positive reference profit to the firm. Market prices, posted prices, and the history of previous transactions between a firm and a transactorare examples of reference transactions.

The dual entitlement means that firm is not allowed to increase its profits by violating the entitlement of its transactors to the reference price, rent or wage.

example: Acceptable or unfair?N= total number of respondents

Question 2A. A small photocopying shop has one employee who has worked in the shop for six months and earns $9 per hour. Business continues to be satisfactory, but a factory in the area has closed and unemployment has increased. Other small shops have now hired reliable workers at $7 an hour to perform jobs similar to those done by the photocopy shop employee. The owner of the photocopying shop reduces the employee's wage to $7.

results: (N = 98) Acceptable 17% Unfair 83%

Question 2B. A small photocopying shop has one employee... [as in Question 2A]... The current employee leaves, and the owner decides to pay a replacement $7 an hour.

results: (N = 125) Acceptable 73% Unfair 27%

Note: The current wage of an employee serves as reference for evaluating fairness of lowering an employee's wage but not n for evaluating the fairness of the wage paid to a replacement. The entitlement of an employee to a reference wage does not carry over to the new employee, even with the same employer.

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Another exampleQuestion 2A. (same as before) A small photocopying shop has one

employee who has worked in the shop for six months and earns $9 per hour. Business continues to be satisfactory, but a factory in the area has closed and unemployment has increased. Other small shops have now hired reliable workers at $7 an hour to perform jobs similar to those done by the photocopy shop employee. The owner of the photocopying shop reduces the employee's wage to $7.

results: (N = 98) Acceptable 17% Unfair 83%

Question 3. A house painter employs two assistants and pays them $9 per hour. The painter decides to quit house painting and go into the business of providing landscape services, where the going wage is lower. He reduces the workers' wages to $7 per hour for the landscaping work.

results: (N = 94) Acceptable 63% Unfair 37%

Note that the same reduction in wages that is judged acceptable by most respondents in Question 3 was judged unfair by 83 percent of the respondents to Question 2A.

Note:

*The relevant reference transaction is not always unique. There may be disagreement about what is the reference transaction.

Ex: When competitors change their price or wage

* the reference transaction provides a basis for fairness judgments because it is normal, not necessarily because it is just. Terms of exchange that are initially seen as unfair may in time become the reference transaction.

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2. Outcomes to the transactors(Kahneman et. al called it ”The coding of outcomes”

The principle rule of fair behavior and dual-

entitlement is that one person should not

achieve a gain by simply imposing an

equivalent loss on another.

Question 1.

A hardware store has been selling snow

shovels for $15. The morning after a large

snowstorm, the store raises the price to $20.

Is this action: results: (N = 107) Acceptable 18% Unfair 82%

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The outcomes in the snow shovel example of Question 1 were a $5

gain to the firm and a $5 loss to the representative customer and

considered unfair.

If however, the same price increase been induced

by a $5 increase in the wholesale price of snow

shovels, the outcome to the firm would have been

zero and this would be perceived as more “fair” .

However empirical findings have shown that there

is an asymmetry in the type of cost. People are

found to be more sensitive to out-of-pocket costs

than to opportunity costs and more sensitive to

losses than to foregone gains

Example: framing effect and money illusion

Question 4A. A company is making a small profit. It is located in a community experiencing a recession with substantial unemployment but no inflation. There are many workers anxious to work at the company. The company decides to decrease wages and salaries 7% this year.

Results: (N = 125) Acceptable 38% Unfair 62%

Question 4B A company is making a small profit. It is located in a community with substantial unemployment and inflation of 12% . There are many workers anxious to work at the company. The company decides to increase salaries only 5% this year.

results: (N = 129) Acceptable 78% Unfair 22%

Although the real income change is approximately the same in the two problems, the judgments of fairness are strikingly different. A wage cut is coded as a loss and consequently judged unfair. A nominal raise which does not compensate for inflation is more acceptable because it is coded as a gain to the employee, relative to the reference wage.

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• Question 6A. A small company employs several people. The workers' incomes have been about average for the community . In recent months, business for the company has not increased as it had before. The owners reduce the workers' wages by 10 percent for the next year.

results: (N =100) Acceptable 39% Unfair 61%

Question 6B. A small company employs several people. The workers have been receiving a 10 percent annual bonus each year and their total incomes have been about average for the community. In recent months, business for the company has not increased as it had before. The owners eliminate the workers' bonus for the year.

results: (N = 98) Acceptable 80% Unfair 20%

The reference price in this case is ambiguous. Total income is the same in both cases (average for the community) and the result after the change is the same,

but the framing of the question has an effect- i.e: removing a bonus (with a lower salary)in the second case is considered acceptable, lowering wagesis not. The reference wage in A is higher than in B.

3. Circumstances of changing

transaction terms

The authors examine the rules of fairness that apply to three classes of occasions in which a firm may reconsider the terms that it sets for exchanges.

(i) Profit reductions, for example, by rising costs or decreased demand for the product of the firm.

(ii) Profit increases, for example, by efficiency gains or reduced costs.

(iii) Increases in market power, for example, by temporary excess demand for goods, accommodations or jobs.

-

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Ex: protecting profitmost people consider that firms are entitled to their reference profit when

circumstances change

Question 7. Suppose that, due to a transportation mix-up, there is a local shortage of lettuce and the wholesale price has increased. A local grocer has bought the usual quantity of lettuce at a price that is 30 cents per head higher than normal. The grocer raises the price of lettuce to customers by 30 cents per head.

Results: (N =101) Acceptable 79% Unfair 21%

Question 8. A landlord owns and rents out a single small house to a tenant who is living on a fixed income. A higher rent would mean the tenant would have to move. Other small rental houses are available. The land-lord's costs have increased substantially over the past year and the landlord raises the rent to cover the cost increases when the tenant's lease is due for renewal.

Results: (N = 151) Acceptable 75% Unfair 25%

Protecting the firms reference profit applies to

employers as well.

• Question 9A. A small company employs several workers and has been paying them average wages. There is severe unemployment in the area and the company could easily replace its current employees with good workers at a lower wage. The company has been making money. The owners reduce the current workers' wages by 5 percent.

results: (N = 195) Acceptable 23% Unfair 77%

• Question 9B.... The company has been losing money. The owners reduce the current workers' wages by 5 percent.

results: (N = 195) Acceptable 68% Unfair 32%

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Note: While respondents find it acceptable for a firm protect its reference profit – this is only true with costs that pertain directly to the transaction at hand.

for example: it is considered unfair for a landlord to raise the rent on an accommodation to make up for the loss of another source of income.

Kahneman, Knetsch and Thaler found 62 percent of the respondents considered it acceptable for a landlord to charge a higher rent for apartments in only one of two otherwise identical buildings, because a more costly foundation had been required in the construction of that building.

The assignment of costs to specific goods explains why it is generally considered unfair to raise the price of old stock when the price of new stock increases:

Profit increasesStudies indicate that standards of fairness do not restrict firms to

the reference profit when their costs diminish.

Ex: Question IIA. A small factory produces tables and sells all that it can make at $200 each. Because of changes in the price of materials, the cost of making each table has recently decreased by $40. The factory reduces its price for the tables by $20.

Results (N = 102) Acceptable 79% Unfair 21%

Question II B. .... the cost of making each table has recently decreased by $20. The factory does not change its price for the tables.

Results (N = 100) Acceptable 53% Unfair 47%

Note the even division of opinions on Question 11B

The Dual-entitlement view is supported in that the rules of fairness permit a firm not to share in the losses that it imposes on its transactors, without imposing on it an explicit duty to share its gains with them.

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Exploitation of Increased Market

Power Example 1 with the snowstorm and snow shovels as well as question

2a, using a shortage of labour to cut wages can also be seen as examples of exploiting market power. But it need not even be such extreme cases

Question 12. A severe shortage of Red Delicious apples has developed in a community and none of the grocery stores or produce markets have any of this type of apple on their shelves. Other varieties of apples are plentiful in all of the stores. One grocer receives a single shipment of Red Delicious apples at the regular wholesale cost and raises the retail price of these Red Delicious apples by 25% over the regular price.

results: (N = 102) Acceptable 37% Unfair 63%

Raising prices in response to a shortage is considered unfair even when close substitutes (other apples) are available.

Conventional economic analyses assume that excess demand for a good creates an opportunity for suppliers to raise prices, and that such increases will indeed occur.

The profit-seeking adjustments that clear the market are in this view ethically neutral.

However, this is not the common view among consumers. Community standards of fairness effectively require the firm to absorb an opportunity cost in the presence of excess demand, by charging less than the clearing price or paying more than the clearing wage.

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If we were to summarize some of the findings of

the dual entitlement principle

• Raising price to maintain profit is perceived to be fair

• Raising prices to increase profit is not• Maintaining price when costs decrease (or not

reducing price as much as cost reduction) is

considered relatively fair.

Examples of economic consequences.

• Markets may fail to clear in the short run

• Prices more responsive to cost than demand

changes

• Scarcity may occur when one firm sells similiar

goods.

• Stickiness of wages

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Fairness games.

Examples of common games that are used to

investigate fairness and social preferences

-ultimate bargaining games

-dictator games

-trust games

-prisoners dilemma games

-public good games.

ultimate bargaining games

mostly 2 player games- a proposer (P) and a responder (R)

• The proposer decides on how a specific sum of money (say 100 SEK) is to be divided between himself and the responder. So he offers the sum x to R and reserves (100-x) for himself.

• R can either accept the offer in which case the money is divided accordingly, or reject the offer in which case both receive nothing.

• According to SEM based on pure self interest the proposer will propose the smallest amount of money possible and the responder will accept.

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The Proposer (P) offers x of 100

The responder (R) accepts or rejects the proposers offer

R accepts R rejects

(P= 100-x; R=x) (P=0; R=0)

The SEM predicts that the proposer will propose the smallest amount of money possible

and the responder will accept.

Results from UBGWhat do the empirical findings consistently show?

60-70% of all offers are between 0,4 and 0,5 share of the total (surplus). Almost none are below 0,2.

Low offers are frequently rejected (0,2 or below are rejected about 50% of the time).

The results are fairly robust even with higher stakes. Camerer (1995) found that a few people would even be willing to reject the equivalent of 3 months income in order to “punish” the proposer for an “unfair” proposal.

Interpretation of results:

Rejections: respondents who perceive behavior as “unfair” will be willing to incur a cost for the satisfaction of “punishing” the proposer “spiteful”.

Proposals: these can be explained by proposers wishing to behave “fairly” as well as avoiding the risk of receiving a rejection and losing money if the proposal is too low ie. the offer may be due to altruistic or strategic motives (or both).

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Dictator gamesA very simple game involving no strategic interaction.

The proposer decides the distribution of the money and the other part must accept the offer.

The value if this game is that as the proposer does not have to fear a rejection- all positive proposals are altruistic rather than strategic.

• SEM predicts that the offer will be zero. Results from dictator games find that people do share although the average offer (20%) is lower than in ultimatum games.

Dictator games cont………

Why do people give money away- i.e. what do these games measure? “pure altruism”? “warm glow”? “inequality aversion”? etc. Can we transfer the results to real life?

Note: house money, blind/double blind effects were found by Shogren, Cherry, Frykblom etc.

List found that when dictators are also allowed to take away money (ex -$10… they give close to 0)� implies that once you change the structure of payments so that dictators can feel like a “good person”, ie: self image motivation, then they payments will be much lower.

Ie: Dictator game: they felt like a good person if they gave away money

Game 2: they felt like a good person if they don’t take away money.

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Trust games.

Trust is often an element in incomplete contracts (a complete contract is one that specifies all possible outcomes). Most contracts are incomplete , renting a property, employing someone, partnership in a business, getting married etc. Trust is seen as a way to lower transaction costs and can be seen as “social capital”.

Correlation between level of trust and high rate of growth and development has been found Knack and Keefer 1997.

• Essence of trust games involve an Investment by the truster (I) in the Trustee (T). The investment is risky ( the trustee may bail out). However if the return is sufficient then the investor may benefit.

Example of a typical trust game:Investment by the truster (I) in the Trustee (T)

• I has an amount x he can either keep or at least partly invest.

• If I invests y (and keeps x-y), then this earns a return of y*(1+r).

• T must then decide how much of y*(1+r) he would share with I. (i.e. T plays the dictator game at this stage). If T keeps z and returns y*(1+r)-z then the total payoffs are that I receives (x-y)+ y*(1+r)-z= x+ r*y -z.

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I has a total of x to invest

Pay-off 1I = x; T = 0

I invests 0 I invests y

Investment y grows to y(1+r)T plays dictator and distributes y(1+r)

Pay-off 2I= x-y; T= y(1+r)

T does not share T keeps z

Pay-off 3I= x+ry-z; T= z

The prediction of the SEM is that there will be no trust. Reason: If there was trust then T will choose not to share (payoff 2) according to SEM which I knows and as payoff 2 for I is less than payoff 1, I will not trust.

Empirical findingsEmpirical findings: With a return, r=2 , only 6%

followed the SEM prediction. The average investment was 50% (of $10) , 16% invested everything.

Average amount repaid however was 95% of investment: thus, return on trust was very close to 0. Games are interesting as it allows positive reciprocity to be measured.

Larger returns than in the traditional dictator game.

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Prisoner Dilemma games:

Classic co-operation game: two prisoners who cannot

communicate: Objective is to minimize jail time. Prisoner B

Prisoner A

confess Not confess

confess 5 years, 5 years 0 years, 10 years

Not confess 10 years, 0 years 1 year, 1 year

The best combination is for both to not confess, but there

is a paradox because the dominant strategy in this case is

for both to confess-and is in fact what the SEM model

predicts.

Empirical findings:

In one shot games, people co-operate (not confess) about 50% of the time.

Why then do they co-operate (not confess) when non co-operation is the dominant strategy? Altruism? or the expectation of matching co-operation?

because we don’t know PD games are a blunt tool for predicting real-life behavior.

• When pre-play communication is allowed, increased co-operation has been found, although this should not have an effect according to SEM.

• another variation on the PD is sequential play (a kind of trust game)

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Public good games:

• Characteristics of a public good are non depletion and non exclusivity.

ie. A good cannot easily be provided for one person without even providing it for another and consumption of the good by one person does not lessen the quantity for another. ex: a lighthouse, a view, cleaner environment etc.

• The provision of these kind of goods generally are associated with a free rider problem where each person will contribute less (zero according to the SEM model)than her value for the good, hoping to free ride on others� under-provision of the public good.

An example of a public good game:

• In the basic game subjects are given tokens (or money) X. They secretly choose how many of their private tokens(Y) to put into the public pot.

• Each subject keeps the tokens they do not contribute plus an even split of the tokens in the pot (researchers running the game multiply the number of tokens by m in the pot before it is distributed to encourage contribution).

ΣΣΣΣYj= contribution of all players, N= number of playersPlayer i then receives Xi-Yi+mΣΣΣΣYj/N.

The best for the group is that all individuals put in X so that the total money distributed will be as large as possible. But the best for each individual would be to give nothing�everyone will lose, which is the SEM conclusion.

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ex: 10 people participate, each person initially has $10,

m=2 (ie: the pot is doubled).

-If everyone puts in $10 then the pot will increase to $200 and everyone will get $20.

But if 1 person puts in 0, and all else puts in $10 then the pot of $90 will increase to $180. Then, everyone will receive $18 except the person who defaulted, who will get $10+$18=$28. The dominant strategy is for everyone to default although the best would be to co-operate. Default by everyone is the SEM conclusion.

• Empirical evidence finds however that depending on the framing and variations that people often co-operate.

• -subjects contribute about ½ their resources. On average- but generally contribute all or nothing Altruism? Or expectation of co-operation? Framing: repeated games results? If they see their follow players, house money (cherry etc)

Factors affecting social preferences

The different games described here have been

studied under different conditions in order to

better understand the nature of social

preferences. These conditions come under

tree main category of variables.

-Methodological and structural variables

-Descriptive variables

-Demographic variables

Read that section yourself…..

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Inequality aversion models(also called difference-aversion models)

Bakground

• Certain types of behavior (e.g. giving to charity, donating blood etc.) are difficult to explain with standard economic theory and with the emergence of experimental economics this became particularly apparent.

So why do people depart from equilibrium even in the simplest environments?

In the ‘90s and forwards we find:– Development of theories of social preferences– Experiments that pit them against each other– Experiments that test the predictive power of the theories

A number of social preference models have been developed in an effort to explain and organize the evidence from economic experiments. It has been found that people share with others in dictator games, reject offers in ultimatum games, cooperate in public good games etc., all of which is in direct conflict with traditional microeconomic utility theory.

We will look at three difference aversion models that do not incorporate reciprocity.

We will mainly use the Wilkinson book and the article”Would the right social preference model please stand up!” Dinky Daruvala, Journal of Economic Behavior and Organization 2010.

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Theories of inequality aversion: Subjects dislike inequality relative to relevant comparison groups.

The three most well known models are by

– Fehr & Schmidt– Bolton & Ockenfels– Charness and Rabin.

• Inequality aversion models (Fehr & Schmidt, QJE, 1999; Bolton & Ockenfels, AER, 2000): Both assume that utility is increasing with one’s own money payoff but decreasing with the difference between one’s own and others’ money payoffs

• Quasi-maximin model (Charness & Rabin, QJE, 2003): assume that utility is increasing with an agent’s own money payoff, with the lowest of all agents’ payoffs, and with the total of all agents’ payoffs (efficiency concerns). This model comes also under the banner of social preference models

All three models explain ”their” structure of fairness by modifying the utility function.

Fehr and Schmidt (1999)

Ui (x)= xi - ααααi /(n-1) ΣΣΣΣ max[xj-xi, 0]- ββββi /(n-1)ΣΣΣΣ max[xi-xj, 0]

Where αi ≥ βi ; 0≤ βi

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Ex: Two individuals i and j. In the case of n=2, the sum-signs disappear

Ui (x)=xi - ααααi max[xj-xi, 0]- ββββi max[xi-xj, 0]

Assume that for individual i, ααααi =1, ββββi =0,5

Case 1: i gets 100, j gets 100� the last 2 terms disappear and Ui=100.

Case 2: i gets 100, j gets 50- the second term is 0, the third term is 0,5*50=25 so Ui=100-0-25=75.

Utility is lower because i feels it is unfair for j to receive less (altruism or guilt).

Case 3: i gets 100, j gets 150- the second term is 1*50=50 , the third term is 0 so Ui= 100-50-0= 50. Utility is lower than both Case 1 and 2 because of envy.

The SEM would say that the individual is indifferent between the three cases.

The Bolton-Ockenfels model

(ERC)• Bolton and Ockenfels present an unspecified “motivation” function

that is given by

• Ui(x)= U(xi, si) where si=xi/ Σxj that is the individual’s share of the total payoff.

• The authors assume that utility is increasing in xi, but for any given xi, utility decreases as the relative payoff, si, moves away from the social reference share 1/n.

• Thus, for any given payoff xi the function is maximized when si=1/n, n being the number of individuals in the reference group.

• In the case where si>1/n, the marginal rate of substitution between absolute and relative pay-offs will determine how much the individual is willing to sacrifice in order to obtain a more egalitarian solution.

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The difference between the two difference aversion models is that in the Fehr-Schmidt model the individual compares her own pay-off with each and every other individual in the reference group. In the Bolton-Ockenfels model the individual’s only concern is her share of the total surplus and the pay-offs of other individuals do not enter directly into the motivation function. In the case where a transfer of money is made from an individual with a higher pay-off to an individual with a lower pay-off, utility will increase in the Fehr-Schmidt model but remain unchanged in the ERC model.

The Quasi-maximin model of Charness

and Rabin (2000)

The model assumes that people are willing to

make sacrifices to increase the payoff of all

recipients, but especially for the lowest pay-

off recipient. The individual has also concerns

for the total surplus (efficiency concerns) The

individual’s utility function is given by

∑∑∑∑====

δδδδ−−−−++++δδδδγγγγ++++γγγγ−−−−====n

1jjn21ii ]x)1(}x...x,xmin{[x)1(U

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Ui=(1-γ)xi+γ[δ min{x1, x2….xn}+(1-δ)Σxj]

• The parameter γ∈[0, 1] corresponds to the weight the individual places on social welfare, expressed as

[δ min{x1, x2….xn}+(1-δ)Σxj] versus her own monetary payoff .

• When γ=0, then preferences are consistent with pure self-interest.

• If , γ=1the individual displays purely “disinterested” preferences where the individual values the pay-offs of

others as much as her own.

Quasi-Maximin continued

Ui=(1-γ)xi+γ[δ min{x1, x2….xn}+(1-δ)Σxj]The parameter δ∈[0, 1] measures the degree of

concern for helping the lowest pay-off

recipient versus increasing the total surplus.

Thus δ=1 is consistent with the Rawlsiancriterion while δ=1 corresponds to maximisation of the total surplus (only

efficiency is important).

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The various social preference models provide different explanations for the experimentally observed behavior, but it is sometimes possible to explain the same experimental data using different models. For example, sharing in dictator games can as being due to maximin preferences while the same results can be explained by difference aversion according to Bolton and Ockenfels and Fehr and Schmidt models.

Similarly rejections in ultimatum games and cooperation in prisoner’s dilemma games is ascribed to difference aversion by Bolton and Ockenfels and Fehr and Schmidt while others, ex. Rabin interprets such behavior as reciprocity.

One comparison is made by Daruvala 2010 – Would the right social preference model please stand up!! JEBO.

So which model is the correct one?

Daruvala 2010 – an experiment that placed the individuals’ preferences into one of the different models where the design of the experiment is such that membership in one of the models (including a general model) is mutually exclusive. Results find that individuals are heterogeneous , and have strong preferences for the surplus- which implies that the difference aversion models are lacking this element.

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resultsTable 1: Frequency of participants that qualify into the different model categories and give surplus increasing donations. Number of respondents

within each category. (% of total)

Number of respondents that gave surplus increasing donations. (% of group)

Fehr-Schmidt 9 (6,8%) 3 (33.3%)

ERC 28 (21,1%) 9 (32.1%)

Quasi-Maximi 36 (27,3%) 10 (27.8%)

Inequality-averse 39 (29,5%) 11 (28.2%)

Self Interest 10 (7,6%) 0 (0.00%)

Other 10 (7,6%) 3 (30.0%)

Total 132 (100%) 36 (27,3%)

Some implications.

*Market clearing and sticky prices/wages

*Public goods- behavioral economics more

optimistic than traditional

*Crowding out of intrinsic incentives- explicit

incentives (for example economic incentives)

may lead to crowding out ex. Day care fines

and blood donations.

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Rationality

(from diverse chapters in the book +

articles)

Rationality

• Rational behavior, in the broad meaning of “sensible”, planned, and consistent behaviorhas traditionally believed to govern most conduct in economic markets, because of individuals pursue self- interest and because of the tendency of market to punish foolish behavior.

However, there is a growing body of behavioralevidence against the rational model.

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Perceptions/beliefs

AttitudesProcess

Preferences

Affect

Motives

INFORMATION

CHOICE

The Decision Process according to psychologists.

Many studies show that individuals faced with decision-making tasks in

carefully experimental settings often exhibit behavior that is inconsistent

with the homoeconomicus model. The leading research paradigm has

focused on Tversky and Kahneman’s experimental studies of cognitive

anomalies: circumstances in which individuals exhibit surprising

departures from rationality.

Tversky's (1977) " Daniel Kahneman and I have studied the cognitive processes

underlying the formation of preference and belief. Our research has shown that

subjective judgments generally do not obey the basic normative principles of

decision theory. Instead, human judgments appear to follow certain principles that

sometimes lead to reasonable answers and sometimes to severe and systematic

errors. Moreover, our research shows that the axioms of rational choice are often

violated consistently by sophisticated as well as naive respondents, and that the

violations are often large and highly persistent. In fact, some of the observed

biases, such as the gambler's fallacy and the regression fallacy, are reminiscent of

perceptual illusions. In both cases, one's original erroneous response does not lose

its appeal even after one has learned the correct answer.”

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Rationality…Defining rationality: no absolute consensus

Three definitions:

1) Self-interested behavior; some define rationality as acting in your own best interest. Then it would be irrational to smoke, not wear a seatbelt etc. Baumeister calls such behavior as “self-defeating”.

2) using reason, rather than allowing emotions or instinct to affect decisions.

3)Transitive preferences. In traditional economics, we assume that individuals make consistent choices; this is one of the axioms of rationality, specifically the concept of transitive preferences.

Prediction with SEM is that people may act irrationally but the aggregate will still be consistent with SEM

The differences in definition� disagreement

about what is rational choice. For decision

making:

Baumeister wrote “A rational being should

pursue enlightened self-interest.”

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Enlightened implies perfect knowledge- which is rarely the case.Behavioral economists take the view that if we misjudge what is in our best self-interest than this does not mean the individual is irrational:

Why would an individual make a mistake of judgment? Many reasons for example.

• The individual may have incomplete information• cognitive failures due to problems with processing

information within the given time constraint.

This is called bounded rationality meaning that people have limited time and capacity to weigh all the relevant benefits and costs of a decision.

Another way to look at bounded rationality is that given limitedtime and capacity they use rationality only after havinggreatly simplified the choices available. Thus the decision-maker is a satisficer -one seeking a satisfactory solution ratherthan the optimal one.

The SEM states self-interest is that an individual will maximize expected utility. Is pursue the same as maximize?

Even here- the constraints of bounded rationality is relevant.

Kahneman and Tversky found that when faced with judgment in a problem-solving situation, the human brain relies on a multitude of complex strategies.

In a knowledge-poor situation or under constraints of time or uncertainty, we depend on 'rules of thumb' or cognitiveheuristics.

Rules of thumb are associated with “satisficing”- we don’t always bother pursuing the “optimal” but the “good enough”.

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Even if we apply the concept of bounded rationality (lack of time and information), we may still misjudge self-interest (cannot be explained by bounded rationality).

This can occur due to self-serving bias:

ex: better-than-average effect. the individual is biased to believe that he or she typically performs better than the average person in areas important to their self-esteem. This effect, also called "illusory superiority" has been found when people rate their own driving skill, social sensitivity, leadership ability and many other attributes.

Self-interest in itself is a vague concept. Traditionally measured by economists as utility – where “utility is a measure of subjective value”. However the statement does not clarify the word value.

-We economists tend to prefer to talk about utility as welfare or well-being - rather than pleasure or happiness. This is mainly because the latter terms are value laden and often thought of in terms of long run (happiness) and short run (pleasure).

-Neuro-scientific evidence also finds that many experience feelings of happiness and sadness at the same time.

-Other problems are predicted utility vs decision utility.

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Criteria for Rationality

1) Attitudes and preferences should follow the basic rules of logic and probability theory

2) Attitudes and preferences should be coherent, ie: consistent

3) Attitudes and preferences should be not be formed on irrelevant factors

4) Attitudes and beliefs should not be incompatible with empirical observations known to the individual.

We can use these criteria to discuss irrational behavior.

Types of violation of rationality using

the 4 criteria

1) Reasoning

2) Choice

3) Nature of utility

4)The role of visceral factors

5) Self-deception

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Faults in ReasoningDecision making is often made using cognitive

heuristics. One such heuristic is the

representativeness heuristic, the use of which

systematically lead individuals to make poor

judgements in some circumstances.

• representativeness heuristic: people judge likelihood of events based on how it

'represents' a larger group or other similar

examples .

Consequences of the

representativeness heuristic

• People ignore preexisting distribution of categories or base rate frequencies

• People are insensitive to prior probability of outcomes

• People are insensitive to sample size

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Is it more likely that Susan is a

Librarian, a Teacher, or a Lawyer?

Susan is very shy and withdrawn, invariably

helpful, but with little interest in people, or in

the world of reality. A meek and tidy soul, she

has a need for order and structure, and a

passion for detail.

Is it more likely that Susan is a Librarian, a

Teacher, or a Lawyer?

Linda is 31 years old, single, outspoken, and very

bright. She majored in philosophy. As a

student, she was deeply concerned with

issues of discrimination and social justice, and

also participated in anti-nuclear

demonstrations.

Which is more likely?

• Linda is a bank teller.• Linda is a bank teller and is active in the

feminist movement,

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Gamblers fallacy and the ”Hot hand”Caused by a misinterpretation of random series

Gambler’s Fallacy: They see a ‘normal’ event and think it ‘rare’, they think chance will ‘correct’ a series of ‘rare’ events.

The Hot hand, in contrast, is a belief in positive autocorrelation of a non-autocorrelated random sequence of outcomes like winning or losing.

For example, imagine someone repeatedly flipping a (fair) coin and guessing the outcome before it lands.

-If she believes in the gambler's fallacy, then after observing three heads in a row, her subjective probability of seeing another head is less than 50%. Thus she believes a tail is "due," and is more likely to appear on the next flip than a head.

-If however, she believes in the hot hand, then after observing three correct guesses in a row her subjective probability of guessing correctly on the next flip is higher than 50%. Thus she believes that she is "hot" and more likely than chance to guess correctly.

Cont. gamblers fallacy and the hot hand

• Both fallacies have important implications for economic behavior, e.g., clearly relevant in

context of investing.

• Overconfidence causes people to:– Overstate the likelihood of favorable events– Understate the uncertainty involved

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ChoiceViolations of the second criteria; coherence (consistency).

There are many situations where people’s choices display lack of coherence or consistency (second criteria). Many are covered in prospect theory and support theory

• Ex: loss aversion, event splitting, framing effects, preference reversals etc.

Violations of the third criteria (influence of irrelevant information) can be seen in anchoring effects (affects both judgments and choice) and context effects.

Ex: CONTEXT EFFECTS

The anomalies in this case arise because the presentation of information influences how it is processed.

Ex microwaves

• Simonson & Tversky (1992) report an experiment involving microwave brands A and B, and a more expensive model A* a deluxe version of brand A.

They found that the proportion of consumers choosing A was higher from the choice set {A,A*,B} than from the choice set {A,B}

Apparently, the presence of the expensive model A* in the choice set made A appear to be a bargain, and thus more attractive.

Violates the third criteria (influence of irrelevant information).

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Another example: framingImagine a disease is expected to kill 600 people

– Under program A, 200 people will be saved– Under program B, there is a 1/3 probability that 600

people will be saved and a 2/3 probability that no people will be saved

72% prefer A to B

– Under program C, 400 people will die– Under program D, there is a 1/3 probability that no one

will die and a 2/3 probability that 600 people will die

78% prefer D to CObserve, the outcomes and questions in A and C as well as B and D are

identical- the first problem, a positive frame emphasizes lives gained; in

the second, a negative frame emphasizes lives lost.

Anchoring

People rely on “anchor values” in making

number estimates

Experiment from finance : People pay attention

to fund advertising with “big numbers”

(distorting their risk-return perceptions)

Just changing fund name affects investors’

estimates of expected returns“Euro Star 100 fund” = 11.8%

“Euro Star 500 fund” = 22.6%

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Nature of utilityPeople often tend to mispredict their utility

(sometimes due to visceral factors). They

may fail to take account of past experiences

in decision making and generally

overestimate present factors on predicted

future utility.

The role of visceral factors.People often act against their self-interest in full

knowledge that they are doing so; they experience a feeling of being ‘‘out of control.’’ This phenomenon is often attributed to the operation of ‘‘visceral factors,’’ which include “drive” states such as hunger, thirst and sexual desire, moods and emotions, physical pain, and craving for a drug one is addicted to.

This behavior violates the the fourth criteria for rationality

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Visceral factors cont:

Visceral factors tend to be reccuring states and

often follow a similiar pattern, they increase in

intensity until they are relieved, they

temporarily fall to a low level before rising

again. This roller-coaster charateristic has an

effect on our decision behavior.

Self-deception

- Self-perception theory; people infer their intentions from their actions.

The theory asserts that people develop their attitudesby observing their own behavior and infering whatattitudes must have caused them. The theory is counter intuitive in nature, as the conventional viewis that attitudes come before behaviors. Further, the theory suggests that a person induces attitudeswithout accessing internal cognition and moodstates. The person reasons their own overt behaviorrationally in the same way they would attempt to explain others’ behaviors.

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Self-deception cont.

Cognitive dissonance theory (Festinger); there is a tendency for individuals to seek consistency among their cognitions (i.e., beliefs, opinions).

Dissonance results when an individual must choose between attitudes and behaviors that are contradictory.

Dissonance can be eliminated by reducing the importance of the conflicting beliefs, acquiring new beliefs that change the balance, or removing the conflicting attitude or behavior.

Cognitive dissonance cont.

Festinger 1991 "If you change a person’s behavior, his thoughts and feelings will change to minimize the dissonance”

By this Festinger meant that that we humans have a deep abiding needin their psyche to be consistent in our attitudes and behaviors; wewant to feel in agreement and unified in thought and action

Cognitive dissonance is a very powerful motivator which will often leadus to change one or other of the conflicting belief or action. The discomfort often feels like a tension between the two opposingthoughts. To release the tension we can take one of three actions:

-Change our behavior.

-Justify our behavior by changing the conflicting cognition.

-Justify our behavior by adding new cognitions.

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Cognitiv dissonance ex.Assume I realized the college I am attending is not offering

me the classes I’m interested in. I am feeling a post-decision dissonance, now that I’ve chosen my school, within myself due to this logical inconsistency:

-I value a college that offers classes interesting to me.

-I am not attending a college that offers classes interesting to me.

My belief and behavior conflict so I seek to eliminate and reconcile the difference.

My belief and behavior conflict so I can

1. devalue my belief and say, "Classes aren’t supposed to be interesting anyway."

2. emphasize a new belief that supports my staying at the college. " I am getting a good education, having fun, and it’scheaper than most."

3. leave my college. "My value for interesting classes is moreimportant than staying here."

The first two choices above involve the concept called selectiveexposure, i.e., I avoid opposing thoughts in order to decreasedissonance.

The third choice reaction to this inconsistency is keeping my original attitude’s integrity. This is a result of post-decisiondissonance, I decided I would attend. I looked at what I’dchosen and decided I did not like it enough to stay with it.

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An excellent paper on cognitive dissonance in

economics written by Akerlof and Dickens.

”The economic consequences of cognitive

dissonance”

GA Akerlof, WT Dickens - The American

Economic Review, 1982

Self-deception cont.

Another form of self- deception is the self-serving bias

(described earlier).

A self-serving bias occurs when people attribute their

successes to internal or personal factors but

attribute their failures to situational factors beyond

their control. This may lead to over-confidence.

Overconfidence is more common for difficult tasks

while easy tasks sometimes involve under-

confidence; hard/easy effect.

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Objections to violations of Rationality

There have been many objections by SEM

defenders to the studies that point to

violations of rationality. These objects can be

classified inte three categories

1. Trivialisation

2. Misinterpretations

3. Inappropriate tests.

1. TrivialisationThis category claims that the violations observed

are unsystematic and unreliable;ex:

Randomness: deviation are just random errors

commonly observed in statistical distributions

Incentives: Responders lack incentives to give

true or reliable answers

Expertise: Responders lack expertise, experts

would give better responses

Need for cognition

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2. Misinterpretation

Objections belonging to this category concern

claims that the irrationality observed is

because participants have a different

understanding of the task than was intended.

-The conjunction error

-Framing effects

-Interpretations of probabilities

3. Inappropriate testsThe last category questions the approriateness

of tests of rationality

-computational limitations

-inappropriate problem formats

- (inappropriate norms)

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SummaryThe various objections cannot explain away the

large body of systematic evidence violating the SEM assumptions: but it does not make sense to redefine rationality because of this. Many economists suggest the formulation of dual-process models of resoning whichoperate in different situations. I.e. In certainsituations, people use analytical, logical rulebased decision system- while in others theyuse heuristic processes.