The document summarizes a lecture on social preferences in economic decision making. It introduces experimental games like the trust, ultimatum, and dictator games that show people's preferences go beyond narrow self-interest. It presents the inequity aversion model of Fehr and Schmidt which proposes that individuals care about fair distributions and dislike inequitable outcomes. The model is then applied to explain behaviors in trust and ultimatum games. Expected readings and additional materials on social preferences are also listed.

1. 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)

2. 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

3. Last Week..
 Last week Jon introduced how optimal incentive
contracts are derived.
 participation constraint
 i.e. the principal must pay the agent his
opportunity cost/ outside option.
 Incentive compatibility constraint
 i.e the principal need to monetarily incentivise the
agent to exert the effort level that is profit
maximising to himself.
 That is where C(e)’=P(e)’

4. 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%.

5. 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.

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

7. …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)

8. TRUST GAME

9. 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?

10. Round 1 Round 2
Investme
nt (I)
Return
(R)
Investment
(I)
Return
Results From the Game

11. The Trust Game

12. 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!

13.  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

14. 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.

15. 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%

16. Ultimatum Game

17. 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).

18. 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.

19. 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)!

20. 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.

21. 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

22. 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

23. 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.

24. Inequality Aversion (Fehr and Schmidt, 1999)

25. Inequality Aversion (Fehr and Schmidt, 1999)
 Say you have two players: Alex (A) and Jon (J) with payoffs πΑ
and 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:

26.  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

27. 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)

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

29. 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 𝜋 𝐴, 𝜋𝐽 respectively
UA(π)= πΑ – αA max (πJ –πΑ,0) – βA max (πΑ –πJ,0)

30. 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?

31. 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

32. 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.

33. 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.

34. Recommended Reading
 Fehr, E., Kirchler, E., Weichbold, A., & Gächter, S. (1998). When social
norms overpower competition: Gift exchange in experimental labor
markets. 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.

35. 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.