EWOT Ten

Fairness and Transaction cost

Rizzo talked about the ultimatum game again in his review session audio, which inspired me some new thinking about ultimatum game. Last time I tried to interpret it with game theory; I argued that to accept is the dominant strategy. But in reality, people always sometimes really refute trade. Last time, I thought it was the rationality of the buyers that matters, now I think maybe I failed to put people’s value toward fairness into consideration.  

Since we know that trade can benefit other sides, what prevents the trade that benefits both sides come to reality? Transaction cost is the answer. In the ultimatum game case, the transaction costs that cause people to refuse the proposal is not a monetary trade-off, but their value of fairness. People generally believe that a typical 9-1 proposal is “unfair”. Let’s skip the discussion whether is view is right or not and see what happens so that this transaction is prevented. If all participates are all perfectly rational, the marginal cost is zero for the acceptor of 9-1 proposal while the marginal profit is 1. In this case, since marginal cost is less than the marginal profit, people will accept. Yet when we put people’s value toward fairness into computation, and transfer this intangible cost into mathematical figure, say 2. Then the marginal cost is 2, while the marginal profit, 1, is less than the marginal cost. As a result, the transaction will not happen.

In reality, we should not only consider the rationality of potential buyers and sellers, but need to consider the intangible transaction cost that’s really hard to be transferred into monetary measures.