Gintis Moral Sentiments and Material Interests The Foundations of Cooperation in Economic Life (MIT, 2005)

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best deterrence for potential shirkers. The parameters of the experiment are chosen such that a risk-neutral and selfish agent maximizes expected utility by choosing an effort level of 4 if faced with the maximum fine. Since the enforceable effort level is 4 under the explicit contract, while it is only 1 under an implicit contract, the self-interest model predicts that principals prefer the explicit contract.

The experimental evidence is completely at odds with these predictions. In total, the implicit contract was chosen in 88 percent of the cases. In view of the relative profitability of the different contracts, the popularity of the implicit contract is not surprising. Those principals choosing the explicit contract made an average loss of 9 tokens per contract, while those preferring the implicit contract made an average profit of 26 tokens per contract. Since the fixed verification cost in the explicit contract was 10 tokens, the explicit contract would have been much less profitable even in the absence of these costs. For both contracts, the average income of the agents was roughly 18 tokens. Implicit contracts were more profitable because—contrary to the standard prediction—they induced much higher effort levels. The effort level in the implicit contract was 5.2 on the average (on a scale of 1 to 10), while the effort level in the explicit contract was 2.1 on the average.

How did implicit contracts induce much higher effort levels than predicted? A major reason is that in the presence of strongly reciprocal principals, the promised bonus does not merely represent cheap talk, because reciprocal principals can—and actually do—condition the bonus payment on the effort level. The average data clearly reflect this impact of the reciprocal types because the actual average bonus rises steeply with the actual effort level. The principal’s capability to commit himself to paying a conditional bonus is based on his reciprocal inclinations. Conditional bonus payments, in turn, provide a strong pecuniary incentive for the agents to perform as desired by the principals. Why did explicit contracts induce lower effort levels than predicted? A likely reason is that these contracts are perceived as hostile and even induce negative reciprocity, as shown in the previous section.

One might also conjecture that the preference for implicit contracts in this particular experiment is solely caused by the fact that the explicit contract involves a punishment while the implicit contract involves a reward. Further experiments by Fehr, Klein, and Schmidt (2001), however, cast doubt on this explanation. If the implicit contract described in this section competes with a piece-rate contract, the vast majority of principals still prefer the implicit contract.

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5.5.3Individual Versus Joint Ownership

The impact of strong reciprocity on contractual choices suggests that it may not only cause substantial changes in the functioning of given economic institutions, but that it may also have a powerful impact on the selection and formation of institutions. To provide a further example: The present theory of property rights (Hart 1995) predicts that joint ownership will in general severely inhibit relations-specific investments so that it emerges only under very restrictive conditions. This may no longer be true in the presence of strongly reciprocal actors who are willing to cooperate if they expect the trading partner to cooperate as well and who are willing to punish even at a cost to themselves.

To illustrate this point, consider two parties, A and B, who are engaged in a joint project (a ‘‘firm’’) to which they have to make some relationship specific investments today in order to generate a joint surplus in the future. An important question that has received considerable attention in recent years is who should own the firm. In a seminal paper, Grossman and Hart (1986) argued that ownership rights allocate residual rights of control to the physical assets that are required to generate the surplus. For example, if A owns the firm, then he will have a stronger bargaining position than B in the renegotiation game in which the surplus between the two parties is shared ex post facto, because he can exclude B from using the assets which make B’s relationship specific investment less productive. Grossman and Hart showed that there is no ownership structure that implements first best investments, but some ownership structures do better than others, and there is a unique second-best optimal allocation of ownership rights. They also show that joint ownership is, in general, not optimal. This result is at odds with the fact that there are many jointly-owned companies, partnerships, or joint ventures. Furthermore, the argument neglects that strong reciprocity may be an important enforcement mechanism to induce the involved parties to invest more under joint ownership than otherwise predicted.

In order to test this hypothesis, Fehr, Kremhelmer, and Schmidt (2001) conducted a series of experiments on the optimal allocation of ownership rights. The experimental game is a simplified version of Grossman and Hart (1986): There are two parties, A and B, who have to make investments, a; b A f1; . . . ; 10g, respectively, in order to generate a joint surplus vða; bÞ. Investments are sequential: B has to invest first and her investment level b is observed by A, who has to invest

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thereafter. We consider two possible ownership structures: Under A- ownership, A hires B as an employee and pays her a fixed wage w. In this case, monetary payoffs are vða; bÞ w a for A and w b for B. Under joint ownership, each party gets half of the gross surplus minus her investment cost—12 vða; bÞ a for A and 12 vða; bÞ b for B. The gross profit function has been chosen such that maximal investments are efficient—that is, aFB ¼ bFB ¼ 10, but if each party gets only 50 percent of the marginal return of his or her investment, then it is a dominant strategy for a purely self-interested player to choose the minimum level of investment, a ¼ b ¼ 1. Finally, in the first stage of the game, A can decide whether to be the sole owner of the firm and make a wage offer to B, or whether to have joint ownership.

The prediction of the self-interest model is straightforward. Under A-ownership, B has no incentive to invest and will choose b ¼ 1. On the other hand, A is the residual claimant, so she will invest efficiently. Under joint ownership each party gets only 50 percent of the marginal return, which is not sufficient to induce any investments. In this case, B’s optimal investment level is unchanged, but A’s investment level is reduced to a ¼ 1. Thus, A-ownership outperforms joint ownership and A should hire B as an employee.

In the experiments just the opposite happens. Party A chooses joint ownership in more than 80 percent (187 out of 230) of all observations and gives away 50 percent of the gross return to B. Moreover, the fraction of joint ownership contracts increases from 74 percent in the first two periods to 89 percent in the last two periods. With joint ownership, B players choose on the average an investment level of 8.9, and A responds with an investment of 6.5 (on the average). On the other hand, if A-ownership is chosen and A hires B as an employee, B’s average investment is only 1.3, while all A players choose an investment level of 10. Furthermore, A players earn much more on the average if they choose joint ownership rather than A-ownership.

These results are inconsistent with the self-interest model, but it is straightforward to explain them with concerns for strong reciprocity. Under joint ownership, the investments are associated with positive externalities and, hence, joint ownership favors positively reciprocal behavior. If, under joint ownership, B expects A to behave reciprocally, even a selfish B player has a strong incentive to make high investments because this induces the reciprocal players A to invest, too. Under A- ownership, the incentives for B are quite different because B does not benefit from the investments of A. Hence, the selfish Bs choose the

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minimal investment under A-ownership. If there is sufficient complementarity between the investments of A and B, the joint surplus is therefore much higher under joint ownership. This makes it profitable for A to choose joint ownership.

5.6Proximate Models of Strong Reciprocity

The evidence from this chapter indicates that strong reciprocity has a deep impact on fundamental economic issues. It is an important behavioral force that shapes the functioning of competition, governs the laws of cooperation, and has a decisive impact on how incentives work. Strong reciprocity creates implicit incentives and renders some explicit incentives quite inefficient. By changing the incentives for the selfish types, it also affects the prevailing interaction patterns and constraints on individual behavior—the prevailing contracts and institutions relative to a world that is exclusively populated by self-interested people.

We believe that—in view of the importance of strong reciprocity— mainstream economics as well as the social sciences in general have much to gain by routinely incorporating concerns for strong reciprocity into the analysis. This means that when analyzing an economic or social problem, one should routinely try to derive the implications of the assumption that, in addition to the purely self-interested types, roughly 40 to 50 percent of the people exhibit strongly reciprocal preferences. It is obvious that to achieve this a precise mathematical model of strongly reciprocal preferences is desirable. In the past few years, several authors have worked on models of strong reciprocity (Rabin 1993; Levine 1998; Dufwenberg and Kirchsteiger 2004; Falk and Fischbacher, this volume, chapter 6; Segal and Sobel 1999; Charness and Rabin 2002). These papers are very useful because they sharpen the notion of strong reciprocity. However, they also show that it is extremely difficult to build simple and tractable models of strong reciprocity. The problem is that the explicit modeling of intention-based or type-based strong reciprocity quickly renders these models very complex and difficult to handle.

The first best solution to the modeling problem would surely be a simple and tractable model of strong reciprocity. However, since this solution is not presently available, there is also a need for simpler models that mimic the outcomes of strong reciprocity models in a wide variety of circumstances but that do not explicitly model strong

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reciprocity. Such models have been developed by Fehr and Schmidt (1999), and Bolton and Ockenfels (2000). They are based on the assumption that ‘‘fair’’ types dislike an inequitable distribution of economic resources. The impressive feature of these models is that although they are much simpler than strong reciprocity models, they correctly predict the outcome of experiments in a wide variety of games. The model of Fehr and Schmidt (1999), for example, is consistent with the stylized facts in scenarios presented earlier in the chapter—the bilateral ultimatum and gift exchange game, market games under exogenous and endogenous contract enforcement, cooperation games with and without a punishment opportunity, and contract choice and property rights experiments. This suggests that it is possible in many instances to capture the behavioral predictions of strong reciprocity with simpler models of fairness.

However, the black-boxing of strong reciprocity via simple fairness models must be done with a background knowledge about the limits of these models. Mindless application of these models may lead to wrong predictions, as is demonstrated in the experiments of Brandts and Sola (2001), and Falk, Fehr, and Fischbacher (2003). In the Falk, Fehr, and Fischbacher (2003), paper, the rejection rates of the (8/2)- offer (8 for the proposer and 2 for the responder) in four different mini-ultimatum games are compared. The games differ only with regard to the available alternative to the (8/2)-offer. In one game the alternative was (5/5), in the second game it was (2/8), in the third game it was (8/2), and in the last game it was (10/0). Note that if the responder cares only about the distribution of payoffs, the rejection rate of the (8/2)-offer should be the same in all four games.

In fact, however, the rejection rate is monotonically declining across the four games. It is highest in the (5/5)-game, where (5/5) was the alternative, and lowest in the (10/0)-game. A plausible interpretation of this result is that in the (5/5)-game an offer of (8/2) indicates an unfair intention or an unfair type, while in the (10/0)-game this is not the case. Thus, if responders punish unfair intentions or unfair types, they should exhibit a higher rejection rate in the (5/5)-game. This example indicates that if the set of feasible alternatives changes across situations such that the possibilities for expressing good or bad intentions changes, simple fairness models do not capture important aspects of behavior.

It is, however, interesting that even in these situations, a simple model can be useful because the prediction of the model provides hints

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when intentionor type-based strong reciprocity is likely to matter. The prediction thus alerts the researcher about the limits of the model. For instance, if (5/5) instead of (10/0) is the alternative to (8/2), the Fehr-Schmidt model (1999) predicts that for reasonable rejection rates, the population of proposers who make the (8/2)-offer is less fair. Thus responders will make different inferences about the type or the intention of the population who made the (8/2)-offer when (5/5) is the alternative compared to when (10/0) is the alternative. This inference induces strongly reciprocal responders to reject the (8/2)-offer more frequently when (5/5) is the alternative.26

It is also important to keep in mind that models that have been developed to explain a diverse set of facts in laboratory experiments must be used with care and need perhaps some adaptations when applied to field situations. For example, it is often not possible to determine the relevant reference agents in the field without further empirical analysis, while in an experiment, the set of the other players in the group is often a good first approximation. Likewise, it does not seem likely that the effort-relevant fairness judgements of a worker are based on a comparison between the worker’s income and the income of the top managers of the firm. Instead, the behaviorally relevant comparisons tend to be more local—that is, comparisons with her coworkers or comparisons with the average value of the output she generates.

5.7Conclusion

The self-interest hypothesis assumes that all people are exclusively motivated by their economic self-interest. This hypothesis is sometimes a convenient simplification and there are, no doubt, situations in which almost all people behave as if they were strictly self-interested. In particular, for comparative static predictions of aggregate behavior, self-interest models may make empirically correct predictions because models with more complex motivational assumptions predict the same outcome. However, the evidence presented in this paper also shows that fundamental issues in economics and the social sciences in general cannot be understood solely on the basis of the self-interest model. The evidence indicates that concerns for fairness and strong reciprocity are important for bilateral negotiations, for the functioning of markets and incentives, for the structure of property rights and contracts, and for the laws governing collective action and cooperation.

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Notes

1.Economists and biologists defined the term ‘‘reciprocity’’ in the past in different ways. Biologists think of reciprocity, or ‘‘reciprocal altruism,’’ as tit-for-tat strategies in repeated interactions (Trivers 1971; Axelrod and Hamilton 1981). Some economists (Binmore 1998) use the term in a similar way. During the last ten years, however, an increasing number of contributions show that reciprocal behavior also exists in sequentially structured oneshot interactions. Reciprocity in one-shot interactions cannot be explained on the basis of selfish motives. Therefore, we use the term ‘‘strong reciprocity’’ to describe these non– self-interested behaviors to distinguish them from reciprocal behaviour of self-interested agents in a repeated game.

2.Strictly speaking, Levine’s model of reciprocity is not based on intentions, but on the reciprocation to the other players’ preferences. A subject with Levine-type preferences is more altruistic (or less spiteful) towards an altruistic player and more spiteful (or less altruistic) towards a spiteful player. The model thus captures a kind of type-based reciprocity.

3.For evidence suggesting that fairness and reciprocity is important in the field see, for example, Agell and Lundborg (1995), Bewley (1999), Frey and Weck-Hanneman (1984), Frey and Pommerehne (1993), Greenberg (1990), Kahneman, Knetsch, and Thaler (1986), Lind and Tyler (1988), Ostrom (1990, 2000), Seidl and Traub (1999), and Zajac (1995).

4.In the experiments, human subjects make decisions with real monetary consequences in carefully controlled laboratory settings. In particular, the experimenter can implement one-shot interactions between the subjects so that long-term self-interest can be ruled out as an explanation for what we observe. As we will see, in some experiments the monetary stakes involved are quite high—amounting up to the income of three months’ work. In the experiments reviewed in this chapter, subjects do not know each other’s identities, interact anonymously, and sometimes even the experimenter cannot observe their individual choices. Due to the anonymity conditions, the laboratory environment is quite unfavorable to the emergence of reciprocal behavior. Yet, if we observe reciprocal behavior under such unfavorable conditions, it is even more likely to prevail in nonanonymous interactions between people who know each other.

5.For surveys on ultimatum games, see Roth (1995) or Camerer (2003). Gift exchange games have been conducted by scholars such as Brandts and Charness (forthcoming), Charness (2000, forthcoming), Fehr and Falk (1999), Ga¨chter and Falk (2002), Falk, Ga¨chter, and Kova`cs (1999), and Hannan, Kagel, and Moser (2002).

6.The remaining subjects, except one, exhibit no significant change in the acceptance threshold. Only 1 out of 70 subjects exhibits a significant decrease in the threshold relative to the baseline. Note that if a subject places a very high value on fairness, the acceptance threshold may already be very high in the baseline condition so that there is little reason to change the threshold in the reputation condition. Identical thresholds across conditions are, therefore, also compatible with a social preference approach. Only a decrease in the acceptance threshold is incompatible with theories of social preferences.

7.In the study of Roth et al. (1991), competition led to an even more extreme outcome. However, in their market experiments, 9 competing proposers faced only 1 responder, and the responder was forced to accept the highest offer.

8.In the meantime, the gift exchange game has been framed in goods market terms, labor market terms, and in a completely neutral language. The results indicate that there are no framing effects.

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9.In each period the same stationary situation is implemented—there are 12 workers, 8 firms, and each worker’s reservation wage is 20. In a given period, employers and workers can make as many wage bids as they like, as long as they have not yet been signed on. Trading is anonymous. Every worker can accept an offer made by a firm and every firm can accept an offer made by a worker.

10.A variety of studies have found that one major reason why managers are reluctant to cut wages in a recession is the fear that wage cuts may hamper work performance. Among others, Bewley (1999, this volume, chapter 11) reports that managers are afraid that pay cuts ‘‘express hostility to the work force’’ and will be ‘‘interpreted as an insult.’’ For similar results see Agell and Lundborg (1995), and Campbell and Kamlani (1997).

11.For the severe difficulties created by unobservable heterogeneity in this context, see Murphy and Topel (1990), and Gibbons and Katz (1992).

12.This situation mimics a classic exchange problem in the absence of exogenous contract enforcement. A would like to have the good that B possesses, because she values that good more than B does and vice versa. Since A and B cannot write a contract that is enforced by a third party and since both have to send their goods simultaneously to the other person, they have a strong incentive to cheat.

13.For rigorous proofs that reciprocity (or inequity aversion) transform the PD into a coordination game, see section IV in Fehr and Schmidt (1999).

14.Social dilemma games are generalised PD-games in the following sense: There is a Pareto-superior cooperative outcome that renders everybody strictly better off relative to the Nash equilibrium.

15.Social psychologists have also found evidence that people who believe that others cooperate more will themselves cooperate more (Dawes 1980; Messick and Brewer 1983; Hayashi et al. 1999). Some of them have interpreted this in terms of a false consensus effect. According to the false consensus effect, the causality runs from a subject’s cooperativeness to the subject’s belief that others cooperate. However, the evidence in Fischbacher, Ga¨chter and Fehr (2001) and in Hayashi et al. (1999) shows that the causality goes the other way round: If the other players contribute more strongly, reciprocal subjects contribute more on average.

16.The official title of former president Clinton’s reform initiative—‘‘The Personal Responsibility and Work Opportunity Reconciliation Act’’—is telling in this regard.

17.The written instructions for the subjects do not use value-laden terms such as ‘‘punishment points.’’ Instead, the instructions are framed in neutral terms. For example, subjects do not assign ‘‘punishment points’’ but just ‘‘points’’ to the other players.

18.In the experiments, subjects first participate in the game without a punishment opportunity for ten periods. After this, they are told that a new experiment takes place. In the new experiment, which lasts again for ten periods, the punishment opportunity is implemented. In both conditions, subjects remain in the same group for ten periods and they know that after ten periods the experiment will be over.

19.Francis’ (1985, 269) description of social ostracism in communities of the British miners provides a particularly vivid example. During the 1984 miners’ strike, which lasted for several months, he observed the following: ‘‘To isolate those who supported the ‘scab union,’ cinemas and shops were boycotted, there were expulsions from football teams, bands, and choirs, and ‘scabs’ were compelled to sing on their own in their chapel services. ‘Scabs’ witnessed their own ‘death’ in communities which no longer accepted them.’’

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20.Suppose we offer you £100 for hitting a stranger in the face. Even if the stranger had no possibility to hit back, most people would probably reject this offer.

21.A plausible reason for this is that if subjects cooperate successfully for five periods and then some group members try to cheat (free-ride) in the final period, the cooperators may be more angry than when they face free-riding in earlier periods. Being cheated by a ‘‘friend’’ might make people angrier than being cheated by a ‘‘stranger.’’

22.There is an interesting difference between the ultimatum game experiments with reputation formation discussed in this chapter and the punishment of free-riders in the partner treatment. Recall that responder’s acceptance thresholds were significantly higher in the reputation treatment of the ultimatum game relative to the baseline treatment. In the reputation treatment, a responder could aqcuire an individual reputation for being a tough bargainer and he could reap the full benefits of his reputation. In the partner treatment of the public goods game, the punishment of free-riders constitutes a second-order public good because all group members benefit from the cooperation-enhancing effect of the punishment. This may be one reason why we observe so little strategic punishment in the partner treatment.

23.To prevent hostility from being introduced merely by the use of value-laden terms, we avoided terms like ‘‘fine,’’ ‘‘performance,’’ and so forth. Instead we used a rather neutral language—for example, ‘‘price deduction.’’

24.Note that according to this interpretation, there is no crowding out of an intrinsic (reciprocal) motivation here. Instead, the preference for reciprocity implies that workers respond in a hostile manner to incentives that are perceived as hostile.

25.Employers are, in general, not free to cut a worker’s wage for shirking, while they have few legal problems when they refuse to pay a promised bonus.

26.One way to explain this evidence is to modify the Fehr-Schmidt (1999) model of inequity aversion such that the disutility from disadvantageous inequality is lower if a person faces a subject with a high preference against advantageous inequality. This basically boils down to a type-based model of reciprocity. The model by Falk and Fischbacher (this volume, chapter 6) can also explain this evidence.

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