Can Contract Theory Explain Social Preferences?

For several decades, a growing body of research has shown that humans do not always

choose to maximize material payoffs. Economists following the lead of psychologists Daniel

Kahneman and Amos Tversky (1979) and Matthew Rabin (1993) have built on such research

to suppose that individuals are attentive to fair distribution rewards between themselves as

well as personal payoffs. (Ernst Fehr and Klaus Schmidt (1999)) An alternative approach,

suggested by Elizabeth Hoffman, Kevin McCabe and Vernon Smith (1996) argue that laboratory

subjects that perceive a potential for future interaction as approximated by social

distance act on a preference for reciprocity.

Both approaches capitalize on the power of psychology to enhance understanding of

economic exchanges between particular people in specific laboratory conditions. Yet, psychology

is not only concerned with the problem of explaining behavior, but it is also in the

business of modifying behavior. On of the shelves of the psychology section of any bookstore

one will find numerous works devoted to helping individuals modify their behavior so that

they drink and smoke less, and learn to have more rewarding social interactions at work and

in private life.

Economists suppose that individuals maximize rewards not because they believe that

people do so in every case, but because the maximizing supposition provides a useful unified

model of behavior in designing better economic institutions. The model not only rationalizes

the profit motive, but explains how even successful institutions may be destroyed by the

common human desire to maximize possessions—if that leads to malfeasance, theft, or general

corruption.

In this note I suggest that economics may also learn more frompsychology about positive

behaviors — such as the complex dynamics of honesty, fairness, and trust. Rather than insist

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that people are endowed with a stable set of unchanging preferences, we may ask instead

how small modifications in preferences can lead to significant improvements in economic

performance.

Specifically, I suggest that contract theory can be a starting point for a larger enquiry

into exactly how preferences might be modified to enhance market performance. I consider

two substantive themes. First I show how contract theory may help to anchor a theory of

fairness. Second, I show that a small taste for trustworthiness can lead to a large increase

in cooperation in a relational contract.

Fairness is a crucial theme because notions about it are decisive in determining whether

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