Inequity Aversion and Public Policy

One of the more important psychological concepts for those interested in public and economic policy is that of inequity aversion.  Inequity aversion theorizes that human beings have a natural tendency to sway away from outcomes which they perceive as unfair or inequitable.

I find this to be fascinating because I believe that the root of trade and money can really be found in equity(note: by equity I mean the concept of fairness, not any of the other uses of the word).  Early trade and barter arose with individuals trading one good for another (or a good for a service).  Such calculations really had a rule of thumb approach to them which could be said to be rooted in the individual utility which was driving the actor’s decisions.  However, with the advent of standardized commodity units (like furs, bushels of wheat, cowry shells, etc.) a concept arose whereby people could visualize in their minds what was truly a “fair” deal or not in a way which went beyond a single transaction and could apply to all transactions as a gauge of real value.  Cultural norms could help indicate to someone just how many furs were equal to a bushel of wheat, which added a new dimension to trade beyond simple conceptions of utility. 

If one is to take a pure utility argument to an extreme, then the buyer could pay $1 million for a soda simply because it increases his own utility.  Of course nobody from a modern society would even consider such a deal, even if they really wanted to have a soda, because we know that $1 million is vastly too much to pay for such a good.  The idea of someone paying $1 million for a soda is absurd because any rational person could tell you that paying $1 million for a soda is an unfair deal.  But besides the fact that such a transaction simply doesn’t make economic sense, there is also a moral realm to such a transaction whereby one could say that actual inequity would be occurring.  If any individual were to convince a someone who is unfamiliar with the cultural and market norms of what the fair value of a soda is to pay $1 million for one, most people would say that such an action would constitute fraud, and that the act is not just bad business but bad behavior which amounts to an injustice which should be corrected.

 This moral sense of unfairness coincides with pure economic calculations of what a good deal is, and in many ways serves as an extra factor which helps guide economic actors to coordinate goods in an efficient way.  And this moral factor is not driven merely by being able to sense when an unfair or far deal is occurring, but also by our inner desire to prevent an unfair deal from occurring in the first place.  And it is through this aversion to inequity that we are able to develop standards of what is equitable and what isn’t, and these standards help guide market actors in their own economic decisions in a way that goes beyond mere utility.  The buyer is not trying to simply increase her utility or meet her needs when buying a good, she is also trying to do it in a way which she believes is equitable for her.  We can see this at work in real life, as in most cultures the greedy businessman who overcharges for goods and underpays workers is not seen just as being bad at business, but as a bad person who is a moral villain.  This adds a layer of complication to the argument that actors in a self-regulating free market would simply refuse to do business with unscrupulous individuals, because in addition to refusing to do business with them people also have a desire to actually enact retribution on them.  They do not simply want to harm them in the future by denying them business, they want to make them pay for past crimes as well, in which case simple market action of finding a different person to transact with may not be enough for people to feel that justice has occurred.

The best evidence for inequity aversion and how it works can be found in experiments done in game theory.   The dictator game for example, allows one individual to split apart a group of units he has (often a cake or a pile of money in an amount which is easy to divide), where he has to give a certain percent to another person and a certain percentage to himself.  In the dictator game, the “dictator” has the freedom to choose whatever ratio he wants, so that he could give himself a larger proportion or give the other person a larger portion, or split it 50/50.   Studies of this game found that the most common choice the dictator makes is to keep it all for himself, but the second most common result is to split it 50/50. 

This becomes even more interesting in another variation of the dictator game called the ultimatum game where the second individual can choose whether to reject the offer or not.  While the dictator still has the sole power to split the units apart, the recipient now has the power to veto the deal so that both he and the dictator end up with nothing.  Unsurprisingly, in the ultimatum game the dictator, having knowledge of this, is more likely to create fair deals from the start.  However even more interesting is that these studies have shown that the recipients regularly reject unfair deals, so as to sacrifice their own reception of money in order to cancel the dictator from receiving the higher share.  Offers of 70/30 and under tend to be regularly rejected.

These studies tell us a few interesting facts about human behavior.  First is that individuals in the dictator position do deal out unequal splits, sometimes even dramatically so (100/0) when they feel that they are in a position to get away with it.  And while the majority of individuals may give an unfair deal, there is a sizeable minority who do strive to give out more fair deals.  Secondly, these games show that the recipients will gladly forgo the benefit of the deal if it means canceling out what they perceive as an inequity.  Now there have been some criticisms of some that absolute value would alter the results, aka, if you actually could receive $30 in USD rather than $30 in monopoly money the recipient would be more likely to take the money and run.  However, amazingly enough, experiments done to see whether this is true have shown that the results are not greatly altered, the absolute value of what is being divided has not been shown to correlate with any decrease in the rate of rejection by the recipient, which indicates just how powerful this moral sense of inequity really is in determining human behavior.

And of course these findings should have very real relevance for looking at modern economic arrangements.  For example, we can see elements of this behavior with the labor movements of the late 19^th and early 20^th century. Workers addressing what they saw as inequity in economic arrangements would resort to strikes and demonstration which not only halted production, but also often cost them their very jobs.  These actions have puzzled many as it seems to be the workers shooting themselves in the foot, after all, they probably would have gained more income if they simply took the deal offered to them by their employers instead of protesting against it.  Those who demonize labor unions use these examples as evidence that labor unions are irrational and harmful to the economy.  However, when the concept of inequity aversion is applied to these events, they seem to make more sense, as they could simply be manifestations of the same behaviors observed in game theory which show just how deeply ingrained morality and a sense of justice is in our economic thought processes.

 Perhaps an even more interesting example could be in communism.  Outraged with what they saw as the unfairness of 19^th century predator capitalism, socialists and communists called for a total downfall of the system, and created numerous disruptions for society.  The revolutions which popped up over Europe inarguably created unrest and probably hurt the poor and middle class just as much as they did the rich.  The inefficiencies of socialism in those countries where communism did take hold probably prevented a growth of wealth to the degree that one could argue that economically the proletariat really had a zero sum gain, they probably could have made just as much if not more if they simply carried on with capitalism like those in Western Europe did (and indeed the wealth of Western European nations attests to this).   Of course, when inequity aversion is taken into consideration, one could postulate that these actions may have had more to do with principal rather than any attempt at replacing capitalism with a more efficient system.  In installing a communist regime they insured that the privilege and status of wealth was destroyed, the proleteriet in many ways impeded their own economic future so that they could ensure that the rich would not get away with this perceived injustice. 

And of course this should bring in mind some of the aspects of Nash Equilibrium in the ultimatum game as compared to the dictator game, where by the proposers (dictators) in the ultimatum game are more likely to give a fair proposal than in the dictator game as they understand that if they give an offer which is too one sided they risk losing everything if the receiver vetoes.  In terms of labor history in the West, the fear of losing it all prompted capitalist countries to develop policies such as workplace regulations and welfare states to help calm the proletariat and put them on a stronger footing.  And while some may argue that this had the effect of reducing the marginal utility of capital in favor of labor, it helped to reduce the social strife that characterized that age.  And if one were to consider to the losses which the capitalist would endure from large strikes and threats of revolution, one could argue that the economy actually achieved more wealth and growth after abandoning laissez faire for more social democratic policies as it reduced the incentives of laborers to sabotage the entire economic arrangement.  By realizing what was at stake due to the news coming from places like Russia, capitalist countries realized that perceptions of inequity could cause dramatic problems if they were not calmed.  

Of course, while there is ample evidence for inequity aversion in people, we still find that the dictator is still capable of cheating the other person if he can, a true free rider if you will.  But, the less confident he is that he will get away with it, the less likely he is to attempt such a feat.  Furthermore, variations of these games have found that the options available to the players can alter the level of altruistic behavior seen, with proposers who are overly generous under one variation of the game becoming shockingly licentious in another variation.  This suggests that people’s levels of altruism are directly related to their environment and the options presented to them can alter what they perceive is to be expected of them.  And what they perceive to be expected of them can cause seemingly good people to become much more abusive and unfair, which shouldn’t be surprising to those of us familiar with experiments like the Sanford prison study. 

Overall the findings from these games suggest a picture of humanity which is far more complicated than the one put out by people like Milton Friedman.  Humans are a species which is not only capable of acting in unfair and inequitable ways if they feel that they can get away with it or that it is expected of them, but also capable of amounting to extreme, self-defeating measures if they feel that an injustice has been committed against them.  These contradictions should be of no surprise to those who are familiar with human psychology and the complicated behaviors of our species.  However, to many these contradictions are simply over looked.  Clearly the actions of individuals in these games and real life indicate that there are elements of utility function which remain tantalizingly intangible, which should call into question any models of economic behavior which attempt to present utility function in quantifiable terms.  Because by all measurements, there really is no evidence that the vetoing by the receiver actually increases his utility at all, instead it indicates that an economic benefit can be costlier to an individual if it offends his inequity aversion, things like pride or desire to punish bad behavior are actually weighing in on utility function in a way which can be hard to predict and quantify.  Yet they have obviously shown to be a very important force in allowing an actor to come to an economic decision.

Also, it must be said that the results from the dictator and ultimatum games can be remarkably mixed, the only real constants we see are that proposers in the dictator game are more likely to give themselves a greater share and that receivers in the ultimatum game routinely reject divisions less than 30%.  However, there is still a great deal of individual specificity in just to what degree this occurs in a game and as stated earlier, slight alterations in the rules and options available to the players can yield different rates of unfair proposals and rejections.  We see that human behavior is not a monolith, and while there are trends, it remains incredibly difficult to create a model of a uniform actor in regards to these concepts.

In terms of social policy, we should be very keenly aware of the existence of inequity aversion and seek to avoid those instances where inequity exists.  And given the evidence that people can be willing to shoot themselves in the foot if it means exacting justice, it should be something that is to be feared.  People such as Milton Friedman seem to believe that free market capitalism has all the tools to deal with the complexities of human behavior, including that of inequity aversion.  However, the historical and real life data suggests otherwise.  The property and contract rights in free market capitalism can put people in a position very similar to the dictator in these games, and like the results of the dictator game, some of these individuals choose to act in a way which gives them a bigger piece of the pie.*  Workers, perceiving an unfair situation can resort to extreme measures to correct this injustice, in a way which goes beyond mere explanation of simple economic utility and reflects a level of seemingly irrational and emotive behavior within both the capitalist who knows his deal may anger workers and the workers who hurt their own economic utility in an attempt to exact justice.  

And of course this is exactly the problem which was occurring in the late 19^th and early 20^th century.  Thinkers like Friedman seem to suggest that courts and contract law could correct this, but this too is incorrect.  The property and contract laws of common law countries evolved from medieval and proto-capitalist economic situations, and were more focused on buyer seller relations and distribution.  While they worked well for the markets of the 18^th and early 19^th century, they really were not equipped to deal with the complexities of labor relations which emerged in the second industrial revolution.  Many workers were employed under at will employment contracts, which pretty much meant that employers could do whatever they wanted.  And the reactionary courts of the Lochner era were certainly not sympathetic to labor claims, and saw the capitalist as well within his rights to have the unequal bargaining power.  The courts of the late 19^th and early 20^th century were not friendly to labor, and indeed to this day contract and property law is more oriented towards distribution than towards worker rights.  There was also the element of the culture of the day, which held the capitalist in high regard.  Laissez faire economics puts the entrepreneur and the capitalist on a pedestal, and allows them much freedom in their decisions, as it is said that from their freedom to make decisions, economic coordination can occur which benefits all of society.  This notion is still very much present among laissez faire advocates today, who celebrate the capitalist and believe that his discretion should be respected at all time, as the decisions he makes fit within a bigger picture which in its aggregate makes life better for all of us.  Of course this should make us all think of what I discussed earlier in how the options presented to the dictator can alter his behavior, if the capitalist is told to believe that it is crucial that he pursue profits and must follow his self-enrichment to the fullest extent, he may not only feel entitled to give himself a greater share of the income from production, but that it is actually expected of him to do so.

And it would be hard to argue that these attitudes and behaviors were not the norm in the late 19^th and early 20^th century, and indeed many capitalists did try to deal out very unfair deals.  This of course created much strife, with an economic model and business culture conducive to allowing unequal distribution of profits from production and a legal system seemingly unable or unwilling to address these concerns, this was a breeding ground for inequity aversion to boil up and create unrest.  So how did society get out of this dilemma?

The answer of course lies with the new form of law which emerged in that period: the regulation.  Unlike the equity and contract law which simply seeks to correct a past harm, or penal codes which outright forbade certain behavior, the regulation dealt with behavior which was legal, and merely set in place guidelines as to how it should be conducted.  By putting in place regulations for the workplace, the capitalist was restricted in his options, making him less likely to and less able to deal out unfair distributions.  And with laws in place that guaranteed certain wages and benefits to workers, these unfair results were simply avoided in the first place.  The evolution and emergence of regulation as a form of law was meant to directly address the flaws in laissez faire capitalism, one of which was the social strife caused by inequity aversion.  The fundamental difference in outlook between regulations and the early common law, is that instead of waiting to correct a bad event, the regulation seeks to prevent it from occurring in the first place.  This notion is much more in line with the realities of human nature, rather than simply “letting things play out” as laissez faire advocates desire, regulations are made with the understanding that sometimes underlying irrationalities in human behavior can create outcomes which rather than correct injustice, only serve to make things worse.  Instead of falling for the Lockean fallacy that individuals will always try to be pro-social and avoid bad behaviors in a free market, regulations are made with the understanding that humanity is a complicated species which is very much capable of producing undesirable results if environmental conditions permit.  Many of the strikes and riots which occurred in that era did not correct any bad behaviors, nor did they yield greater efficiency, they simply represented sunk costs that only hurt society and markets, sunk costs which could have been avoided.

Those who complain about labor regulations and welfare states may not be fully cognizant of the alternative scenarios which could arise if a laissez faire scheme was reinstated.  The inconveniences of regulation and taxation (which as of yet have failed to destroy capitalist incentives and growth) may not just be wasteful spending, but rather important investments which fuel growth by allowing for greater social cohesion and lower incidences of strife.  The normal market mechanisms and cooperative exchange are not enough, there is an element of strong arming in both labor and capital which are unable to resolve these disputes in a cohesive way from market mechanisms and common law alone.  The attempt at creating policies which reduce labor tension and creates avenues for equity and reduction of social unrest are one of the main focuses of the highly successful social markets undertaken in the Nordic Model and Rhineland Capitalism. This also serves to add an objective element to arguments for helping the poor and protecting labor.  Some have mistaken earlier arguments I made regarding the welfare state as simply being moralistic ones on the grounds that we should avoid them simply because it is wrong to be “mean” to the poor.  But when concepts such as inequity aversion are taken into account, those who cannot be swayed on moral arguments alone should be swayed by purely utilitarian and materialistic ones in the fact that ignoring the concept of equity can create social harms which bring about real costs to society that can be quite devastating.

Finally, as one last point, it should be important to note that some studies of the ultimatum and dictator games have found that individuals from industrialized countries are more likely to deal out 50/50 splits than those who are not.  This ties in to the argument I made at the very beginning of this article about the role that perceptions of equity play in people’s ability to make economic calculations.  By having an industrialized economy with regulations, societies are also helping to create moral signaling which guides people as to what an actual equitable deal is.  This not only makes us more proficient economic actors, but increases instances of organic altruistic behavior.  Laws regulating behavior have an extra aspect to them, which while they are unable to govern morality, can signal to individuals just what sorts of behaviors are acceptable and which aren’t.  Just as the capitalist was taught and expected to be inequitable by the culture of laissez faire, the culture of social democracies with regulatory framework and welfare states teaches individuals to act in a way which does not give rise to inequity aversion.  This fits in with the social organism hypothesis I have outlined before, whereby successful societies through natural selection tend to choose actions which ensure their survival and wellbeing.  And if we have a system whereby equitable behavior arises more organically and spontaneously, we will have a better functioning economy and a more cohesive society.  And that is something which is better for all of us.

 

 

*At first glance this appears to be similar to Marx’s model of the capitalist firm, whereby the capitalist is ripping off the worker by stealing his labor value.  However, Marx seemed to see this as a trait inherent to capitalism that was almost structural and would inevitably occur.  In reality the results are a little more complex, some capitalists like Henry Ford or Costco CEO Craig Jelinek do go out of their way to give a fair deal to their workers, while others seem to go out of their way to take as much from their workers as they possibly can.  It is not a monolith, and of course this does fit in line with the findings of game theory which indicate that inequitable deals have an element of individuality to them that can vary from person to person.