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Chapter 18
Social
Economics
1
18 Social Economics
Chapter 18 Outline
18.1 The Economics of Charity and Fairness
18.2 The Economics of Trust and Revenge
18.3 How Others Influence Our Decisions
Key Ideas
1. Many people have preferences that go beyond material wealth.
2. Charity, fairness, trust, revenge, and conforming to those around us
represent a few examples.
3. Economic tools can be used to understand when such factors will
play an important role.
4. Economists have found that such behaviors are important when
their opportunity cost is low.
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18 Social Economics
Evidence-Based Economics Example:
Do people care about fairness?
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18 Social Economics
Is economics only about self-interest?
Beyond utility maximization and profit maximization, economics
is also about altruism and giving, how our preferences are
formed, and playing fair.
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18.1 The Economics of Charity and Fairness:The Economics of Charity
People can give of their time…
Exhibit 18.1 Volunteering Around the Globe
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18.1 The Economics of Charity and Fairness:The Economics of Charity
…and their money
Exhibit 18.2 U.S. Household Giving in 2011 by Recipient Status
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18.1 The Economics of Charity and Fairness: The Economics of Charity
Why do people give to charity?
 Have you ever donated your
time and/or money to a
charitable cause.
 What did they get out of it?
 In order to promote giving, we
need to answer that question
so that society can provide the
right incentives to encourage
people to do more of it.
Why give?
1. To help others
2. To help yourself
To help others
Pure altruism -- a motivation solely to help others
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18.1 The Economics of Charity and Fairness: The Economics of Charity
To help yourself
Impure altruism -- a motivation solely to help oneself
 How does giving to charity help the giver? Examples (a).to
gain prestige, (b). giving out of guilt, (c ). social pressure (d)
religious duty. Do you think it matters
Key: if we want to construct environments that encourage
giving, it does matter what motivates people to give.
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18.1 The Economics of Charity and Fairness: The Economics of Fairness
Would you pick Friend or Foe?
 How many would pick Friend, how many would pick Foe.
 Foe would be the logical choice if you just wanted to maximize the money you got.
 In spite of that, only about half of the contestants picked Foe.
That is, some people seemed to have a preference for fairness.
Exhibit 18.3 Friend or Foe TV Game Show: A Variant of the Prisoners’ Dilemma
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18.1 The Economics of Charity and Fairness: The Economics of Fairness
Fairness -- willingness of individuals to sacrifice their
own well-being to either improve upon the
well-being of others or to punish those who they perceive
as behaving unkindly
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18.1 The Economics of Charity and Fairness :The Economics of Fairness
 Play the game with your own “fairness penalty” and assume that Joe is interested in
playing fair, too. This payoff matrix reflects the same payoffs as before, except the
payoff to picking Foe is reduced by a penalty for not being fair.
 How large should the penalty have to be to create Friend as the dominant strategy. (It
would have to be at least $8,200.)
Exhibit 18.4 Friend or Foe TV Game Show with Fairness Preferences
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18.1 The Economics of Charity and Fairness: The Economics of Fairness
 People may act

differently on TV in
front of millions of
people than they would
in normal
circumstances.
 So to provide a better
measure of the extent to
which people value
fairness, economists use
the Ultimatum Game.
The rules for the
game—the Proposer is
given a pot of money
that he/she splits, giving
the Responder some
amount. The Responder
is told how big the pot
was and how much
his/her split is. The
Responder then chooses Exhibit 18.6 The Ultimatum Game
to accept the offer, or
reject it, in which case
neither player receives
anything.
Working backwards, we
can see that the
Responder should take
any positive amount since
it is greater than zero.
Knowing this, the
Proposer should make
the lowest positive offer.
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18.1 The Economics of Charity and Fairness: The Economics of Fairness
But neither Proposers nor Responders act this way.
 Would you accept one cent from a Proposer. If
it turns out that people typically offer between
25% and 50%, and that Responders often
reject offers less than 20%, why these low
offers would be rejected.
 This is opportunity cost at work, with a
“price” being put on fairness. At one cent, the
opportunity cost of rejecting (the price of
fairness) is low, so the odds of a Responder
rejecting the offer are high; i.e., the Responder
is demanding more fairness at a low price.
 When the opportunity cost of rejecting is
higher, the Responder is less likely to reject,
reflecting the increased price of fairness.
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18.1 The Economics of Charity and Fairness :The Economics of Fairness
Evidence-Based Economics Example:
Do people care about fairness?
 Economics can predict the relationship
between low offers and how much fairness
is demanded when the size of the pot is
relatively small.
 But what happens when the pot is very
large—does the same relationship hold?
 Conducting the Ultimatum Game in a
relatively poor country allows economists
to offer a large pot to the participants, while
not representing a large outlay in cash.
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18.1 The Economics of Charity and Fairness: The Economics of Fairness
 As the size of the pot increases, the Proposers’ offers decrease.
 Also point out that as the size of the pot grows, Responders are more likely to
reject low offers, suggesting that people care less about fairness as the
opportunity cost increases.
Exhibit 18.7 Offers and Rejection Rates in the Ultimatum Game
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18.2 The Economics of Trust and Revenge: The Economics of Trust
 Trust lies behind everything that has been discussed so far. Part of the function of
the legal system is to make sure economic transactions occur more efficiently (think
of contract law, for example), but not all aspects of every transaction can be
subjected to legalities.
 Trust, therefore, is critical to making our economy run efficiently.
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18.2 The Economics of Trust and Revenge: The Economics of Trust
Would you trust Gary?
 The set-up of this game: Jen must decide whether to trust Gary or not. If she
doesn’t, they each get $10.
 If she does, Gary decides whether to defect or cooperate. If he cooperates, they
both get $15. If he defects, she gets nothing, and he gets $30.
Exhibit 18.8 A Trust Game Between Jen and Gary
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18.2 The Economics of Trust and Revenge: The Economics of Trust
Backward induction:


Since Gary’s payoff is greater if he defects ($30 vs. $15), he will choose
defection.
Knowing this will be Gary’s choice, Jen will choose not to trust Gary (she
gets $10 vs. $0)
Is this the best outcome?
No, this outcome is not the best one—the total benefit is $20 when the total
benefit could be $30
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18.2 The Economics of Trust and Revenge :The Economics of Trust
 We can view being trustworthy as we viewed fairness—some people have a
preference for being seen as trustworthy. If Gary has this preference, his payoff to
defecting would be lower by some amount, changing his incentives.
 Now Gary will choose to cooperate since the payoff to doing so is higher than that
for defecting. Knowing this, Jen will choose to trust him, maximizing their payoff.
Exhibit 18.9 A Trust Game Between Jen and Gary with a $20 Guilt Penalty
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18.2 The Economics of Trust and Revenge: The Economics of Revenge
 What role does revenge play in our economy? What are the costs and benefits of
revenge? This game extends the Trust Game by adding another step for Jen. She
can decide to impose a penalty on Gary if he defects; i.e., she can get revenge.
 If Gary knows that Jen will not get revenge, he will still choose to defect. But if he
knows she is vengeful, then he would do better if he cooperates ($15 vs. $10),
which is the optimal outcome.
Exhibit 18.10 A Trust Game Between Jen and Gary with a Punishment Option
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18.3 How Others Influence Our Decisions: Where Do Our Preferences Come From?
Preferences are the result of
 Nature
 Socialization
 Indoctrination -- agents imbue society with their
ideology or opinion
Peer effects -- influence of the decisions of others on
our own choices
Examples of peer effects on their own preferences or behavior. (1) that
college freshmen roommates tended to have similar GPAs. Does having
a roommate who is studious influence your own behavior? (2). Do you
work harder at the gym if the person next to you is kicking it?
18.3 How Others Influence Our Decisions : Following the Crowd: Herding
Herding --- Behavior of individuals who conform to the decisions of
others
 Why would people engage in herding? 2 reasons
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18.3 How Others Influence Our Decisions: Following the Crowd: Herding
Why would people engage in herding?


They are afraid to be wrong
Assume that if others are doing something, they must have a good
reason—they have more (or better) information
The house next door to you is for sale.
Should you be worried?
 Not one house. But if the house across the street is
also for sale, should you worry now? What if 5 more
houses are put on the market?
 The Idea: the more houses that are put up for sale, the
more likely it is that remaining houses will be put on
the market.
 As more houses are on the market, potential buyers
start wondering why everyone wants to leave the
neighborhood, meaning that if any houses are going to
be sold, the price must be reduced, causing even more
homeowners to want to leave.
Information cascade -- when people make the same decisions as others,
ignoring their own private information
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