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UNIT 7: SOCIAL PREFERENCES –APPLICATIONS1. Introduction
2. Application 1: Public Good Game
• Reciprocity
3. Application 2: Giving To Charity
• Crowding out or crowding in
4. Application 3: Price And Wage Rigidity
• Firm Pricing And Fairness
5. Application 4: Contract Theory
6. Application 5: Financial Market
7. Conclusion
1. INTRODUCTION
What makes Nash Equilibrium limited in designing the optimal strategy for each player is that we have some
social motives that we usually take into account when behaving. In this way, social preferences constitute an
important motive why actual behaviour may not conform to Nash predictions
Think about cooperation, fairness, inequality aversion when making decisions in interaction. Nash equilibrium
has its limits when we take into account these dimensions.
We will look at 5 applications where social preferences play an important role. Understanding social preferences
and their role is very important for policy recommendations.
APPLICATION 1: PUBLIC GOOD GAME
Public Good Game. Any project in which not everyone would have incentives to contribute. The theoretical
equilibrium or Nash equilibrium for a public good game (hospital, roads…etc.) is for no one to contribute because
at the end the material equilibrium since some people would contribute but the others would have a role of free
riders, is for no one to have a contribution. However, in reality, the social optimum or equilibrium is that people
do contribute for public good games. How we can see the gap of those who contribute and the others who do not?
There is a group of n people. Each group member is given an amount (e.g., $20). And they are asked how much
they would like to contribute to a group project. Economically, is important to understand the motives behind
any incentives for people to contribute to such a project, as they are costly.
Any money contributed is increased by a factor 0< k <2 (e.g., 1.6) and at the end, the return would split amongst
the group members.
Example: There are 4 persons in the group, factor k = 1.6. If one person contributes $1, then the overall return
of the project would be: 1.6 x $1 = $1.6, then each person in the group will get ((1.6 x $1)/4) = $0.4.
The person that contributed 1€ would only get back €0.4 so it is not in her “material” interests or incentives to
contribute because he is going to get less than the other people but the other person who didn’t contribute
anything would do the free rider and he would get return at the end
So, a person that is interested only in her own material payoff would not contribute. In fact, the Nash equilibrium
for this game is for no one to contribute anything in public good game. However in reality, people do contribute
in public good game.
Fehr, E., & Gachter, S. (2000). Cooperation and punishment in public goods experiments. American Economic
Review, 90(4), 980-994. They try to design public good game, but they did different treatments trying to see what
the incentives behind contribution are and; if they include a treatment where they have for example partnership,
does that actually make a difference or not.
They run the experiment:
• With “partner treatment” where the same 4 subjects played the game 10 rounds.
, • With “stranger treatment” where each person was matched with three randomly chosen people who they did
not play with in the first round.
Subjects contributed to the first round (different from 0) but contributions fell over time compared to the
treatment where people played with the same partner.
If you feel that you are part of a social group (e.g., neighbourhood) push people to contribute more than if they
are strangers. This suggests that giving to others is not unconditional, people expect reciprocity (monetary or
social speaking) when contributing.
Particularly, if subjects who contribute and see that there are some people that do not do so (free riders).
The second variant of the public good game is that they try to create a public good game with punishment to see
if give more incentive to people to provide more. We can see that there is a contribution over all but once you
include punishment it increases the contribution.
Subjects play the game as above but in a second stage, each person can pay an amount t to punish another
person’s monetary payoff amount by $1.
With punishment, there are high and increasing investments over time. Those who contribute less are punished
more.
1.1 RECIPROCITY
When we talk about the limits of the theoretical equilibrium of a public good game we think about reciprocity
and the willingness of people to contribute for a common good. But we need to be aware of the people that are
altruistic by nature and those who are not.
People voluntarily give and take from others. We have to take account of social preferences.
Remember we are not altruists. Many do not give at all. Those that do, do so with strings attached.
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