Theories of Fairness and Reciprocity - Evidence and Economic Applications∗ Ernst Fehra) University of Zurich and CEPR Klaus M. Schmidtb) University of Munich and CEPR Published in: Mathias Dewatripont, Lars Peter Hansen and Stephen J Turnovsky (2003): Advances in Economics and Econometrics, Econometric Society Monographs, Eighth World Congress, Volume 1, pp 208 – 257. Abstract: Most economic models are based on the self-interest hypothesis that assumes that all people are exclusively motivated by their material self-interest. In recent years experimental economists have gathered overwhelming evidence that systematically refutes the self-interest hypothesis and suggests that many people are strongly motivated by concerns for fairness and reciprocity. Moreover, several theoretical papers have been written showing that the observed phenomena can be explained in a rigorous and tractable manner. These theories in turn induced a new wave of experimental research offering additional exciting insights into the nature of preferences and into the relative performance of competing theories of fairness. The purpose of this paper is to review these recent developments, to point out open questions, and to suggest avenues for future research. JEL classification numbers: C7, C9, D0, J3. Keywords: Behavioral Economics, Fairness, Reciprocity, Altruism, Experiments, Incentives, Contracts, Competition ∗ We would like to thank Glenn Ellison for many helpful comments and suggestions and Alexander Klein and Susanne Kremhelmer for excellent research assistance. Part of this research was conducted while the second author visited Stanford University and he would like to thank the Economics Department for its great hospitality. Financial support by Deutsche Forschungsgemeinschaft through grant SCHM-1196/4-1 is gratefully acknowledged. Ernst Fehr also gratefully acknowledges support from the Swiss National Science Foundation (project number 1214-05100.97) and the Network on the Evolution of Preferences and Social Norms of the MacArthur Foundation and the EU-TMR Research Network ENDEAR (FMRX-CTP98-0238). a) Ernst Fehr, Institute for Empirical Research in Economics, University of Zurich, Bluemlisalpstrasse 10, CH-8006 Zurich, Switzerland, email: [email protected]. b) Klaus M. Schmidt, Department of Economics, University of Munich, Ludwigstrasse 28, D-80539 Muenchen, Germany, email: [email protected] 1 Introduction 1 2 Empirical Foundations of Fairness and Reciprocity 3 2.1 Where does Fairness matter? ..................................................... 3 2.2 Experimental Evidence .............................................................. 4 2.3 Interpretation of the Evidence ................................................... 9 3 Theories of Fairness and Reciprocity 11 3.1 Social Preferences ..................................................................... 12 3.1.1 Altruism ........................................................................ 12 3.1.2 Relative Income and Envy ............................................ 14 3.1.3 Inequity Aversion ......................................................... 15 3.1.4 Altruism and Spitefulness ............................................ 17 3.2 Models of Intention-Based Reciprocity ................................... 18 3.2.1 Fairness Equilibrium .................................................... 18 3.2.2 Intentions in Sequential Games ................................... 20 3.2.3 Merging Intentions and Social Preferences .................. 21 3.3 Axiomatic Approaches ............................................................. 23 4 Discriminating between Theories of Fairness 25 4.1 Who are the Relevant Reference Actors? ..............................… 25 4.2 Equality versus Efficiency ....................................................… 27 4.3 Revenge versus Inequity Reduction .....................................… 31 4.4 Does Kindness Trigger Rewards .............................................. 34 4.5 Summary and Outlook ..........................................................… 36 5 Economic Applications 38 5.1 Competition and Fairness – When Does Fairness Matter? ...... 38 5.2 Endogenous Incomplete Contracts .......................................... 40 5.3 The Optimal Allocation of Property Rights ............................ 44 6 Conclusions 46Non-technical summary Most economic models are based on the self-interest hypothesis that assumes that all people are exclusively motivated by their material self-interest. In recent years experimental economists have gathered overwhelming evidence that systematically refutes the self-interest hypothesis. The evidence suggests that many people are strongly motivated by other-regarding preferences and that concerns for fairness and reciprocity cannot be ignored in social interactions. Moreover, several theoretical papers have been written showing that the observed phenomena can be explained in a rigorous and tractable manner. Some of these models shed new light on problems that have puzzled economists for a long time like, e.g., the persistence of non-competitive wage premia, the incompleteness of contracts, the allocation of property rights, the conditions for successful collective action and the optimal design of institutions. These theories in turn induced a new wave of experimental research offering additional exciting insights into the nature of preferences and into the relative performance of competing theories of fairness. The purpose of this paper is to review these recent developments, to point out open questions, and to suggest avenues for future research. Furthermore, we will argue that it is not only necessary but also very promising for mainstream economics to take the presence of other-regarding preferences into account. Why are economists so reluctant to give up the self-interest hypothesis? One reason is that this hypothesis has been quite successful in providing accurate predictions in some economic domains. For example, models based on the self-interest hypothesis make very good predictions for competitive markets with standardized goods. This has been shown in many carefully conducted market experiments. However, a large amount of economic activity is taking place outside of competitive markets – in markets with a small number of traders, in markets with informational frictions, in firms