The Ultimatum Game

Last time ("One of the strangest matches ever") I talked about some of the reasons why incentive schemes fail, using a few examples from game theory.  Let's just assume that these plans are well-designed to begin with and that we aren't dealing with the kinds of unintended consequences that occurred in the 1994 football match between Barbados and Grenada.  I've also discussed the so-called "crowding out effect" (also known as the "overjustification effect") in the past (see, for example, my post "Holes" from last April), a well-described phenomenon in behavioral economics.  Recall that individuals are motivated to do perform tasks for either intrinsic (e.g., the joy and satisfaction we get from achieving our goals or doing a job well) or extrinsic (e.g., financial rewards) reasons.  Unfortunately, when individuals are paid for their services, the joy and satisfaction that they receive from completing a task actually decreases (hence, the "crowding out" effect).  

For example, a daycare center was trying to motivate parents to pick up their children on time, so they instituted a modest ($3) fine for parents who showed up late.  What happened?  Rather than decreasing late shows, the number of parents who showed up late to pick up their children skyrocketed!  The daycare created a financial relationship between the parents and staff (whereas before the relationhip was more social), and the "price to pay" for being late (inconveniencing the daycare staff versus paying the $3 fine) was no longer that big of a deal.

It's also important to remember that we are dealing with humans here.  The 18th century economist Adam Smith introduced the concept of the "invisible hand" in his classic The Wealth of Nations, writing "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."  In other words, according to Smith the free market incentivizes individuals to act in their own self-interest to produce what is necessary for society as a whole.  Subsequently, economists coined the term "Homo economicus" (or "economic man") to denote that individuals make rational decisions to maximize their utility (consistent with rational choice theory).

Most people forget (or just don't know) that Smith also wrote a book called The Theory of Moral Sentiments and wrote that individuals also have sympathy for the well-being of others.  Humans don't always make decisions based purely on maximizing their own utility.  And even if we aren't necessarily looking out for others, we generally want decisions to be made fairly.  Want a concrete example?  Look no further than the "Ultimatum Game".  

I mentioned the "Ultimatum Game" in a post a few months ago ("A rut is a grave with the ends kicked out"), but I want to talk about it again now that I've covered some background on game theory.  The basic set-up is as follows.  There are two players in this game.  Player 1 has a $10 and is instructed to split the $10 with Player 2, however way he or she decides.  The catch is that if Player 2 refuses to accept the offer, no one gets to keep the money.  Sounds easy enough, right?  So how would you play?

The "Ultimatum Game" has been played literally millions of times, and when Player 1 selects, for example, a $7.50/$2.50 split, Player 2 rejects the offer almost every time (actually, 95% of the time).  In other words, most individuals would prefer to go home with nothing than be treated unfairly (or so they perceive).  Everything that we've learned about game theory in the past few posts would tell us that Player 2 should accept the offer and walk away with $2.50 (which, he or she did not have at the beginning of the game).  As a matter of fact, the majority of studies show that Player 2 will almost always reject Player 1's offer when it is less than a 60/40 split!

There's a different variation of the game that is called the "Dictator Game" which is also interesting.  The Nobel Prize winning economist Daniel Kahneman developed this version in the 1980's, in which Player 1 (the "dictator") makes an offer that Player 2 has no choice but to accept.  If all individuals cared about was maximizing their own self-interest (consistent with the "Homo economicus" principle discussed above), Player 1's best strategy would be to offer a $10/$0 "split" (i.e. take all of the money).  However, that's not what typically happens in this game.  In most studies, Player 1 gives at least $2 (out of $10, or 20% of the total pay-off)!  

As I stated above, humans behave irrationally when they perceive something as not being fair.  As it turns out, even monkeys play the ultimatum game and respond in a similar way!  Leaders and managers should keep the "Ultimatum Game" (and "Dictator Game") in mind when designing incentive plans.  We will continue our discussion of incentive plans from a game theoretic perspective the next time.