University of Auckland Winter Week Lectures Fifth Lecture 6 July 2007

1. University of Auckland Winter Week Lectures Fifth Lecture6 July 2007 Associate Professor Ananish Chaudhuri Department of Economics University of Auckland

2. Recommendations for further reading • Thomas Schelling • Micromotives and Macrobehavior • The Strategy of Conflict • Michael Chwe • Rational Ritual: Culture, Coordination and Common Knowledge by

3. Recommendations for further reading • Joseph Henrich et al. (Editors) • Foundations of Human Sociality • Matt Ridley • The Red Queen • The Origins of Virtue • Nature versus Nurture • Genome

4. Recommendations for further reading • Robert Putnam • Bowling Alone: The Collapse and Revival of American Community • Francis Fukuyama • Trust – The Social Virtues and the Creation of Prosperity

5. Recommendations for further reading • Robert Frank • Passions within Reason: The Strategic Role of Emotions • Choosing the Right Pond: Human Behavior and the Quest for Status

6. Recommendations for further reading • Brian Skyrms • The Evolution of the Social Contract • Tim Harford • The Undercover Economist

7. Lecture slides available from my home page • University of Auckland http://www.auckland.ac.nz • Business School • Departments • Economics • People • Ananish Chaudhuri • Ananish Chaudhuri’s Personal Homepage

8. Trust • A large number of transactions in our day-to-day lives require us to trust strangers or near strangers • For instance when we buy things on TradeMe or Ebay and hand over our credit card details we are essentially trusting the seller not to rip us off • Joyce Berg, John Dickhaut and Kevin McCabe designed an elegant game to study trusting behaviour

9. Two players Receiver Sender Have $10.00 Have $10.00 Send $X, 0 < X < 10? Gets $3X Send anything Back?

10. Two players Receiver Sender Have $10.00 Have $10.00 Gets $3X Game ends immediately after my decision. Why should I send anything back? Better to keep it all.

11. Two players Receiver Sender Have $10.00 Have $10.00 Send $X, 0 < X < 10? The receiver really has no incentive to send anything back. Therefore it would be silly to send any money since I will lose whatever amount I send. I should just hang on to my $10.00.

12. Two players Receiver Sender Have $10.00 Have $10.00 But wait, suppose I trust the receiver and send him $10.00 Gets $30.00 Sends me back $18.00 End up with $18.00 Ends up with $22.00 WIN WIN!

13. The Trust Game • Amount sent by the sender can be used as a measure of the sender’s trust • Proportion of money returned by the receiver can be used as a measure of the receiver’s trustworthiness • Cannot use absolute amounts since different receivers get different amount

14. Treatment 1 (No history) 32 pairs

15. Treatment 2 (Social History) 28 pairs

16. Chaudhuri and Gangadharan (2007) • Find a significant gender difference in the trust game sender decision with men sending more money than women. (n = 100) • Of the original endowment of $10.00, men on average send $5.30 to the paired receiver. The corresponding numbers for women is $3.47.

17. Amount Sent in the Trust Game Broken up by Gender On average men (n = 47) send $5.30 while women (n = 53) send $3.47

18. Chaudhuri and Gangadharan (2007) • A large number of men send all of the $10.00 initial endowment. • In fact the modal amount sent for men is $10.00 while for women it is $2.00. • Out of 47 men, 16 (34%) sent their entire endowment of $10.00 to the paired receiver. Out of 53 women only 5 (6.4%) did so.

19. Chaudhuri and Gangadharan (2007) • Another curious finding is that those who trust (i.e. send money) are not necessarily trustworthy (i.e. they do not return money) • But those who are trustworthy are also trusting

20. Chaudhuri and Gangadharan (2007) • Define a player as “trusting” if she sent 50% or more of her endowment (n = 42) • Otherwise “non-trusting” (n = 58) • Trusting subjects return 16% on average while non-trusting subjects return 18%. • No significant difference in return behaviour

21. Chaudhuri and Gangadharan (2007) • Define a player as “trustworthy” if she returned at least one-third of any amount received ( n = 27) • If not then we call that player “non-trustworthy” ( n = 55) • Only 82 receivers received any money from the paired proposer

22. Chaudhuri and Gangadharan (2007) • Trustworthy subjects on average sent $5.33 (as the proposer) which is significantly higher than the $3.82 sent by non-trustworthy subjects send $3.82 • Trustworthy subjects are also more generous in a dictator game • Dictator game: Split $10.00 between Player A and Player B

23. Chaudhuri and Gangadharan (2007) • For some players the decision to trust is a general social orientation – that is they are both trusting of others and trustworthy in return • For some others the decision to trust is in the nature of a gamble and these players, while willing to trust, are not trustworthy

24. Putnam – Bowling Alone • Those who are trusting contribute more to charity, give blood, volunteer for community events etc. • The word “trusting” here should probably be replaced with the word “trustworthy”

25. Why does any of this matter? • A growing body of research suggests that “social capital” as embodied in the tendencies to “trust” strangers and “reciprocate” such trust influence a wide range of economic phenomena

26. Why does any of this matter? • Fukuyama (1995) argues that differences in the level of trust among citizens might explain differences in their levels of development • Putnam (2000) – “Bowling Alone” – social capital

27. Why does any of this matter? • Knack and Keefer (1997) find strong correlation between rates of growth and fractions of citizens who said they generally trust people. • Knack and Keefer (1997) find that trust and civic cooperation are associated with stronger economic performance

28. Using Experiments to measure social capital and Predict Financial Decisions • Dean Karlan looks at the ability of the trust game to predict decisions in the context of a Peruvian micro-credit program FINCA (n = 864)

29. Uses survey questions on trust, fairness and helpfulness • Generally speaking, would you say that most people can be trusted or that you can’t be too careful in dealing with people? • Do you think most people would try to take advantage if they got a chance, or would they be fair? • Would you say that most of the time people try to be helpful, or are they mostly looking out for themselves?

30. Using Experiments to measure social capital and Predict Financial Decisions • Karlan finds that “trustworthy” players are more likely to repay a debt one year later • The more trustworthy the individual, (1) the lower the default, (2) the less likely is the person to drop out and (3) the higher the voluntary savings

31. Using Experiments to measure social capital and Predict Financial Decisions • However the results for trusting behaviour are counter-intuitive • The more trusting the player, the lower are voluntary savings and the more likely is the player to drop out • Karlan also makes the point that the decision trust may reflect a predilection for accepting a gamble rather than a general social orientation

32. Using Experiments to measure social capital and Predict Financial Decisions • As for the survey questions, answering affirmatively is negatively correlated with default and dropping out • The questions however do not predict savings behaviour

33. Using Experiments to measure social capital and Predict Financial Decisions • The survey questions predict default or trustworthy actions but fail to predict savings or trusting actions

34. Concluding Remarks • The starting hypothesis of game theoretic analysis of strategic decision making situations is individual self-interest • We have seen that emotional factors such as trust, reciprocity, altruism as well as beliefs about others’ preferences play a crucial role in economic transactions

35. Concluding Remarks • Conclusions drawn on the basis of economic theory that does not incorporate such emotional factors may not be accurate • I will conclude with an example applicable to labour markets

36. Concluding Remarks • Most labour relations in real life are governed by contracts • Such contracts are typically explicit – with a clear statement of salaries to be paid and penalties in the case of non-performance • But you can also write implicit contracts

37. Concluding Remarks • Implicit contracts are less well specified and rely on mutual trust and reciprocity of employers and workers • According to traditional economic theory implicit contracts should perform badly with widespread shirking • But in reality they perform quite well • Employees seem to respond negatively to the employer’s mistrust and are no more likely to work harder under explicit contracts

38. Concluding Remarks • Thank you very much for attending these lectures • I teach a post-graduate course on these topics in the Department of Economics in case you or someone you know are interested in pursuing this further

39. Questions?