Question

2. Imagine that you would like to know your friend's outcome-based social preferences. You (i) She chooses $4 for herself and $3 for you over $5 for herself and $I for you. (ii) She chooses $3 for herself and $4 for you over $5 for herself and $9 for you (iii) She chooses $7 for herself and $1 for you over $2 for herself and $2 for you. (a) Which of these three choices is consistent with your friend being purely altruistic? ask her to make choices between divisions of money. Here is what she chooses: (b) Which of these three choices is consistent with your friend being purely selfish/individualistic? (c) Which of these three choices is consistent with your friend maximizing group welfare? (d) Which of these three choices is consistent with your friend being extremely inequality averse? (e) What if your friend is only moderately inequality averse? Could that explain all three choices? () If your answer to (e) is yes, identify the range of a and B values in the Fehr-Schmidt model that would be consistent with your friend's choices. If your answer to (e) is no, explain how some of the choices lead to contradictory α or β values.

Answer 1

a) Choice 1. Its because she chooses (4,3) over (5,1) as she out of her altruism losses $1 so that I can gain $2.

b) Choice 3. Its because she chooses (7,1) over (2,2), so she maximizes her payoff without thinking about the other.

c) Choice 3. Its because incremental social welfare is the incremental benefit from making a choice =

total benefit - total cost = (Amount that I get + amount that she gets) - (Amount that I forgo + Amount that she forgoes).

For choice 1,   incremental social welfare = 7-6 = $1

For choice 2,   incremental social welfare = 7-14 = -$5

For choice 3,   incremental social welfare = 7-4 = $3.

So incremental social welfare is highest in choice 3.

d) Choice 1 represents that she is inequality averse. Lets define an index of inequality as,

Inequality = (Amount that I get - Amount that I forgo)² + ( amount that she gets - Amount that she forgoes)²

For choice 1, inequality = 1 + 4 = 5

For choice 2, inequality = 4 + 25 = 29

For choice 1, inequality = 25 + 1 = 26