Experiments in Economics

Playing fair with money

Ananish Chaudhuri

• Publisher: Routledge
• Year: 2008
• ISBN:
  9781134023905
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Business allgemein

Are humans fair by nature? Why do we often willingly trust strangers or cooperate with them even if those actions leave us vulnerable to exploitation? Does this natural inclination towards fairness or trust have implications in the market-place? Traditional economic theory would perhaps think not, perceiving human interaction as self-interested at heart. There is increasing evidence however that social norms and norm-driven behaviour such as a preference for fairness, generosity or trust have serious implications for economics. This book provides an easily accessible overview of economic experiments, specifically those that explore the role of fairness, generosity, trust and reciprocity in economic transactions.

Ananish Chaudhuri approaches a variety of economic issues and problems including:

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• Pricing by firms

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• Writing labour contracts between parties

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• Marking voluntary contributions to charity,

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• Addressing issues of environmental pollution,

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• Providing micro-credit to small entrepreneurs,

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• Resolving problems of coordination failure in organizations.

The book discusses how norm-driven behaviour can often lead to significantly different outcomes than those predicted by economic theories and these findings should in turn cause us to re-think how we approach economic analysis and policy.

Assuming no prior knowledge of economics and containing a variety of examples, this reader friendly volume will be perfect reading for people from a wide range of backgrounds including students and policy-makers. The book should appeal to economics undergraduates studying experimental economics, microeconomics or game theory as well as students in social psychology, organizational behaviour, management and other business related disciplines.

Part 1
Introduction

The starting point of much economic thinking is the assumption of individual rationality. While the word rationality often implies different things in different disciplines, in economics this term means that in situations involving strategic decision making, the people making those decisions care mostly about their own monetary payoffs; or they care about their own satisfaction (or “utility” as economists refer to it) where that utility is primarily a function of the monetary payoffs accruing to them or their kin. In other words, humans are primarily motivated by “self-regarding” preferences. But we now have voluminous evidence that in a wide variety of economic transactions social norms and norm-driven behaviour, such as notions of fairness, willingness to be generous towards or cooperate with strangers, willingness to trust strangers and reciprocate others’ trust, play a crucial role.

This can work both ways. Sometimes perfectly feasible deals may not get made because one side believes that the other side is being deliberately unfair. But at the same time deals that should not get made do get made because people are perfectly willing to trust strangers with their money. Enterprises such as eBay or TradeMe essentially rely on such willingness to trust strangers and are making money out of it. Sometimes notions of what is fair or unfair may act as a constraint on firms maximising their profit. Buyers may refuse to buy something they desperately need if they think that firms are taking advantage and charging unnecessarily high prices (a practice often known as “price gouging”) – for instance doubling the price of snow-shovels immediately after a snow-storm. Sometimes it might prevent people from getting jobs in the midst of a recession because firms are unwilling to cut the wages of existing workers even though the unemployed ones are willing to work for a much lower wage.

These are some of the things that I will talk about in this book. But before that I need to take you through some preliminary ideas and concepts. I hasten to add that this book is written for people with no background in economics. Don’t worry if you don’t know what the words “demand” and “supply” mean – in fact the words “demand” and “supply” appear rarely in this book – it won’t matter. As long as you have an inquisitive mind and are open to new ideas and thoughts, this book is for you.

A large number of decisions in our day to day lives require us to engage in “strategic decision making”. What does strategic decision making mean? It means that what I decide to do in a particular situation will affect the well-being of another person (or a group of people) – and in turn what someone else does will crucially impact upon my own well-being. Here are some examples of such situations:

• people trying to decide whether to contribute money towards building a local park or another similar charity;
• the local bakery offering a discount on pastries just before closing;
• a Persian-rug seller haggling over the price and deciding how quickly to lower the price;
• a Hadza man in Tanzania deciding whether to join another hunter in order to jointly hunt a stag for the day or to try catching a rabbit on his own;
• an employee deciding how hard to work when the employer is away;
• people bidding for art, oil-leases or knick-knacks on eBay.

Economists (and increasingly others in evolutionary biology, political science, sociology and business-related disciplines such as management, organizational behaviour and marketing) routinely rely on a set of tools called “game theory” to understand how people make decisions in such situations. Game theory is essentially a language for describing strategic interactions when what happens to one person is affected by another person. Thus a number of situations that confront us in our day to day lives – such as the ones listed above and many others – can be thought of as “games” with us as “players”, and they can be analysed using the tools of game theory.

While it is always hard to pin-point when exactly a particular set of ideas arose, most scholars would agree that the origins of game theory can be traced back to the publication of the book The Theory of Games and Economic Behavior written by John von Neumann and Oskar Morgenstern in 1944. Subsequently other scholars have added to our understanding of strategic decision making including John Nash, John Harsanyi, Reinhard Selten, Robert Aumann and Thomas Schelling. Nash, Harsanyi and Selten were honoured with the Nobel Prize in Economics in 1994 while Aumann and Schelling were similarly honoured in 2005.¹

Let me highlight why many of these situations involve strategic decision making by looking at the first example listed above. Close to where I live in the city of Auckland is a playground for small children called “Little Rangitoto Reserve”. I go there often with my young daughter. Surprisingly the equipment in this playground – the slides, the swings, the jungle gym and the monkey-bars – were not provided by the Auckland City Council but were rather bought by local residents on the basis of voluntary contributions. On the face of it, this is probably not surprising to any of you since you may have experience with similar such ventures or others which rely on voluntary charitable contributions for a good cause. It happens all the time and as a result we tend to forget that this is actually quite an accomplishment.

Let me explain why. Suppose you want to build a similar public park in your neighbourhood and you decide to approach local households for a certain contribution. Not everyone in the neighbourhood has to contribute for the park to get built. As long as some of the families contribute you will have enough money for the park.

What are the chances that you will be able to raise enough money? The chances are actually good but there is an inherent social dilemma here. For the time being suppose (as economists often tend to do) that by and large people are self-interested and care (mostly) about their own welfare. It is obvious that if everyone does chip in with a contribution then the park will get built and everyone in the neighbourhood can take their children there. Collectively then we will all be better off if everyone cooperated.

But let us think for a minute about an individual (who cares primarily about her own well-being and those of her close ones) trying to decide whether to contribute or not. Suppose she does not contribute any money to the pot and the park does not get built. Then she is not better off but she is not worse off either since there was no park there before and there will not be one in the future. But suppose she does not contribute but enough money is raised to build the park. Now a park is quite different from (say) a health club because once the park is built it is extremely difficult to keep anyone out regardless of whether she has paid or not. Typically you cannot really have a membership for a public park. So even if someone has not paid, this person cannot be prevented from going to the park once it is built. So she has not contributed anything but still gets to enjoy a walk in the park with her child or her dog. This person is then better off since she has not paid anything out of her own pocket but still gets to enjoy the open air of the park and the verdant surroundings. So then it appears that whether the park gets built or not – for an individual who cares primarily about her own self-interest – the practical course of action is not to contribute any money.

Economists refer to this type of behaviour as “free-riding” – taking advantage of other people’s contributions. But if everyone reasoned along the same lines then no one will contribute and the park will never get built!

Joseph Heller summed up this phenomenon eloquently in Catch 22 while discussing Yossarian’s reluctance to help build the officers’ club:²

Sharing a tent with a man who was crazy wasn’t easy but Nately didn’t care. He was crazy, too, and had gone every free day to work on the officers’ club that Yossarian had not helped build.

Actually, there were many officers’ clubs that Yossarian had not helped build, but he was the proudest of the one on Pianosa. It was a sturdy and complex monument to his powers of determination. Yossarian never went there to help until it was finished; then he went there often, so pleased was he with the large, fine, rambling, shingled building. It was truly a splendid structure, and Yossarian throbbed with a mighty sense of accomplishment each time he gazed at it and reflected that none of the work that had gone into it was his.

In the economist’s parlance Yossarian is free-riding on the effort put in by the other officers, an occurrence not altogether uncommon in many economic settings, which require a group of people to collaborate. Many of you who are used to working with groups of people and are aware of the problems that arise will recognise Yossarian’s behaviour. Economists typically argue that faced with a group enterprise, such as building the officers’ club or a local park or contributing to charitable causes in general, self-interested humans will inevitably behave like Yossarian and, therefore, such enterprises are doomed to failure. Economists go on to suggest that in equilibrium – the usual term used is a “Nash equilibrium” after John Nash who first proposed the idea – all self-interested actors will free-ride and no one will contribute towards building the park! Here the phrase “equilibrium” suggests a lack of any tendency or desire to change. If no one contributes and the park does not get built then collectively everyone is worse off and everyone realises that everyone is worse off. But no individual wishes to change his behaviour. A single individual contributing will not change the outcome (the park will most likely not get built) while this individual will be out of some cash from his own pocket at no additional benefit to himself. Everyone realises that it is better if everyone contributes but once they are caught in the free-riding trap – the equilibrium – it is extremely difficult to get out of it. The only way to get out of the trap will be for everyone to change their minds simultaneously which again creates a similar collective decision-making problem which led to us falling into the trap in the first place.

Once again our intrepid hero Yossarian of Catch 22 sums up the nature of this equilibrium succinctly in the following conversation with Major Major Major Major³:

“Suppose we let you pick your missions and fly milk runs,” Major Major said. “That way you can fly the four missions and not run any risks.”

“I don’t want to fly milk runs. I don’t want to be in the war any more.”

“Would you like to see our country lose?” Major Major asked.

“We won’t lose. We’ve got more men, more money and more material. There are ten million people in uniform who can replace me. Some people are getting killed and a lot more are making money and having fun. Let somebody else get killed.”

“But suppose everybody on our side felt that way.”

“Then I’d certainly be a damned fool to feel any other way. Wouldn’t I?”

Everybody refusing to fly missions is the least desirable outcome in this case – at least from Major Major’s and the country’s perspective – but if one person does not fly missions while others do then the person not flying is better off and eventually the others will stop flying as well – a Nash equilibrium.

At this point you might be thinking that everyone is not like Yossarian or, for that matter, not like an economist! (“No wonder people call it the ‘dismal science’,” you might be muttering under your breath.) If you do not agree with this assumption that is fine because, as I will show you shortly, this assumption is mostly wrong. Yes, people donate large amounts to charity. They donate blood and organs to others. Across a vast majority of transactions, humans routinely cooperate with non-related strangers. Maybe because they believe that this is the behaviour expected of them and not to comply with that expectation imposes psychological costs. But I do need to point out that if you are someone who perceives human beings as being essentially kind and cooperative – altruistic – across the board then, as I will show you (and as many of you probably know from experience), that view would be incorrect as well. People are neither purely self-interested nor purely altruistic but rather they are conditional co-operators whose behaviour is determined to a large extent by what they think their peers will do. I will talk about this at length in Part 4. But we need to start somewhere if we want to build a model of human behaviour that generates accurate predictions and economists feel that the assumption of rational self-interest is a good place to start. So let us start there and see where and how far that gets us.

Suppose we want to find out the real motivations behind people’s actions. Why do some people routinely cooperate? Why do some freeride? How would you go about answering these questions? Traditionally researchers have followed two different paths. The first of these is to rely on surveys where we ask people questions about what motivates them. Why did someone do what he did? Surveys are straight-forward and usually yield valuable insights. But at the same time there are drawbacks to this approach as well. The problem is that sometimes people’s response to what they would do in a particular situation does not predict accurately what they would really do when actually placed in that situation. In technical terms we sometimes say that people’s attitudes do not always correlate well with their behaviour. This essentially means the following: suppose I ask you whether you were willing to contribute $50 for a good cause and you said yes. But when eventually the envelope gets passed around and you have to actually part with the money you may renege on that promise completely or put in less than $50. I am not saying that you will do it, but it has been known to happen. Moreover, responses in these questionnaires may differ substantially from behaviour not because the respondent is trying to mislead the researcher but because the respondent may possess an incorrect perception of his own and others’ views or reactions. That is, the respondent might honestly think that he will behave in a certain way in a particular situation but when that specific situation comes to pass he behaves quite differently.

Here is an example of such dichotomy between attitudes and behaviour taken from the literature in social psychology. In the early 1930s Richard LaPierre wanted to discover if people who had various prejudices or negative attitudes towards members of other ethnic groups would actually demonstrate these behaviours in an overt manner. For approximately two years LaPierre travelled around the US with a young Chinese couple. They stopped at 184 restaurants and 66 hotels. They were refused service only once and on the whole received a better than average standard of service from the establishments visited. After returning from two years of travelling around, LaPierre wrote to all the businesses where he and the Chinese couple had dined or stayed. In a letter, which gave no indication of his previous visit, he enquired whether they would offer service to Chinese customers. While virtually none of the establishments had actually refused service, in the survey the majority expressed the opinion that they would not serve the Chinese visitors. There are many other examples of such dissonance between attitudes and behaviour.

The second avenue of exploration, as opposed to relying on survey questionnaires, has been to look at naturally occurring field-data generated by a real-life economic phenomenon. That is, if you wanted to understand whether and why people contribute to charity then you might dig up data on charitable contributions and analyse that data. This has been the more traditional and usual approach in economics. In order to understand behaviour one needs to look at data that pertained to a particular phenomenon. In fact the famous American economist and the recipient of the Nobel Prize in 1970, Paul Samuelson wrote in his undergraduate textbook (which until recently was the most popular text in universities not only in the US but across the world):

(e)conomists cannot perform the controlled experiments of chemists or biologists because (they) cannot easily control other important factors. Like astronomers or meteorologists, (economists) generally must be content largely to observe.

The problem with field, i.e. naturally occurring, data is that this data may not always be available or not available in the exact form that is needed to answer a particular question. Moreover, since the data is generated by a one-time economic phenomenon it may not necessarily be in the form that allows us to make causal inferences; i.e. whether a particular phenomenon X caused another phenomenon Y. Furthermore, if one is trying to understand people’s preferences and beliefs, it is often very difficult to do this using natural data since beliefs or preferences cannot easily be observed.

Economic experiments provide an alternative way of addressing these questions about people’s motivations. Contrary to what Samuelson thought, economists found out that it is indeed possible to create laboratory experiments in economics as in other hard sciences and these experiments can be extremely valuable in unravelling the mysteries of motivations, preferences and beliefs. The idea is to take a fundamental economic problem and then design a suitable decision-making experiment. Then you recruit participants to take part in the experimental game and afterwards you analyse the data to see whether people’s behaviour corres...