Question

The homo economics view of man’s behaviour as applied to the bulk of finance theory portrays decision makers and being both self-interested and rational. Neoclassical economics makes some fundamental assumptions about people:

1. People have rational preferences across possible outcomes or states of nature.

2. People maximize utility and firms maximize profits.

3. People make independent decisions based on all relevant information.

In light of the following hypothetical experiments, discuss the above

Experiment 1:

Ten people are in Room X (givers) with a further ten people in Room Y (takers). Each giver in Room X will be paired with a taker in Room Y although they will not know the identity of the other. Givers have been given $20 and can transfer any part of their $20 to a taker in Room Y. Takers can either choose to keep the amount sent, in which case the amount proposed is final or else reject the amount sent, in which case both individuals receive nothing. That is, you can send any dollar amount from $0 to $20 and the taker can accept this offer, or reject it, in which case you both receive nothing. For example, If the taker accepts and you send $10, you keep $20 - $10.

You are a giver. How much do you give?

Experiment 2:

Ten people are in Room X (givers) with a further ten people in Room Y (takers). Each giver in Room X will be paired with a receiver in Room Y although they will not know the identity of the other. Givers in Room X have been given $20 and can transfer any part of their $20 to a taker in Room Y. The taker cannot reject the amount sent.

You are a giver. How much do you send? For example, If you send $10, you keep $20 - $10.

Experiment 3:

Ten people are in Room X (givers) with a further ten people in Room Y (returnee). Each giver in Room X will be paired with a returnee in Room Y although they will not know the identity of the other. Givers have been given $20 and can transfer any portion of their $20 to a returnee in Room Y.

Every dollar sent by a giver is tripled on receipt by the returnee. Returnees have the ability to send money back to the givers which would range between $0 and three times the amount received.

You are a giver. How much do you send?

Answer 1

Experiment 1.

The question is asking us how much the giver should hive to the taker so that he is maximizing his welfare. The important point to note here is that the amount that needs to be divided must be a dollar amount, we can't divide a dollar into cents. In short we need to calculate the best strategy for the giver, since he is making the offer to the takers. And one more thing to note, the All 10 givers are identical so we just need to calculate the best strategy for 1 giver and we can say that everyone will act in the same manner since everyone is maximizing its own welfare.

The optimal offer that the giver should make is 19-1, that he must offer $1 to the taker. Let's see why this must be the case.

As a giver you are looking to maximize your own welfare, what is the maximum amount that you can keep while making giver to accept the offer at the same time.

The maximum amount that you can keep is whole $20 but in this case you are not offering anything to the taker, so he is will going to reject the offer and no one will get anything according to the question. So we need to give him some positive amount of money out of $20 to make him accept the offer.

So what's the least amount of dollar money that we can give him? It's $1 since we are not allowed to divide dollars into cents, so this is the best strategy for the giver. He is getting the maximum possible amount out of $20 and still given enough to the taker such that he accepts the offer.

So as a giver we should make the following offer, in which giver takes $19 and gives $1 to the taker.

Experiment 2.

This experiment is even more straight forward, the giver can transfer any part of the $20 to the taker not only dollar amount. But with that there is additional information that the taker can't reject the offer made by the giver.

Now again we need to ask ourselves, what is the best strategy for the giver, such that he maximizes his welfare.

The best strategy for the giver in this case is to offer $0 to the takers. Since there is no point giving anything to the taker as he has now no power to reject the offer made by the giver. So there is no need to give him some positive amount in order to make him accept the offer.

So the best strategy for the the giver in this case is to divide $20 as, 20-0. That is he keeps all of the $20 and gives $0 to the taker.

Experiment 3.

Again in this case, we are asked to tell what is the best strategy for the givers. In this experiment the takers are replaced by the returnees. Returnees can return the money back to the givers 3 times of the money that they receive from givers.

Again the best strategy for the giver is to make an offer in which giver will $0 to returnees. Let's see why it is the case.

The only change in this experiment from experiment 2 is that in this case there are returnees in place of takers which can give back 3 times the money to the giver.

But note one thing, people only maximizes their own utility and don't care about others. As soon as givers give any positive amount of money to the returnees, returnees will have no incentive to return back the money to the givers. Because the assumption of rationality dictates that returnees must care about their own welfare.

So the best strategy for the giver is to give $0 to the returnees and since they can't reject the offer, givers will get all of $20. Which is the best case for them.

Note : This question is purely based on the fundamental assumptions of economics, which is individuals are rational. And their behavior is dictated by the rationality. This is what we have done above, thinking rationally we have reached a best strategy for giver in each experiment which maximizes its own welfare.