Contributions published at Microeconomics and Experimental Economic Research (Ernst Fehr)

"Economists long considered money illusion to be largelynirrelevant. Here we show, however, that money illusion has powerfulneffects on equilibrium selection. If we represent payoffs in nominal terms,nchoices converge to the Pareto inefficient equilibrium; however, if we liftnthe veil of money by representing payoffs in real terms, the Pareto efficientnequilibrium is selected. We also show that strategic uncertainty about thenother players’ behavior is key for the equilibrium selection effects ofnmoney illusion: even though money illusi on vanishes over time if subjectsnare given learning opportunities in the context of an individual optimizationnproblem, powerful and persistent effects of money illusion are found whennstrategic uncertainty prevails."

In many occupations workers’ labor supply choices are constrained by institutionalnrules regulating labor time and effort provision. This renders explicit tests of the neoclassicalntheory of labor supply difficult. Here we present evidence from studies examining labornsupply responses in “neoclassical environments” in which workers are free to choose whennand how much to work. Despite the favorable environment the results cast doubt on thenneoclassical model. They are, however, consistent with a model of reference dependentnpreferences exhibiting loss aversion and diminishing sensitivity.

One of the most basic questions in economics concerns the effects of competition onnmarket prices. We show that the neglect of both fairness concerns and decision errors prevents ansatisfactory understanding of how competition affects prices. We conducted experiments whichndemonstrate that the introduction of even a very small amount of competition to a bilateralnexchange situation - by adding just one competitor - induces large behavioral changes amongnbuyers and sellers, causing large changes in market prices. Models that assume that all people arenself-interested and fully rational fail to explain these changes satisfactorily. In contrast, a modelnthat combines heterogeneous fairness concerns with decision errors predicts all comparative staticneffects of changes in competition correctly. Moreover, the combined model enables us to predictnthe entire distribution of prices in many different competitive situations remarkably well.

"Recent studies found evidence for nominal wage rigidity during periods of relatively high nominal GDP growth. It has been argued, however, that in an environment with low nominal GDP growth, when nominal wage cuts become customary, workers’ cuts would erode and, hence, firms would no longer hesitate to reduce nominal pay. If this argument is valid nominal wage rigidity is largely irrelevant because in a high-growth environment there is little need to cut nominal pay while in a low-growth environment the necessary cuts would occur. To examine this argument we use data from Switzerland where nominal GDP growth has been very low for many years in the 1990s. We find that the rigidity of nominal wages is a robust phenomenon that does not vanish in a low growth environment. In addition, it constitutes a considerable obstacle to real wage adjustments. In the absence of downward nominal rigidity, real wages would indeed be quite responsive to unemployment."

In recent years a large number of experimental studies have documented the existence of strong reciprocity among humans. Strong reciprocity means that people willingly repay gifts and punish the violation of cooperation and fairness norms even in anonymous one-shot encounters with genetically experimental evidence suggesting that ultimate evolutionary explanations of strong reciprocity. can rationalize strong reciprocity only if it is viewed as maladaptive behavior whereas the evidence suggests that it is an adaptive trait. Thus, we conclude that alternative evolutionary approaches are needed to provide ultimate accounts of strong reciprocity.

"Typically, laboratory experiments suffer from homogeneous subject pools and self-selection biases. The usefulness of survey data is limited by measurement error and by the questionability of their behavioral relevance. Here we present a method integrating interactive experiments and representative surveys thereby overcoming crucial weaknesses of both approaches. One of the major advantages of our approach is that it allows for the integration of experiments, which require interaction among the participants, with a survey of non-interacting respondents in a smooth and inexpensive way. We illustrate the power of our approach with the analysis of trust and trustworthiness in Germany by combining representative survey data with representative behavioral data from a social dilemma experiment. We identify which survey questions intended to elicit people’s trust correlate well with behaviorally exhibited trust in the experiment. People above the age of 65, highly skilled workersnand people living in bigger households exhibit less trusting behavior. Foreign citizens, Catholics andnpeople favoring the Social Democratic Party or the Christian Democratic Party exhibit more trust.nPeople above the age of 65 and those in good health behave more trustworthy or more altruistically,nrespectively. People below the age of 35, the unemployed and people who say they are in favor ofnnone of the political parties behave less trustworthy or less altruistically, respectively."

We examine experimentally how Chief Executive Officers (CEOs) respond to incentives and how they provide incentives in situations requiring trust and trustworthiness. As a control we compare the behavior of CEOs with the behavior of students. We find that CEOs are consider-ably more trusting and exhibit more trustworthiness than students-thus reaching substantially higher efficiency levels than students. Moreover, we find that, for CEOs as well as for students, incentives based on explicit threats to penalize shirking backfire by inducing less trustworthy behavior-giving rise to hidden costs of incentives. However, the availability of penalizing incentives also creates hidden returns: if a principal expresses trust by voluntarily refraining from implementing the punishment threat, the agent exhibits significantly more trustworthiness than if the punishment threat is not available. Thus trust seems to reinforce trustworthy behav-ior. Overall, trustworthiness is highest if the threat to punish is available but not used, while it is lowest if the threat to punish is used. Paradoxically, however, most CEOs and students use the punishment threat, although CEOs use it significantly less.

The evidence from many experiments suggests that people are heterogeneous with regard to their abilities to make rational, forward looking, decisions. This raises the question when the rational types are decisive for aggregate outcomes and when the boundedly rational types shape aggregate results. We examine this question in the context of a long-standing and important economic problem - the adjustment of nominal prices after an anticipated money shock. Our experiments show that when agents' actions are strategic substitutes adjustment to the new equilibrium is extremely quick whereas under strategic complementarity adjustment lasts very long and is associated with relatively large real effects. This adjustment difference occurs because price expectations are very flexible under substitutability and very sticky under complementarity. Our results suggest that strategic complementarity does not only provide incentives for the rational types to partly mimic the behavior of the boundedly rational types butnit also renders people less rational and forward looking. In addition, underncomplementarity people attribute less rationality to the other players.

This paper reports the results of a series of competitive labour market experiments in which subjects have the possibility to reciprocate favours. In the high stake condition subjects earned between two and three times their monthly income during the experiment. In the normal stake condition the stake level was reduced by a factor of ten. We observe that both in the high and the normal stake condition fairness concerns are strong enough to outweigh competitive forces and give rise to non-competitive wages. There is also no evidence that effort behaviour becomes generally more selfish at higher stake levels. Therefore, our results suggest that, contrary to common beliefs, fairness concerns may play an important role even at relatively high stake levels.

In this chapter we provide a selective survey of experiments to investigate the potential of social motivations in explaining labour market phenomena. We argue that laboratory experiments are a useful instrument to explore issues in labour market theory and personnel economics. Our starting point is the observation that employment relations are frequently governed by incomplete contracts. We show that the norm of reciprocity that leads to gift exchanges is an effective contract enforcement device under conditions of contractual incompleteness. We then present evidence that gift exchange can explain various labour market phenomena that are puzzles from the viewpoint of standard economic theory. Further issues in the related field of personnel economics that have by now been subjected to an experimental scrutiny concern characteristics of the employment relation and the issues of motivation and incentives systems.

In this paper we provide experimental evidence indicating that incentive contracts may undermine voluntary cooperation. This suggests that explicit incentives may have costly side effects that have been largely neglected by economists. In our experiments the undermining effect is so strong that the incentive contracts are less efficient than contracts without any incentives. Buyers, who are in the role of principals, nonetheless, prefer the incentive contracts because they allow them tonappropriate a much larger share of the (smaller) total surplus and are, hence, more profitable for them. The undermining of voluntary cooperation through incentives is, in principle, consistent with models of inequity aversion and reciprocity. Additional experiments show, however, that the reduction of voluntary cooperation throughnincentives is partly due to a framing effect.

"We provide experimental evidence that contractual incompleteness, i.e., the absence of third party enforcement of workers’ effort or the quality of the good traded, causes a fundamental change in the nature of market interactions. If contracts are complete the vast majority of trades are initiated by public offers. Most trades take place in one-shot transactions and the contracting parties are indifferent with regard to the identity of their trading partner. Moreover, the short side of the market attempts to appropriate the whole gains from trade, which causes much disagreement about contract terms.nIf contracts are incomplete the vast majority of trades are initiated by private offers. The contracting parties form long-term relations and the provision of low effort or bad quality is penalized by the termination of the relationship. The threat of terminating the relation turns out to be an extremely powerful discipline device. "

Experimental games turned out to be remarkably productive tools for examining the nature of social preferences and social norms. This paper describes the methods and tools of experimental game theory and provides a selection of games that have been useful. We also discuss the role of evolutionary explanations of and social preference theory in organizing the data in a coherent way.

A substantial number of people exhibit social preferences, which means they are not solely motivated by material self-interest but also care positively or negatively for the material payoffs of relevant reference agents. We show empirically that economists fail to understand fundamental economic questions when they disregard social preferences, in particular, that without taking social preferences into account, it is not possible to understand adequately (i) the effects of competition on market outcomes, (ii) laws governing cooperation and collective action, (iii) effects and the determinants of material incentives, (iv) which contracts and property rights arrangements are optimal, and (v) important forces shaping social norms and market failures.

During the last two decades economists have made much progress in understandingnincentives, contracts and organisations. Yet, they constrained their attention to a very narrow and empirically questionable view of human motivation. The purpose of this paper is to show that this narrow view of human motivation may severely limit understanding the determinants and effects of incentives. Economists may fail to understand the levels and the changes in behaviour if they neglect motives like the desire to reciprocate or the desire to avoid social disapproval. We show that monetary incentives may backfire and reduce the performance of agents or their compliance with rules. In addition, these motives may generate very powerful incentives themselves.

We study the importance of conditional cooperation in a one-shot public goods game by using a variant of the strategy-method. We find that a third of the subjects can be classified as free riders, whereas 50% are conditional cooperators.

"Informal sanctions are a major determinant of a society’s social capital because they are key to the enforcement of implicit agreements and social norms. Yet, little is known about the driving forces behind informal sanctions. We systematically examine the determinants of informal sanctions by a large number of experiments. Our experiments allow us to identify the relative importance of three major potential factors: (i) strategic sanctioning for selfish reasons, (ii) non-strategic sanctions driven by spitefulness, and (iii) non-strategic sanctions that are driven by the violation of fairness principles. In addition, the observed sanctioning patterns provide insights into the relevance of different fairness principles.nOur findings show that the violation of fairness principles is the most important driving force of sanctions but, in addition, a non-negligible part of the sanctions is driven by spitefulness. We find surprisingly little evidence for strategic sanctions that are imposed to create future material benefits. While non-strategic sanctions are of major importance in our experiments, strategic sanctions seem to play a negligible role. Within the class of fairnessdrivennsanctions the motive to harm those who committed unfair actions seems mostnimportant."

Most economic models are based on the self-interest hypothesis that assumes that all people are exclusively motivated by their material self-interest. In recent years experimental economists have gathered overwhelming evidence that systematically refutes the self-interest hypothesis and suggests that many people are strongly motivated by concerns for fairness and reciprocity. Moreover, several theoretical papers have been written showing that the observed phenomena can be explained in a rigorous and tractable manner. These theories in turn induced a new wave of experimental research offering additional exciting insights into the nature of preferences and into the relative performance of competing theories of fairness. The purpose of this paper is to review these recent developments, to point out open questions, and to suggest avenues for future research.

We show that concerns for fairness may have dramatic consequences for the optimal provision of incentives in a moral hazard context. Incentive contracts that are optimal when there are only selfish actors become inferior when some agents are concerned about fairness. Conversely, contracts that are doomed to fail when there are only selfish actors provide powerful incentives and become superior when there are also fair-minded players. These predictions are strongly supported by the results of a series of experiments. Furthermore, our results suggest that the existence of fair actors may be an important reason why many contracts are left deliberately incomplete.

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