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Inequity Aversion Inequity aversion Readings: Fehr and Schmidt (1999) Camerer (2003), Ch. 2.8, pp.101-104 Sobel (2005) pp. 398-401 Puzzles from experimental economics • Compared to self-interest model: •Too muc h ge ne ros ity Dictator games Ultimatum games (genuine or strategic generosity?) Public good games Trust games (trust or generosity?) • Too much sanctioning Ultimatum games Public good games • Too much conditionality Ultimatum, public good, and trust games 1 Strange things happen in labs. So what? • Internal validity: Replicability – Will others get the same result? – Was the experiment conducted professionally? • External validity: Will similar results occur outside the lab? – What is similar between the lab and the outside world? – What is not? What matters of what is not? – Refer to existing theories: Which differences would we, theoretically, exp ect to matter? – E.g.: ”In the real world, stakes are higher” – New experiment: Higher stakes! – Hypotheses on ext. validity might be tested in the lab! – Accumulated body of evidence, established regularities: New theories Some potential explanations • Inequity aversion – a preference for equal payoffs • Reciprocity – a preference for repaying kindness with kindness and meanness with meanness • Preferences for social approval – anonymity? • Altruism – caring for others’ payoff, or others’ utility • All these explanations involve ”non-standard” preferences. 2 Explanations: ad hoc vs. consistency • Anything can be ”explained” by ad hoc adjustments of preference assumptions! • A shares with others, B does not – A has a preference for sharing, B does not? • A sanctions o thers, B dtdoes not – A has a preference for sanctioning others, B does not? • Two approaches: 1. Stick to self-interest model, look for mechanisms making giving or sanctioning individually profitable – Giving → social status → well-paid job → income – Sanctioning → reputation as (irrationally) tough type → better bargaining position → higher income Experiments: Can control for such mechanisms 2. Adjust preference assumptions, but require – General applicability (consistent w. wide array of data) – and/or: Based on knowledge from other disciplines (psychology, anthropology, biology, neurology). Preferences for equity • What if some individuals dislike inequity? – Utility: Increasing in own income and in equity • Possible formalization ((p)one example): 2 Ui u(xi ) (x j xi ) – Utility increasing in own income, decreasing in distance between i and j’s income (symmetrical) • Bolton and Ockenfels (2000): Relative income xi U i U ( xi , N ) x j j 1 3 Fehr and Schmidt (1999): A model of inequity aversion • Individuals care about own income, advantageous inequity, and disadvantageous inequity – Suffer more from disadvantageous than advantageous inequity – Simplification: Linearity Ui xi i maxx j xi ,0 i maxxi x j ,0 – Can alternatively be written: Uxiiiij () xx if xx i j Uxiiiji () xx if xx i j Fehr and Scmidt: Inequity aversion Ui xi i maxx j xi ,0 i maxxi x j ,0 where i≠j, and βi ≤ αi, 0 ≤βi <1 Ui (xj|xi) 45º line i’s utility as a function of j’s income, for a given xi xj xi All else given, i prefers j’s income to equal hers; i’s utility declines in their income difference, more so if i herself is worst off. 4 Ultimatum game: Inequity averse responder • Responder, B, prefers high payoff to himself, and equality between himself and the proposer, A. • Choice: – RjRejec t: {xA,xB}{00}={0,0} – Accept: {xA,xB}={(1- s)X, sX} • Offered share s = 0.5: – Accept yields same income difference as reject. Accept yields more income than reject. Offer is accepted. • Offered share s >0.5: – Accept: higher income difference than reject. Accept yields more income. Assumption βi < 1: One will never throw away income to avoid advantageous inequality. Offer is accepted. Inequity averse responder (cont.) • Offered share s <0.5: – Accept: higher income difference than reject. – Accept yields more income. – No upper boundary on αi: We may throw away income to avoid disadvantageous inequality. U B xB B maxxA xB ,0 B maxxB xA ,0 U B (accept ) sX B [(1 s)X sX ] sX B [X 2sX ] X [s B (1 2s)] U B (reject ) 0 • Reject is preferred if X[s (1 2s)] 0 B • i.e. if s B 1 2 B • Note: X doesn’t matter! 5 Example • αB = 2, βB = 0.4 • Offer from Proposer (A): s = 0.2 U B xB i maxxA xB ,0 B maxxB xA ,0 UB () accept 0.2XXXXX 2max 0.8 0.2 ,0 0.4max 0.2 0.8 ,0 = 0.2X - 2· 0.6X = X (0.2 – 1.2) = - X U B (reject ) 0 • B will reject, regardless of the size of the ”pie” to be shared. Inequity averse Proposer • Prefers high payoff to himself (A) and equality between himself and the responder (B). • Offered share s = 0.5: – If accepted: Yields max. equality, but less than max. income – Both self-interested and inequality-averse responders will accept s = 0.5 • Offered share s >0.5: – If acceptdted: Yield s less income than s = 050.5, and less equality – Proposer will never offer s > 0.5 6 Inequity averse Proposer (cont.) • Offered share s < 0.5: – If accepted: Lower s, higher income, but less equality – Which is most important? – A’s utility when s ≤ 0.5, given thatB accepts: U A x A A maxxB x A ,0 A maxx A xB ,0 (1 s) X A[(1 s) X sX ] X (s(2 A 1) A ) – This is increasing in s whenever βA > 0.5 – If acceptance were not a concern (dictator game), A would offer s = 0 if βA < 0.5, s = 0.5 if βA > 0.5, and be .if βA = 0.5 [0.5 ,0] א indifferent between any offer s Strategic interaction • A must take into account: will B accept? • Assume inequity averse preferences, common knowledge: αA = αB = 2, βA = βB = 0.4 •SinceβA < 0.5, A would prefer to keep all of X himself, despite his inequity aversion. • However, B will reject if 2 s B 0.4 1 2 B 5 • Knowing this, A offers s = 0.4 (or: slightly more). • B accepts. 7 Self-interested Proposer, inequity-averse Responder •Let αA = 0, βA = 0, αB = 2, βB = 0.4 – CkldCommon knowledge • Responder will reject if s < 0.4 – Threat is credible, due to B’s inequity aversion • Knowing this, Proposer will offer 0.4 • No difference between the behavior of self - interested and inequity-averse Proposers! If Proposer does not know Responder’s type • A must consider the probability that B is inequity-averse. • If possible (in the lab, it is usually not!), a self-interested B would pretend being inequity-averse. • In some situations, the existence of inequity-averse types makes self-interested types behave as if they were inequity-averse too. 8 Competition • Responder or proposer competition: – Observed outcomes usually very inequitable – 1 person reaps (almost) all gains, others get (almost) nothing. • Double auction markets: – Observed outcomes usually conform nicely to the self-interest model • DhlDo such results contra dihdict the assumpt ion that (at least some) players are inequity averse? n-person inequality aversion • Fehr-Schmidt model with n individuals: – Normalizes inequality aversion by the number of others (otherwise every new ppylayer k would decrease i’s utility unless xk= xi ) – Self-oriented: compares himself to everyone else, but does not care about inequality between others – Crucial question: What’s the relevant peer group? 1 U (x ) x max x x ,0 i i i i n 1 j i j i 1 max x x ,0 i n 1 j i i j 9 Proposer competition • You’re selling a house with market value X. If it’s not sold, your gain is 0 (you’re moving, no rental market). For any interested buyers, its value is X. • Sales process: 1. Potential buyers i give sealed offers siX 2. You either reject all offers (no sale), or you accept the highest offer. If there is a tie, actual buyer is picked randomly among highest offers. 3. Trade takes place according to accepted offer (if any). 4. If sale took place, your payoff is shX(h is the buyer). Buyer’s gain is (1-sh)X. No sale: All get payoff 0. • If only 1 potential buyer: Standard ultimatum game. – Buyer: Proposer. Seller: Responder. (Sequence!) • Assume: – 10 potential buyers. – Your βB < 0.5, so you will pick the highest offer. Proposer competition – cont. • Self-interest prediction: – Several proposers offer s=1, which is accepted – When there are several potential buyers who all value the house at X, you will get X. • Assume: Every player is inequity-averse – If buyer i’s offers is rejected, he will experience unfavourable inequity: His payoff=0, someone else’s>0 – If his offer is accepted, there will be inequity anyway, but his income will increase, and the inequity can be turned to his advantage – The only (subgame perfect) Nash equilibrium is that at least two proposers offer s=1, of which one is accepted. 10 Why doesn’t inequity aversion affect outcome with proposer competition? –”No s ing le p laye r ca n e nfo rce a n equ itab le outco me. Given that there will be inequality anyway, each proposer has a strong incentive to outbid his competitors in order to turn part of the inequality to his advantage and to increase his own monetary payoff.” (Fehr and Schmidt 1999, p.834) • No buyer can secure less disadvantageous inequa lity b et ween hi mself and th e monopoli st (you) by offering you a relatively low share: If he tries, you can just pick someone else’s offer. Thus, inequity aversion becomes irrelevant. Criticisms of the Fehr-Schmidt model • Linearity – Dictator games: Dictator A will give either 0 (if βA < 0.5) or 0.5 (if βA > 0.5) – Possible modification of model: Utility concave in inequity • Who is the reference group? – Lab: All subjects in experiment? Opponent(s)? – Outside lab...? •Flaws andiki?d aggressive marketing? – Avner Shaked (2005): The Rhetoric of Inequity Aversion, University of Bonn.
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