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Trivers, Robert L. (1972) Parental investment and sexual selection. In Sexual Selection and the Descent of Man, 1871–1971. Ed. B. G. Campbell. Chicago: Aldine, 136–179.

Veblen, Thorstein. (1994 [1899]) The Theory of the Leisure Class. New York: Dover.

Wedekind, Claus, and Manfred Milinski. (2000) Cooperation through image scoring in humans. Science 288:850–852.

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III

Modeling and Testing

Strong Reciprocity

5	The Economics of Strong
	Reciprocity
	Ernst Fehr and Urs
	Fischbacher

5.1Introduction

The purpose of this chapter is to show that economists and other social scientists fail to understand core questions in economics and social theory if they insist on the self-interest hypothesis and rule out heterogeneity in the realm of social preferences. Two developments support our argument. First, during the previous decades, experimental psychologists and economists have gathered overwhelming evidence that systematically refutes the self-interest hypothesis and suggests that a substantial fraction of the people demonstrate social motives in their preferences—in particular, preferences for strong reciprocity. Second, there is also strong evidence indicating that deviations from selfinterest have had a fundamental impact on core issues in economics and social theory.

Social preferences are other-regarding preferences in the sense that individuals who exhibit them behave as if they value the payoff of relevant reference agents positively or negatively. Depending on the situation, the relevant reference agents may be a person’s colleagues, relatives, trading partners, or neighbors. It is important to keep in mind that a person may have different reference agents indifferent domains. Strong reciprocity means that individuals behave as if their positive or negative valuation of the reference agent’s payoff depends on the actions of the reference agent. If the actions of the agent are perceived as kind, a strong reciprocator values the payoff of the reference agent positively. If the actions are perceived as hostile, the payoff of the reference agent is valued negatively. As we will see, strong reciprocity is a particularly important form of social preference.1

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One core question is to understand the workings of competition and the interplay of competition and cooperation in markets, organizations, and politics. Other core questions pertain to understanding the conditions for successful collective actions, the prevailing structure of contracts and property rights, and, above all, the workings of economic incentives, because the workings of incentives constitute the essence of economics. We claim that a satisfactory understanding of these questions is impeded by the self-interest hypothesis. In particular, we provide evidence suggesting that preferences for strong reciprocity shape the functioning of competition, govern the laws of cooperation and collective action, and have a decisive impact on how economic incentives are constituted and how they function. The evidence we present also indicates that, by changing the incentives for selfish types, strong reciprocity affects the prevailing interaction patterns and the constraints on individual behavior, that is, the prevailing contracts and institutions.

The structure of this chapter is as follows. In ‘‘The Nature of Social Preferences,’’ we shortly describe the most important types of social preferences. We then illustrate the preference for strong reciprocity by means of two simple one-shot experiments and discuss whether reciprocal behavior in these experiments can be interpreted as a cognitive mistake—that is a kind of habit that is learned in the repeated interactions outside the laboratory and inappropriately applied to one-shot situations—or whether reciprocal behavior is better interpreted as rational behavior driven by a preference for strong reciprocity. ‘‘Competition’’ then shows that if one neglects strong reciprocity, one cannot understand the important effects of competition on market prices. ‘‘Cooperation’’ deals with cooperation and shows that decisive determinants of cooperation cannot be understood on the basis of the selfinterest hypothesis. ‘‘Economic Incentives and Property Rights’’ deals with economic incentives, contracts, and property rights. We present evidence indicating that neither the effects nor the determinants of economic incentives can be adequately understood if one neglects strong reciprocity and that the interaction between economic incentives and strong reciprocity is likely to have important effects on the optimality of different types of contracts and property rights. ‘‘Proximate Models of Strong Reciprocity’’ discusses some problems in the modeling of strong reciprocity and fairness preferences, and to what extent it is possible to mimic preferences for strong reciprocity by simpler and more tractable models of inequity aversion.

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5.2The Nature of Social Preferences

The last fifteen years have seen a large number of studies indicating that—in addition to economic self-interest—social preferences shape the decisions of a substantial fraction of people. A person exhibits social preferences if the person does not only care about the economic resources allocated to her but also cares about the economic resources allocated to relevant reference agents. In this chapter, we do not attempt to summarize the empirical evidence on social preferences (for surveys, see Fehr and Schmidt 2003, Sobel 2001, and chapter 6). Instead, we are interested in the social and economic implications of people’s social preferences. Before we proceed, it is nevertheless useful to mention the quantitatively most important types of social preferences that have been established.

A particularly important type of social preference is the preference for strong reciprocity. A strongly reciprocal individual responds kindly toward actions that are perceived to be kind and hostily toward actions that are perceived to be hostile. Whether an action is perceived to be kind or hostile depends on the fairness or unfairness of the intention underlying the action. The fairness of the intention, in turn, is determined by the equitability of the payoff distribution (relative to the set of feasible payoff distributions) caused by the action. It is important to emphasize that strong reciprocity is not driven by the expectation of future economic benefit. It is, therefore, fundamentally different from ‘‘cooperative’’ or ‘‘retaliatory’’ behavior in repeated interactions. These behaviors arise because actors expect future economic benefits from their actions. In the case of reciprocity, the actor is responding to friendly or hostile actions even if no economic gains can be expected. Models of strong reciprocity have been developed by Rabin (1993), Levine (1998), Falk and Fischbacher (chapter 6, this volume), Dufwenberg and Kirchsteiger (2004), and Segal and Sobel (1999).2

A second type of social preference is inequity aversion as modeled in Fehr and Schmidt (1999) and Bolton and Ockenfels (2000). Fehr and Schmidt (1999) assume, for example, that inequity-averse persons want to achieve an equitable distribution of economic resources. This means that they are altruistic towards other persons—that is, they want to increase other persons’ economic payoff if the other persons’ economic payoffs are below an equitable benchmark. However, inequity-averse persons also feel envy—that is, they want to decrease the other persons’ payoffs when these payoffs exceed the equitable level. In many

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situations, strongly reciprocal persons and inequity-averse persons behave in similar ways. For example, both strong reciprocity and inequity aversion imply the desire to reduce the payoff of another person if that person made a decision such that the payoff of the strongly reciprocal or inequity-averse person is much lower than the payoff of the other person. Recent evidence (Falk, Fehr, and Fischbacher [henceforth FFF] 2000 and 2001; Offerman 2002) suggests, however, that strong reciprocity is the quantitatively more important motive.

The similarity in the behavior of reciprocal and inequity-averse persons is due to the fact that both concepts depend in important ways on the notion of a fair or equitable payoff. Since models of inequity aversion are much simpler and more tractable than models of strong reciprocity, it is often convenient to ‘‘mimic’’ or to ‘‘black box’’ reciprocal behavior by inequity aversion (see the section on proximate models of strong reciprocity later in the chapter). Some authors (e.g., Charness and Rabin 2002) have also found evidence suggesting that subjects tend to help the least well off. Such behavior is, however, often not distinguishable from inequity aversion, in particular, nonlinear inequity aversion. Recently, Neilson (2000) provided an axiomatic characterization of a nonlinear version of Fehr-Schmidt type inequality aversion.

Strong reciprocity and inequity aversion are very different from unconditional altruism, which constitutes a third type of social preference. Unconditional altruists do not condition their behavior on the actions of others—that is, altruism given does not emerge as a response to altruism received (Andreoni 1989; Andreoni and Miller 2002; Cox, Sadiraj, and Sadiraj 2001). In technical terms, unconditional altruism means that a person values the economic resources allocated to a relevant reference agent positively. An unconditional altruist, therefore, never takes an action that decreases the payoff of a reference agent. Yet, as we will see later in the chapter, an important stylized fact concerns people’s willingness to punish other people for unfair or hostile actions. Unconditional altruism also cannot explain the phenomenon of conditional cooperation, that is, the fact that many people are willing to increase their voluntary cooperation in response to the cooperation of the others.

Finally, research has also shown that a fraction of the people exhibits spiteful or envious preferences (FFF 2001). A spiteful or envious person always values the economic payoff of relevant reference agents negatively. The person is, therefore, willing to decrease the economic payoff of a reference agent at a personal cost to himself (Kirchsteiger 1994;

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Mui 1995), irrespective of the payoff distribution and irrespective of the reference agent’s fair or unfair behavior. Spiteful choices seem to be quantitatively less important than reciprocal choices. Moreover, spitefulness (as well as unconditional altruism) cannot explain why the same people often are willing to help others at a personal cost in one situation while they harm other people in other situations (FFF 2000).

Although previous research clearly indicates that many people exhibit social preferences it is important to keep in mind that not everybody exhibits social preferences. In fact, most studies indicate that there is also a substantial number of people who behave in a purely selfish manner. A key question, therefore, is how the heterogeneity of motives at the individual level can be captured by parsimonious models and how the different individual motivations interact. In this chapter, we concentrate on the existence of strongly reciprocal and selfish types. The reason for this is three-fold. First, empirical evidence clearly suggests that in the domain of payoff-decreasing or punishing behavior, strong negative reciprocity is the dominant motive (FFF 2000, 2001; Kagel and Wolfe 2001; Offerman 2002). Second, in the domain of helping or rewarding behavior, strong positive reciprocity also plays an important role—although other motives like unconditional altruism, inequity aversion, and efficiency-seeking behavior play a role as well (Cox 2000; Charness and Rabin 2002; FFF 2000; Offerman 2002). For reasons of parsimony we will, however, neglect these other motives in this chapter.

Theory as well as empirical evidence suggest that the interaction between strongly reciprocal and selfish types is of first-order importance for many economic questions. The reason for this is that the presence of reciprocal types often changes the economic incentives for the selfish types, which induces the selfish types to make ‘‘nonselfish’’ choices. For example, a selfish person is deterred from behaving opportunistically if the person expects to be punished by the reciprocators. Likewise, a selfish person may be induced to behave in a cooperative and helpful manner because she expects the reciprocators to return the favor. Since the presence of strongly reciprocal types changes the pecuniary incentives for the selfish types, the strongly reciprocal types often have a significant impact on the aggregate outcome in markets and organizations.

We focus our presentation on laboratory experiments because it is impossible to unambiguously isolate the impact of strong reciprocity

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in most real-life situations. A skeptic may always discount field evidence with the argument that, in the field, the notion of fairness is only used for rhetorical purposes that disguise purely self-interested behavior in an equilibrium of a repeated game.3 The experimental evidence on ultimatum games (Gu¨th, Schmittberger, and Schwarze 1982) and the gift exchange games (Fehr, Kirchsteiger, and Riedl 1993) provides transparent illustrations of strong positive and negative reciprocity.4 Since both games have been described in the introductory chapter to this volume, we do not describe the experiments in detail here. It suffices to mention that the rejection of positive offers by the responders in the ultimatum game can be interpreted as strong negative reciprocity, whereas the generous effort choices by the employees in response to generous wage offers in the gift exchange game can be interpreted as strong positive reciprocity. These results have been replicated in numerous studies—in many countries and across a variety of differing conditions.5 It is also worth mentioning that strong reciprocity has been observed in the ultimatum and the gift exchange game even when the stake size in the experiment has been raised to the level of three months income (Cameron 1999; Fehr, Tougareva, and Fischbacher 2002).

5.2.1One-Shot and Repeated Interactions

Sometimes it is argued that reciprocal behavior in anonymous one-shot experiments is due to subjects’ inability to adjust properly to one-shot interactions. One idea (see Binmore 1998) is that outside the laboratory, subjects are typically involved in a network of repeated interactions. It is well-known from repeated game theory that in repeated interactions, rewarding and punishing may be in the long-term self-interest of an individual. According to this argument, subjects who routinely interact in the repeated game of life import routines and habits that are appropriate for repeated interactions into the laboratory’s one-shot situation because they do not understand the strategic differences between oneshot and repeated interactions. Therefore, the observation of reciprocal behavior in one-shot interactions should not be interpreted as a deviation from self-interest but merely as a form of rule-of-thumb behavior, that is, as a cognitive failure to properly distinguish between one-shot and repeated interactions.

Our response to this argument is twofold. First, and most importantly, the argument is refuted by evidence indicating that the vast

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majority of the subjects understand the strategic differences between one-shot and repeated interactions quite well. Later in this chapter we discuss the experiment reported by Fehr and Fischbacher (2003) that explicitly tested for this phenomenon. Second, even if the argument were correct, social scientists would have strong reasons to take the habits and routines that shape people’s behavior into account. The importance of reciprocal behavior for the social sciences does not depend on whether it is interpreted as a deviation from self-interest or as a form of bounded rationality. Reciprocal behavior is important because it affects the functioning of markets, organizations, incentives, and collective actions in fundamental ways.

In principle, it is testable whether people have the ability to distinguish temporary one-shot play from repeated play. Fehr and Fischbacher (2003) investigated this problem in the context of the ultimatum game, and Ga¨chter and Falk (2002) provided evidence for the gift exchange game. Fehr and Fischbacher conducted a series of ten ultimatum games in two different conditions. In both conditions, subjects played against a different opponent in each of the ten iterations of the game. In each iteration of the baseline condition, the proposers knew nothing about the past behavior of their current responders. Thus, the responders could not build up a reputation for being ‘‘tough’’ in this condition. In contrast, in each iteration of the reputation condition, the proposers knew the full history of the behavior of their current responders, that is, the responders could build up a reputation for being ‘‘tough.’’ In the reputation condition, a reputation for rejecting low offers is, of course, valuable because it increases the likelihood to receive higher offers from the proposers in future periods.

If the responders understand that there is a pecuniary payoff from rejecting low offers in the reputation condition, one should in general observe higher acceptance thresholds in this condition. This is the prediction of the social preferences approach that assumes that subjects derive utility from both their own pecuniary payoff and a fair payoff distribution. If, in contrast, subjects do not understand the logic of reputation formation and apply the same habits or cognitive heuristics to both conditions, one should observe no systematic differences in responder behavior across conditions. Since the subjects participated in both conditions, it was possible to observe behavioral changes at the individual level. It turns out that the vast majority (slightly more than 80 percent, N ¼ 72) of the responders increase their acceptance