Psychology, Economics and Incentives

This PhD. Thesis deals with the effects that psychological phenomena may have on the incentives of agents participating in economic interaction. In particular, I focus on how individuals’ preference for certain distributions of welfare among others may affect their effort and other strategic decisions in a variety of contexts. The thesis consists of five chapters. The first one introduces the study. The next two chapters are theoretical and study the effects that aversion to inequity may have on effort decisions. The last two chapters are experimental and show evidence on when welfare comparisons may distort the way experimental subjects play simple games. Chapter 2 studies optimal contracts when employees are averse to inequity as modelled by Fehr and Schmidt (1999). A “selfish” employer can profitably exploit preferences for equity among his employees by offering contracts which create inequity when employees do not meet the employer's demands. I derive the optimal contract under such circumstances and discuss conditions for inequity aversion to affect the optimal output choice. Similar results are obtained for other types of distributional preferences such as status-seeking or efficiency concerns. Chapter 3 studies the mechanics of “leading by example” in teams and it is joint work with Steffen Huck. We show that leadership is beneficial for the entire team when agents dislike effort differentials. We also show how leadership can arise endogenously and discuss what type of leader benefits a team most. Chapter 4 discusses a laboratory experiment in which subjects played constant sum normal form games and stated beliefs about the frequencies of play by their opponents. Contrary to previous experimental evidence, the results show that game-theoretical predictions work reasonably well: 80% of actions coincided with the Nash equilibrium, subjects were good at predicting the action which was played with highest frequency and 73% of actions were best responses to stated beliefs. The chapter argues that game-theoretical predictions might work well in constant sum games because distributional preferences may not be a factor influencing subjects’ decisions in these games. Chapter 5 shows a follow-up experiment in which we study the robustness of the results in Chapter 4 ’s experiment to sequential play in games with the same payoff matrix as the games in the previous chapter. Although we suspected that sequentiality may trigger some psychological phenomena that may lead subjects to deviate from equilbirium, we find that in our constant sum games the subgame perfect equilibrium predictions work well. Overall, we conclude that distributional preferences and other types of psychological phenomena have important economic consequences when they affect individuals' incentives. However, as important as it is to acknowledge the effects of psychologial phenomena it is to identify the type of situations in which they change predictions from standard economic theory.