CHAPTER TWO

INTRODUCTION TO BEHAVIORAL ECONOMICS

DMU,2017E.C

1 BY:Kindie A. 1/30/2025
 CHAPTER TWO
INTRODUCTION TO BEHAVIORAL ECONOMICS
Individual Decision Making
Decision Making: is the process of choosing b/n two/ more alternatives.
 It includes :
1. States of nature
2. Set of Alternatives
3. Pay off
4. Decision criteria
5. Decision matrix
List of alternatives:- set of mutually exclusive decisions that are available to
the decision maker.
 Each alternative can lead to different outcomes based on various external
conditions.
⟹ Eg. A farmer may decide to produce either:

• Wheat
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Alternatives • Corn
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• Soybean
 Cont’d…
2. State of nature :represents the uncertain conditions/external factors that can affect the outcome of
the decision. They are often beyond the control of the decision-maker.
Example: Continuing with the farmer example, the state of nature could include:
 Favorable weather conditions (good rainfall, appropriate temperatures)
 Unfavorable weather conditions (drought, excessive rainfall, Pest infestations)

3. Payoffs: - outcomes w/c might be profits, revenues, costs, or other measures of value.
4. Decision Criteria: is a standards or a benchmarks used to evaluate and compare different
alternatives. They guide decision-makers in choosing the most suitable option based on their goals and
the context of the decision.
5. Pay off Matrix : is a table that contains alternatives, state of nature & pay off.

•
Pay off table

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 Cont’d…
Example: The pay offs for the farmer might look like this:

Favorable Unfavorable
Crop Pest Infestation
Weather Weather

Corn $10,000 $3,000 $1,000

Wheat $8,000 $4,000 $2,000

Soybeans $6,000 $2,000 $500

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 Con’t…

A. Decision Making Under Certainty

 Here, a decision marker knows for surely the consequence of

each alternative, strategy or course of actions to be taken.
 It is possible to foresee (if not control) the facts & the results.

 Thanks to this information, the decision-making process will be

relatively simple. i.e
 the one that maximizes utility & responds better to the objectives set
will be chosen.
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 Cont’d…
 In most conventional economic theories, it is assumed that
individuals make decisions in an environment characterized by
the absence of uncertainty (with certainty).
 When individuals purchase goods, they know exactly what
they are getting.
 Once the allocation of the budget is determined, no
uncertainty is associated with the utility derived.
However, in several real-world situations, the assumption of certainty
may not be tenable.

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 Cont’d…
Decision Making Under Uncertainty

 The decision maker does not know the probability of each of them.

• Here, the different list of alternatives can be combined with each

state of nature to produce an outcome is called Payoff.

 It is, thus, a scenario with poor information is called uncertainty.

 The decision is complicated due to past experiences don‟t make it possible

to predict the future & there are many uncontrollable variables.

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 Cont’d…
 There are several approaches (criteria) to decision making under complete

uncertainty.

 Some of these discussed in this section include:

۞ Optimism (maxi-max or min-min) Criterion

۞ Pessimism (maxi-min or mini-max) criterion

۞ Regret(salvage) criterion

۞ Laplace (equal likelihood) criterion

۞ Hurwicz (coefficient of optimism)

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 Decision Criteria
Maxi-Max
 With the maix-imax criterion, the decision maker selects the decision that will result in
the maximum of the maximum payoffs (profit) or minimum of the minimum (cost).
 The decision maker assumes that the most favorable state of nature for each decision
alternative will occur (optimistic view).
 For example, the investor would optimistically assume that good economic conditions
will prevail in the future. The best payoff for each alternative is identified, and the
alternative with the maximum of these is the designated decision.

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 Decision criteria
Decision: A1 will be chosen.
If the pay off table consists of costs instead of profits, the opposite selection
would be indicated: The minimum of minimum costs. For the subsequent decision
criteria we encounter, the same logic in the case of costs can be used.

Maxi-Min/ Mini-Max

 It consists of identifying the worst (minimum) payoff for each alternative, then
selecting the alternative that has the best (maximum) of the worst payoffs.
 In effect, the decision maker is setting a floor on the potential payoff by
selecting maximum of the minimum.
 It involves selecting best of the worst.

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 Cont’d…
 Example:

Decision: A2 will be chosen based on the max-min criterion

If it is cost, the conservative approach would be to select the maximum
cost for each decision and select the minimum of these costs.

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 Cont’d…
Mini-Max Regret
 Both the maxi-max & maxi-min strategies can be criticized
due to they focus only on a single, extreme payoff &
exclude the other payoffs but Mini-max regret considers this.
 In order to use this approach, it is necessary to develop an
opportunity loss table.
 Hence, opportunity loss amounts are found by identifying the best
payoff in a column and, then, subtracting each of the other values
in the column from that payoff.
 Therefore, this decision avoids the greatest regret by selecting the
decision alternative that minimizes the maximum regret.

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𝑖𝑡ℎ regret = best pay off − 𝑖𝑡ℎ payoff
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 Cont’d…
 Example:

Procedures:

A1:is selected since it has the minimum regret.

13 BY:Kindie A. I.e 3<10<12 1/30/2025
 Cont’d…
Inefficient Reason
 The Minimax regret criterion’s weakness is the inability to
factor row differences. so, the minimax regret strategy will
lead to a poor decision since it ignores certain information. But
insufficient reason offers a method that incorporates more of
the information.
 It treats the states of nature as if each were equally likely & it
focuses on the average payoff for each row, selecting the
alternative that has the highest row average.
 Row average = 1/𝑛(𝑃1 + 𝑃2 + 𝑃3 + ⋯ . . 𝑃𝑛 )
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Where, A. pi=𝑖 𝑡ℎ payof & n = sample 1/30/2025
Example:

Cont’d…

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 Judgment & Choice Under Risk
 This is an intermediate situation between the two extremes.
 Each alternative or course of action has several possible consequences, but the decision
maker knows the probability of each of them.
 Uncertainty is a fact of life.
 But, there are financial institutions such as insurance & the stock markets that can
mitigate at least some of these risks.
 It is important to study individual behavior with respect to choices involving &
how the markets for mitigating risk’s function.
 The d/f situations in which the assumption of certainty would not be tenable are:
 1st Individuals purchase’s of goods are in the nature of games or lotteries for
which the outcome is uncertain (e.g. insurance purchases, stock market
transactions…).
o The purchase of goods doesn’t guarantee any particular outcome. This is the problem of risky
situations.
 2nd individuals behavior is in dealing with others (interdependency).
o Many encounters b/n individuals are in the form of adversary proceedings in w/c the reward
that anyone receives depends on what others do (e.g. price setting, diplomacy, etc.). This is the
topic in game theory or inter-firm strategy).
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 Cont’d…
 3rd, lack of understanding or information concerning the problem to be solved.
Eg , an individual is not able to decide specifically which refrigerator offers the best
quality for the money b/c the individual lacks information & may be willing to pay
for additional information. This is the problem of information asymmetry.
 Risk is can be calculated or estimated by using:
1. Expected monetary Value (EMV)
2. Expected Opportunity Loss (EOL)

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 Probability and Expected Value
 Probability: is the relative frequency with which it will occur.

 Expected value: For lottery X with prizes 𝑋1 , … , 𝑋𝑛 , and probabilities of

𝜋1 , … … … , 𝜋𝑛 , the expected value of the lottery is:
𝒏
 𝑬 𝑿 = 𝑿𝟏 𝝅𝟏 + ⋯ + 𝑿𝒏 𝝅𝒏 = 𝒊=𝟏 𝑿𝒊 𝝅𝒊 .
That is, the expected value of the lottery is the weighted sum of the
prizes, where the weights are the probabilities.
It is simply the size of the prize that the player will win on average
(expected values are averages).
 Actuarially fair games: Games which have an expected value of 0, or those
which cost their expected value for the right to play.

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 Cont’d…
 Example:

The EMV approach provides the decision maker with a value which represents an average payoff
for each alternative. The best alternative is, then, the one that has the highest EMV. The average or
expected payoff of each alternative is a weighted average:
k
EMVi = Σ Pj.Vij
i=1
Where:
EMVi = the EMV for the 𝑖 𝑡ℎ alternative
Pi = the probability of the 𝑖𝑡ℎ state of nature
Vij = the estimated payoff for 𝑖 𝑡ℎ alternative under 𝑖 𝑡ℎ state of nature.
 The sum of the probabilities for all states of nature must be 1.

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 Cont’d…
 Example:

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 Expected Opportunity Loss
 The table of opportunity loss is used rather than a table of profit.
 Hence, the opportunity losses for each alternative are weighted by the
probabilities of their respective state of nature to compute a long run average
opportunity loss.
 the alternative with the smallest expected loss is selected as the best choice.

 EOL (A1) = 0.20(1) + 0.50(0) + 0.30(3) = 1.10 *minimum⟹ A1 is selected

 EOL (A2) = 0.20(0) + 0.50(10) + 0.30(5) = 6.50
 EOL (A3) = 0.20(6) + 0.50(12) + 0.30(0) = 7.20

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 Cont’d…
Exercise : Consider a scenario where a company is deciding b/n 3 projects A,B&C based on potential profit
under the state of nature ( economic conditions) like good, fair & poor.
A. Decide which alternative is preferred by using different criteria?
B. Which project has low risk if probability of economic condition being good, fair & poor is 0.3, 0.5& 0.7 ,
respectively?

Project Good Fair Poor

A 50,000 30,000 10,000

B 70,000 40,000 20,000

C 40,000 60,000 30,000

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 Contingent Consumption
 A probability distribution consists of a list of different outcomes (consumption
bundles) & the probabilities associated with each outcome.
 During uncertainty, a consumer concerned with the probability distribution of getting
different consumption bundles.
 When a consumer decides how much automobile insurance to buy or how much to
invest in the stock market, she/he is focused on probability distribution across different
amounts of consumption.
 Suppose a person has assets worth of $35,000. There is a possibility he may loose $10,000,
with probability 0.01. He can buy insurance at r = $1 for $100. Let the purchased
insurance be K. The probability distributions the consumer faces are:
 Probability of 0.01 of getting $25,000 + K – rK
 Expected asset (EA) = 0.01(35000-
 Probability of 0.99 of getting $35,000 – rK.
10000+ K-rk) + 0.99(35000-rK)
 What kind of insurance will this person choose?
 If the optimal insurance purchase is
 It depends on his /her preferences, I.e
 choose to purchase a lot of insurance 1000,
 Decide to be risk taker & not purchase any insurance EA = 259.9
 People have d/f preferences over probability distributions, just as they have different
preferences over the consumption of ordinary goods.

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 Cont’d…
 As we can see from the example, contingent consumption plan is a
specification of what will be consumed under different circumstances.
 Contingent means depending on something that is not yet certain.
 People have preferences over different plans of consumption, just like
they have preferences over actual consumption.
 If a contingent consumption plan is considered just as an ordinary
consumption bundle, so preferences is defined over different
consumption plans, with the terms of trade being given by the budget
constraint.
 People make choices that reflect their preferences over consumption in
d/f circumstances.
 Like in the case of inter-temporal choice, indifference curves have a
convex shape.
 Thus, consumer
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behavior is perfectly adequate to model behavior under
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certainty & uncertainty by using the concept of IC.
 Cont’d…
• Like in the ordinary sense, optimal choice of decision maker for
d/f state of nature is based on tangency condition
֎ MRS b/n consumption in each state of nature must be equal to the price at
which we can trade off consumption in those states.
֎ convexity of IC
Expected utility
• It is utility derived from consumptions at d/f circumstances . So, if we
utility function to describe preferences of decision makers in d/f state of
natures.
How a person values consumption in one state as compared to another will
depend on the probability that the state in question will actually occur.

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 Expected Utility
 Therefore, utility functions will be written dependent on the
probabilities as well as the consumption levels.
 Example: U 𝑪𝟏 , 𝑪𝟐 , 𝝅𝟏 , 𝝅𝟐 = 𝝅𝟏 𝑪𝟏 + 𝝅𝟐 𝑪𝟐
U 𝑪𝟏 , 𝑪𝟐 , 𝒂, 𝒃 = 𝑪𝒂𝟏 𝑪𝒃𝟐 CobbduGlas utility function

where 𝒂 𝒂𝒏𝒅 𝒃 𝒂𝒓𝒆 the probabilities.

 Utility can be written as a weighted sum of some functions of
consumption in each state, where the weights are the
probabilities.
U 𝑪𝟏 , 𝑪𝟐 , 𝝅𝟏 , 𝝅𝟐 = 𝝅𝟏 𝑽(𝑪𝟏 ) + 𝝅𝟐 𝑽(𝑪𝟐 ).
 A utility function with this particular form is called an expected utility
26 function
BY:Kindie A.or von Neumann-Morgenstern utility function. 1/30/2025
 Cont’d…
 Expected utility is vital in dealing utility under d/f state of natures it is due

to the outcome of random choices are consumption goods that will be

consumed in d/f circumstances (mutual exclusiveness). Thus in choices
under uncertainty, there is independence b/n different outcomes since they
must be consumed separately in different states of nature (Independence
Assumption). The independence assumption implies that the utility function
for contingent consumption has additive property across the contingent
consumption bundles.

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 Cont’d…
 Hence, if c1, c2 & c3 are the consumptions in different states of
nature & π1, π2 and π3 are the probabilities that the states of nature
will happen & if the independence assumption holds, then the
utility function must take the form:
u(c1,c2 ,c3, π1, π2, π3) = π1u(c1 ) + π2 u(c2 ) + π3 u(c3)
 This is an expected utility function.
 The MRS between goods 1 &2 is:
MRS12 = (Δu(c1,c2 ,c3, π1, π2, π3)/ Δc1)/ (Δu(c1,c2 ,c3, π1, π2, π3)/ Δc2)
= (π1Δ u(c1)/ Δc1)/ (π2 Δ u(c2)/ Δc2)

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 Risk Aversion
 The term risk refers to the variability of the outcomes of some
uncertain activity.
 Often „„variance” is used as a proxy for risk.
 If the variability is low, the activity may be approximately a sure
event.
 Why do people, when faced with two choices with the same
expected value, usually choose the one with less variability of
return?

• Loss avoidance behavior feel loos more than gain

It is Due to • DMU of wealth = as wealth  MU wealth 
• Uncertainty avoidance = people dislike uncertainty
• Cognitive Biases = people weigh today than tomorrow

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 Cont’d…
 Based on person‟s response toward risk they are categorized into 3.
Risk averser
Risk lover
Risk neutral
Risk Averser : An individual who always refuses fair bets is said to be risk averse. In
risk aversion,
 there is diminishing marginal utility of wealth
 wealth-utility function is concave (U''(W) < 0).
 the averser is willing to pay so as to avoid a risk (insurance premium) approximately
proportional to Pratt‟s risk aversion measure.
 the utility of the expected value is greater than the expected utility of wealth,
U(E[W]) > E[U(W)] ⟹Jensen's inequality
 the risk-averse individual prefers an expected value of wealth than a random
distribution of wealth.
 E.g, let you have 2 options: getting a guaranteed of br. 1000 or 50% chance of getting br.2000 &
a 50% BY:Kindie
chanceA. of getting br.0. so, for a risk-averser, s/he prefers the guaranteed br.1000 over the
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50/50 chance of br.2000 or br.0.
 Cont’d…
Risk Lover: A risk-lover person prefers a project with
dispersed possible outcomes to a certain project with the
same re turn. In risk loving;
 the utility of the expected wealth is less than the expected
utility of wealth
A person prefers a random distribution of wealth to the
expected value of the wealth
The wealth-utility function is convex
3

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 Cont’d…
Risk Neutral: A risk neutral individual is indifferent b/n
the expected utility of wealth & the utility of the expected
wealth. So, in risk neutral scenario:
o wealth-utility function is linear
o Marginal utility of risk is constant.
o Utility of Expected wealth = expected utility of wealth
Notice: the curvature of wealth-utility function measures the
consumer‟s attitude towards risk.
• Risk is measured by Pratt coefficient of risk aversion.

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 Mean-Variance Utility
• It is an approach that assumes that person‟s preferences can be described by considering
a few summary statistics about the probability distribution of his wealth instead of the
whole probability distribution of its wealth over every possible outcome.
• The variance 𝝈𝟐𝒘 = 𝒔𝒊=𝟏 𝝅𝑺 𝒘𝒔 − 𝝁𝒘 𝟐 , where s represents state of nature, w represents a
random outcome, 𝝅𝑺 is probability & µw represents average of w.
 variance measures the spread of the distribution & is a reasonable measure of
riskiness.
Standard deviation, which is the square root of variance also shows variability.
• The mean-variance model assumes that the utility of a probability
distribution that gives the investor wealth: ws with a probability of πs is
given as a function of the mean & variance of that distribution, 𝑼 𝝁𝒘 , 𝝈𝟐𝒘 .
• mean - Variance utility model is a simplification of expected utility model.

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 Intertemporal Choice
 The standard theory of consumer choice is perfectly adequate to describe

inter-temporal choice.

 The objects of choice (the consumption bundles) become the streams of

consumption over time.

 In the theory of the firm, the long-run can be viewed as a time period during

which scale of operation is changed by investing in an additional capacity to

produce.

 Hence, we could view the problem of determining the long-run equilibrium

output as the problem of choosing the most profitable amount of investment.

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 Optimal Consumption over Time
The budget constraint
 Assume two periods, period 1 and period 2; and a consumer has income 𝒎𝟏 and
𝒎𝟐 , and consumes 𝒄𝟏 and 𝒄𝟐 .
 Assume the consumer can borrow and lend money at some interest rate, r.
 Assume for simplicity that prices in each period are set at 1.
 Assume first the consumer is a saver.
 So, his first period consumption, c1, is less than m1.
 In this case he will earn interest on the amount he saves, 𝒎𝟏 − 𝒄𝟏 , at the interest
rare, r.
 The amount he can consume next period is:
𝒄𝟐 = 𝒎𝟐 + 𝒎𝟏 − 𝒄𝟏 + 𝒓 𝒎𝟏 − 𝒄𝟏 = 𝒎𝟐 + 𝟏 + 𝒓 𝒎𝟏 − 𝒄𝟏

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 Cont’d…
 Now let us assume that the consumer is a borrower, so that his first period
consumption is greater than his first period income, 𝒄𝟏 > 𝒎𝟏 . The consumer will
pay interest rate 𝒓 𝒄𝟏 − 𝒎𝟏 and he has to pay back the loan 𝒄𝟏 − 𝒎𝟏 . Hence,
his budget constraint will be:
𝒄𝟐 = 𝒎𝟐 − 𝒄𝟏 − 𝒎𝟏 − 𝒓 𝒄𝟏 − 𝒎𝟏 = 𝒎𝟐 + 𝟏 + 𝒓 𝒎𝟏 − 𝒄𝟏
 If 𝒎𝟏 = 𝒄𝟏 , then 𝒎𝟐 = 𝒄𝟐 , and the consumer consumes his income in each period.
 Rearranging the budget constraint, we get,
𝟏 + 𝒓 𝒄𝟏 + 𝒄𝟐 = 𝟏 + 𝒓 𝒎𝟏 + 𝒎𝟐 (equation1)
𝒄𝟐 𝒎𝟐
Or 𝒄𝟏 + = 𝒎𝟏 + (equation 2)
𝟏+𝒓 𝟏+𝒓
 Both equations have the form:
𝒑𝟏 𝒙𝟏 + 𝒑𝟐 𝒙𝟐 = 𝒑𝟏 𝒎𝟏 + 𝒑𝟐 𝒎𝟐
 In equation 1, 𝒑𝟏 = 𝟏 + 𝒓 , 𝒂𝒏𝒅 𝒑𝟐 = 𝟏.
𝟏
 In equation 2, 𝒑𝟏 = 𝟏, 𝒂𝒏𝒅 𝒑𝟐 = .
36 BY:Kindie A. 𝟏+𝒓 1/30/2025
 Cont’d…
 Equation 1 expresses the budget constraint in terms of future values and equation
2 expresses the budget constraint in terms of present value.
 The PV is a more natural way to express the inter-temporal budget constraint since
it measures the future relative to the present.
 Convexity of preferences is a very natural case for inter-temporal choice since it
says that the consumer would rather have averages in each period rather than
have a lot today and nothing tomorrow or vice versa.
 If interest rate increase then the budget line tilt to a steeper position, since for a
given reduction in c1, the consumer will get higher consumption in period 2 if
the interest rate is higher.
 If a person is a lender, and the interest rate increases, he will remain a lender.
 If a consumer is a borrower and the interest rate decreases, he will remain a
borrower. r

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 Present Value
 A consumption plan is affordable if the present value of
consumption equals the present value of income.
 If the consumer can freely buy and sell goods at constant
prices, then the consumer would always prefer a higher valued
endowment to a lower-valued one, because an endowment
with a higher value gives rise to a budget line
 In terms of inter-temporal choice, this principle implies that if
a consumer can freely borrow and lend at a constant interest
rate, then the consumer would always prefer a pattern of
income with a higher present value to a pattern with a lower
present value.
 Present value is the only correct way to convert a stream of
payments into today‟s Birr.
 Investments
38 BY:Kindie A. are profitable if their PV of benefits > PV of costs.
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 Cont’d…
 In real life there can be many interest rates: nominal interest
rates, real interest rates, before-tax rates, short-term rates,
long-term rates…
 Hence, in choosing an interest rate, we need to ask which type of
interest rate has the properties most like the stream of payments we
are trying to value.
 E.g, if the stream of benefits is not taxed, we need to use before-tax rates.
 If the stream of benefits would continue for 30 years, we should use the long-
run rate.
 If the interest rate is risky, we should use the interest rate on an investment with
similar risk characteristics. In short, the interest rate measures the
opportunity cost of funds- the value of the alternative uses of your
money.
 Hence, every stream of payments should be compared to your best alternative
thatBY:Kindie
hasA.similar characteristics in terms of tax treatment, risk, and liquidity.
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39
 Dynamic Programing
 A programming technique that traces out the optimal
consumption or production or investment patterns
over time.
 The idea of dynamic programming is based on the
concept of optimal inter-temporal choice of
consumption or production or investment.

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 II. Strategic Decision Making
 Strategic decision-making refers to:
 Identifying the best way to achieve goals & objectives ( long-term)
 assist in describing a company's main objectives to achieve shorter-term goals with a
broad mission.
 Strategic decision making is used in competitive companies & is intended to give a
company a competitive advantage.
 The d/f b/n strategic decision-making & other decision-making processes like
administrative & operational is that:
 Strategic decision-making is a long-term process that takes a lot of resources & has
many uncertainties.
 Administrative decisions are short-term strategies.
 Strategic decision-making keeps the company's long-term future in mind, unlike other
decision-making processes.
• Strategic decision making including:
o Traditional game theory
o Behavioral game theory & etc…
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 Classical (Traditional) Game Theory
Classical Game Theory: is a critical principle of economic theory & assumes that people's
strategic decisions are shaped by rationality, self interest & utility maximization.
 It focuses on the mathematical structure of equilibria & tends to use basic rational
choice theory and utility maximization as the primary principles within economic
models.
 It is normative theory since it shows the decision that rational players should choose,
but does not attempt to explain why that decision was made.
 Behavioral game theory : examines how actual human behavior tends to deviate from
standard predictions & models.
 Behavioral game theory aims to create new models that incorporate psychological
principles since choices are not always rational & do not always represent the utility
maximization choice.

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 Count’d…
 Behavioral game theory seeks to examine how people's strategic decision-making
behavior is shaped by social preferences, social utility & other psychological factors.
 analyzes interactive strategic decisions & behavior using the methods of game theory,
experimental economics & experimental psychology.
 Uses experiments include testing deviations from typical simplifications of economic
theory such as the independent axiom & neglect of altruism, fairness , strategic
reasoning &etc…
 Utilizes largely empirical & theoretical research, laboratory & field experiments as
well as modeling…
 has higher external validity & can be better applied to real world decision-making
behavior.
 is a primarily positive theory rather than a normative theory (classical game theory).
o A positive theory:
 seeks to describe phenomena rather than prescribing a correct action.
 must be testable and can be proven true or false.
o A normative theory:
 is subjective & based on opinions which cannot be proven true or false.

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 Social Preferences
 Social preferences w/c behavioral economics, experimental economics and
social psychology, describe the human tendency not only to care about one's
own material payoff, but also the reference group's payoff and/or the
intention that leads to the payoff.

 The research of social preferences in economics started with lab experiments

in 1980, where experimental economists found subjects' behavior deviated
systematically from self-interest behavior in economic games such as
ultimatum game & dictator game.
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 Determinants of Social Preference
 Social preferences determined by nature and nurture.
 Nature encompasses biological makeup and genetics but
nurture refers to the social environment in which one develops.
 The majority of literature would support that “nature”
influences social preferences more strongly whereas there is
still research to support the heavy influence of socio-cultural
factors.
 Some of these factors include social distance b/n economic
agents, the distribution of economic resources, social norms,
religion & ethnicity.
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 Importance of Social Preferences
 An understanding of social preferences and the disparity that occurs
across individuals and groups can help create models that better
represents the reality.
 Within the financial sector, there exists a positive relationship between
the elements of trust and reciprocity to economic growth as observed in a
reduction of defaults in lending programs as well as the effectiveness of
government and central banking policy.
 The well-functioning of social preferences may assist society in paving the
way to new developments through a decrease in the likelihood of market
failures as well as a reduction in transaction costs.
 Society may also utilize social preferences to increase the flow of
information, transparency & accountability.
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 Formation of Social Preferences
 Biologists, social psychologists and economists have
proposed theories, and documented evidence on the
formation of social preferences over both the long-run
and the short-run.
 The various theories explaining the formation &
development of social preferences may be explained from
a biological, cognitive and socio-cultural (social
learning) perspectives.

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 A. Biological evolution
Kin selection
 Kin selection is an evolutionary strategy where some specific
behavioral traits are favored to benefit close relatives'
reproduction.
 Hence, behavior that appears altruistic can align with the theory
of the selfish gene.
 Kin selection can explain altruistic behavior towards close
relatives even at the cost of their own survival, as long as one's
sacrifice can help preserve a greater amount of the same genes in
close relatives.
For example, worker bees can die from attacking their predators in
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 Cont’d…
Reciprocity selection
 Reciprocity selection suggests that one's altruistic act may evolve from the
anticipation of future reciprocal altruistic behavior from others.
 An application of reciprocity selection in game theory is the Tit-For-Tat strategy
in prisoner's dilemma which is the strategy that the player cooperate at the
initial encounter & then follow the opponent's behavior on the previous
encounter.
 Robert Axelrod and W. D. Hamilton showed that Tit-For-Tat strategy can be an
evolutionary stable strategy in a population where the probability of repeated
encounters between two persons in a population is above a certain threshold.

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 B. Social learning
 Psychologist Albert Bandura proposed that children learn about
pro-social & moral behavior by imitating other pro-social
models, including parents, other adults & peers.
 There are also economic models proposing that parents transmit
their social preferences to their children by demonstrating their
own pro-social behavior.
 Bandura conducted extensive psychological experimentation
into the extent to which children will emulate aggressive
behavior by exposing them to models displaying behavior before
observing the child's behavior once left alone.
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 Cont’d…
 However, empirical support for parents' role in fostering pro-
social behavior is mixed.
For example, some researchers found a positive relation between the
parent's use of induction and children's pro-social behavior, and others
found no correlation between parent's adoption of punitive techniques
and children's pro-social behavior.
 Regarding other sources of social learning, recent field
experiments have provided causal evidences for positive effects
of school program and mentoring program on forming social
preferences &these researches suggested that social interaction,
pro-social role models as well as cultural transmission from
51 family &A. school are potential mechanisms.
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 C. Cognitive factors
 Psychologist Jean Piaget was among the first to propose that
cognitive development is a pre-requisite in moral judgment and
behavior.
 He argued for the importance of social interaction with others
rather than learning in moral development, which requires the
understanding of both rules and others' behavior.
 Other important cognitive skills in fostering pro-social behavior
include perspective taking & moral reasoning, which are
supported by most empirical evidences.

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 Evidences of Social Preferences
Two evidences of social preferences include: Experimental and Field evidences
I) Experimental evidences
 Many initial evidences of social preferences came from lab experiments
where subjects play economic games with others.
 However, many researches found that subjects' behavior robustly and
systematically deviated from the prediction from self-interest
hypothesis, but could be explained by social preferences including
altruism, inequity aversion &reciprocity.
 The ultimatum game, the dictator game, the trust game and the gift-
exchange game are exercises that used to understand social preferences
& their implications.
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 Cont’d….
i. The Ultimatum Game
 Ultimatum game is one of the first experiments that shows
how self-interest hypothesis fails to predict people's behavior.
In this game, the first mover proposes a split of a fixed amount, and
the second mover decides to accept or reject the offer.
If the second mover accepts the offer, the final payoff is exactly
determined by the offer.
However, if the second mover rejects the offer, both subjects will
have zero payoff.
Contrary to the self-interest hypothesis's prediction that the first
mover will propose zero amount and the second mover will accept
the offer, experimenters found proposers will typically offer 25%-
50% of the fixed amount, and responders tend to reject the offer
54 when the split is below 20%.
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 Cont’d…
ii. The Dictator Game
 A relevant game is dictator game, where one subject proposes
the split of a fixed amount and the other subject is only allowed
to accept the offer.
 The dictator game helps to isolate pure altruism from the
strategic concern of the first mover (i.e. the first mover proposes
a larger share to the second mover to avoid second mover's
rejection) in the ultimatum game.
 In this game, the average share decreases to 20% of the fixed
amount, however, more than 60% of the subjects still propose a
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 Cont’d…
iii. The Trust and Gift-Exchange Games
 Two other games, trust game (investment game) and gift-exchange game
provide evidence for reciprocal behavior.
 In the trust game, the first mover is endowed with a fixed amount c & decides the
amount of money b to pass on to the second mover.
 This amount is multiplied by a factor of k when it reaches the second mover &
then the second mover decides how much of this amount (kb) is returned to the
first mover.
 While self-interest model predicts no transfer and no return, experimenters found
that first mover typically transfers roughly 50% of the endowment and responder's
return increases with the transfer.
 In gift-exchange game, the first mover proposes some offer to the second mover
and asks for certain effort level from the second mover, and then the second
mover decides his/her effort that is costly but can increase first mover's payoff.
 Also contrary to the self-interest prediction, first mover's offer in experiments is
usually greater than zero, and the second mover's effort level increases with offer.
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 Cont’d…
 Prisoner's dilemma and its generalized game, public goods game also provide
indirect evidence for social preference, and there are many evidences of
conditional cooperation among subjects.
 Prisoner's dilemma illustrates the fact that the process of cooperation itself can
create incentives to not cooperate.
 Each player may make a contribution to a national public good before all
contributions are summed and distributed to players where the "selfish"
players are given the opportunity to "free ride".
 This game depicts the way in which consumers will tend to free ride without
active intervention yet also the way consumers will change their behavior with
experience.

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 Cont’d…
II) Field Evidences
 Many field evidences documented agent's fairness and reciprocal concern. For
example, Daniel Kahneman, Jack Knetsch and Richard Thaler found that:
 the concern for fairness constrains firm's profit seeking behavior (e.g. raise
price after an increase in demand).
 Many field experiments examine relative pay concerns and reciprocity in work
settings.
 For example, economists Uri Gneezy and John List conducted field experiments where
subjects were hired for a typing job and for door-to-door fundraising and found subjects
exerted larger effort level in group with a higher wage.
 However, this positive reciprocity was short lived.
 Researchers have also found that positive reciprocity is smaller than negative reciprocity.
 In another study, job applicants were hired to catalog books for 6 hours with a pronounced
wage, but applicants were later informed with either wage increase or wage cut.
 Researchers found the decrease in effort in wage cut group was larger than the increase in
effort in wage increase group.
 However, positive reciprocity did not extend to other activities (volunteering to work for
58 one more
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 Economic Models of Social Preference
 Existing models of social preferences can be divided
into two types: distributive preferences & reciprocal
preferences.
Distributive preferences are the preferences over the distribution
& total magnitude of the payoff among the reference groups,
including altruism and spitefulness, fairness and inequity aversion
and efficiency concern.
Reciprocal preferences reflect agent's concern over the intention
of other's behavior.

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 Cont’d…
1. Distributive Preferences
A. Pure altruism, warm glow, and spitefulness
 Pure altruism in economic models represents an agent's concern
on other's well-being.
 A person exhibits altruistic preference if this person's utility
increases with other's payoff.
 A related economic model is impure altruism, or warm-glow,
where individuals feel good (gain a "warm-glow" utility) from
doing something good without caring about other's payoff.
 Spitefulness or envy preference is the opposite of pure altruism. In
this instance, an agent's utility decreases with other's payoff.
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 Cont’d…
B. Fairness and inequity aversion
 Fairness and inequity aversion models capture the agent's concern on the fair
distribution of payoffs across agents & especially the aversion to payoff
differences.
 In the Fehr-Schmidt model, an agent compares his payoff to each other
opponents in the group.
 However, the agent's utility decreases with both positive and negative payoff
differences between self and each other opponent in the reference group.
 Moreover, the agent dislikes payoff disadvantage more than payoff advantage.
 Hence, the agent presents altruistic behavior towards others when an agent is
better off than others, and displays spiteful behavior when the agent is worse off
than others.
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 Cont’d…

C. Efficiency concern and quasi-maximin preferences

 Economists Gary Charness and Mathew Rabin found that in some cases, agents
prefer more efficient outcomes (i.e. outcomes with larger social welfare)
than more equal outcomes and they developed a model where agents' utility is
a convex combination of own material payoff and the social welfare.
 Moreover, they assumed agents have quasi-maximin preferences, meaning that
agents' care on social welfare includes the minimum payoff among agents as
well as the total payoff for all agents in the group.
 However, the agent will care less about others' payoff if others are better off
than self.

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 Cont’d…
2. Reciprocity
 An agent has the motivation to reciprocate towards both kind and unfair behavior.
 Rabin (1993)'s model is one of the earliest models that characterizes reciprocal
behavior.
 In this model, the agent's payoff depends on the other opponent, and agent forms
belief of the other opponent's kindness, which is based on the difference between the
actual payoff that the agent receives and the fair payoff.
 Agents will reciprocate positively if he/she perceives the other
individual's behavior as kind and fair, and respond negatively if he/she
perceives it as unfair.
 Other researchers further generalize Rabin (1993)'s model by studying repeated
interactions in N-person extensive form game, and also by including inequity aversion
into agent's preference.
 Charness and Rabin also augmented their quasi-maximin preference with reciprocity
concern.
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 Economic Applications of Social Preferences
 The failure of recognizing social preferences will lead to a biased understanding of
much important economic behavior.
 Three important ways in which social preferences are applied to real world economics
are known and explained.
A. Understanding cooperation
 Reciprocal and inequity averse individuals can cooperate if they are sure that others
will cooperate too and can punish the free riders.
 This has implications for designing proper social mechanisms to solve the free-riding
problem.
 People contribute more to public goods than self-interest alone would suggest.
 This provides support for the notion of voluntary contribution.

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 Cont’d…
B. Design of economic incentive
 Accounting employee's reciprocity and fairness concerns can
help design better contracts (e.g. trust contract, bonus
contract) to enhance employee's effort and to solve firm's
agency problems.
 Moreover, the design of relative pay in the workplace can
affect employee's job satisfaction and well-being.
 Research on social preference has also facilitated the
understanding of monetary incentives' crowding-out effect.
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 Cont’d…
C. Design social policies
 The distributive and reciprocal preferences mentioned previously are
integral in good government and the upholding of ethical standards.
 Without the existence of these preferences, it is unlikely that society
would achieve desirable allocations of economic goods due to self-interest
and the "free rider" problem.
 Research and experimentation into social preferences assists, in the design
of optimal incentives used in public policy.
 Accounting individual's fairness concerns can affect the design of social
policies, especially for redistributive policies.
 In addition, reciprocal preferences can affect people's evaluation of
different policies towards the poor, depending on the individual's belief
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 END OF CHAPTER
TWO

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