The ballot box and economics textbook are on a collision course around the world, and we thought Nic Colas' (of ConvergEx) analysis of what behavioral economists call The Ultimatum Game was worth a refresher. That’s where two strangers divide a fixed sum of money, with one person proposing a split and the other accepting or rejecting it. It’s a one-shot deal, so the proposer tries to work out the minimum amount required to get the other person to go along. Classical economics says that a $1 proposal out of a $100 pot should work, but in real life (and this study has been done everywhere from the rainforests of South America to the bars of Pittsburgh) it takes 25-50% offers to win the day. Nic found three recent updates to the Ultimatum Game that each speak directly to the current political state of play in Europe and the United States. One shows that proud people (or those led by nationalist-minded politicians, perhaps) need higher offers in order to accept a split. The second shows that the Game works even for small amounts. The last – and the first such study we’ve ever seen from a mainland Chinese university – shows that worries over social status complicate the already difficult mental calculus of "How much is enough?"
All the proposed solutions to the European and American debt crises seem to meet at the crossroads of what is "Fair." A tough word, that, since it means different things to different people. A trip to several online etymology resources – the Oxford English Dictionary website sits behind a paywall that would make Hadrian proud – delivered this composite description of the word’s historical usage:
- From the Old English – “Beautiful, lovely, pleasant.”
- From archaic Scandinavian languages – “Beautiful” or “fit”
- From the Middle Ages – “Light complexioned” or “free from bias”. The latter is from another strain of the word, meaning “Moral, or pure, or free from blemish.”
- From the 1850s – the words starts to become incorporated into sports commentary, meaning “Proper.”
In other words, “Fair” in medieval times is the linguistic equivalent of today’s “smoking hot, but not too trampy.” How that meaning migrated to its current definition of “Equitable,” “legitimate” or “honest” must be a long journey. Too bad – it seems more civilized and sweeter to say that David Beckham or Kate Upton or (fill in your favorite celebrity name here) is “Fair.”
And just as the word has evolved over the years, so has the view of economists on its role in human decision-making. Classical economics had little use for the concept during its heyday in the middle part of the last century. Hand a logical thinking human a $1, and that will always make them feel better off. Why would it be otherwise? The notion that the marginal dollar is always welcome at the city gates of consumer psychology is pervasive in modern economic theory. It even makes an appearance in that credit card advert with Jimmy Fallon and the baby that is on every 15 seconds across America: “Who doesn’t want more money?”
In the early 1980s, behavioral psychologists studying how humans bargain came upon an elegant experiment that proved classical economics had the marginal dollar construct very, very wrong (Kuth, Schmittberger, and Schwarze, 1982). They asked pairs of people, strangers to each other, to split a pot of money. The only catch was that it was a one-shot deal. One person proposes a split, the other person accepts or rejects it. Accept, and both parties keep the money as agreed. Reject, and no one gets anything. The marginal dollar construct of classical economics would have you believe that the person in charge of offering the split could put out $1 out of $100 and get the other person to agree. Laughably wrong, of course.
The Ultimatum Game, as researchers now call this experiment, is the single most replicated and refined study in what is now called behavioral finance. It has been done with illiterate Amazonian tribespeople, drunk students on pub crawls in Pittsburgh, and both men and women jacked up on testosterone. The results are always the same: the person proposing the split needs to offer up at least 20%, and usually closer to 50%, to have a change of seeing their offer accepted. It seems a genuine constant of human nature that people need to feel that they are being treated “Fairly.” Moreover, the price of this requirement is explicit, as they are willing to give up real money just to make sure the other person doesn’t get more than they deserve.
I recently came across three updates to The Ultimatum Game that further expand on this central theory of perceived “Fairness”:
- The money isn’t actually the issue. Amazon has an online portal called www.mturk.com that is a effectively a marketplace for short projects and the people that want to work on them. Israeli researchers leveraged this platform to run a modified Ultimatum Game using only small amounts of money. Instead of $20 or $100, which are the more common monetary pools used for similar studies, they ran the game with over 700 subjects using either no money at all or just $1. The idea here was to test if the subjects would grow more “Rational” when only de minimus amounts were on the table. The answer: an unequivocal “No.” Even when small amounts were at stake, the “Fairness” issue still ruled the day in the same proportions as when “Real” money is on the line. See here: http://www.plosone.org/article/info%3Adoi%2F10.1371%2Fjournal.pone.0031461.
- Self-worth explains part of the puzzle. Do you know someone who always dates the “Wrong” people or lets others walk all over them? Don’t let them be a subject in The Ultimatum Game, because they are about the only ones for whom the $1 out of $100 looks like an acceptable split. As it turns out, self-worth is a strong determining factor in how much someone accepts in the game. See here: http://www.plosone.org/article/info%3Adoi%2F10.1371%2Fjournal.pone.0015095.
- And notions of social status explain some more. In the first Ultimatum Game study I have seen written up from mainland Chinese researchers, the form of the game is altered to give the person judging the offer a sense of what offers their peers in the study received. If you tell a subject that their peers are seeing 35% offers, they are much less likely to accept a 30% proposed split. See here: http://www.ncbi.nlm.nih.gov/pmc/articles/PMC3213677/.
One way to look at the current tensions in both European and American debt discussions is as an Ultimatum Game between governments and individuals. Take Greece, for example. Classical economics would say – and you will hear a lot of policymakers echo – that the Greeks should take whatever deal they can. Something is better than nothing. All the lessons of the Ultimatum Game studies point to an entirely different conclusion. The Greek feel that they have been treated unjustly. After all, the wealth created by the fraudulent government accounting really accrued to only a handful of people. So whatever deal might be on the table is not “Fair” (that word again…). And even if it means being materially worse off, Greeks may well choose that route.
And the new studies I highlight in this note seem to push that conclusion even more strongly. The Greek people are nothing if not proud. And they are also sensitive to the notion that the turmoil of the last three years has diminished their social standing in the European community. Put those two factors together, and the upcoming vote on June 17th feels even more unsettled than one would think. At the end of the day, the stresses of the ongoing financial crisis are not just about the money. And since humans react the same everywhere around the globe when it comes to the Ultimatum Game, the lessons of that study are just as relevant in Athens, Georgia as Athens, Greece. The upcoming U.S. presidential election will certainly prove that.