Friday, September 18, 2009

Paradoxes in Economics: The Ultimatum Game

Economics, with its basis in rational decision making, can lead to paradoxical results. One classic paradox is the ultimatum game whereby one player has an amount of money (say $100) and has to make an offer to share some part of it with the other player. The second player can only say 'yes' and both players get the agreed upon shares, or 'no' and both players get nothing. It is played only once.

The economic solution to the game simple: the first player offers the smallest amount possible (say $1) and the second player agrees (as $1 is better than nothing). In the real world, however, this rarely happens - the second player will often say no to too small an offer as the dis-utility of the feeling of being cheated is worth more than $1. [This by the way, just means we have to be more careful when we describe the 'true' payoffs to players and include psychic costs] The first player is also motivated by the positive utility one gets from being generous.

I was reminded of this last night when I watched a wonderful Argentinean movie "Nine Queens." [I have to travel to Buenos Aires for a conference and this was suggested as a good movie to watch to see a little of the city] You can get the gist of the plot from the trailer (though it is a pretty awful trailer - don't worry the movie is very good), but in it there is a scene that illustrates the ultimatum game perfectly. A forger has made a perfect copy of some extremely rare stamps and is ready to sell them to a wealthy collector when he falls ill and is unable to complete the transaction that absolutely has to happen that day. So he calls a fellow confidence man to help him and offers a 50-50 split. The con man realizing the nature of the game says "no: 90% for me and 10% for you." What is the sickly forger to do? 10% is better than 0, so he agrees. Of course the con man should have realized he could have offered only 1%, but perhaps the dis-utility from the feeling of being taken advantage of may have led to a refusal, so he adjusted.

Its a good movie and highly recommended, especially if you want to practice your spanish with a rapid-fire Argentinean accent. [If not, the sub-titles are fine]

The ultimatum game is one paradox of economics, I'll leave you with another classic: why do you leave a tip after service in a restaurant at which you are not a regular?

Can you think of other paradoxes in economics?

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