Can Contract Theory Explain Social Preferences?∗

During the last several decades, a growing body of laboratory research has shown that human subjects do not always choose to maximize material payoffs. Economists following the lead of psychologists Daniel Kahneman and Amos Tversky (1979) and Mathew Rabin (1993) have built on such research to suppose that individuals are concerned about the distribution of material rewards between themselves and others as well as with personal payoffs. (Ernst Fehr and Klaus Schmidt (1999)) An alternative approach, suggested by Elizabeth Hoffman, Kevin McCabe and Vernon Smith (1996) argues that subjects in the laboratory perceive the situation as one with the potential for future interaction, and their behavior is motivated by a preference for reciprocity. Both approaches capitalize on the power of psychology to enhance our understanding of economic exchanges between particular people in specific laboratory conditions. Yet the converging interest of psychology and economics in systems of rewards and social preferences has depth and breadth, dating at least as far back as Adam Smith in his The Theory of Moral Sentiments (1759). The convergence today is marked by precise research on the degree of the effectiveness of incentives, but also in quantifying the role of trust, fairness, honesty, and other attributes in helping people in such important goals as curtailing harmful drinking, smoking, and eating habits and learning to interact more rewardingly with partners, friends, and colleagues. Economists have supposed 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 that may guide the design of better economic institutions. The model helps not only in rationalizing the profit motive, but in explaining how even successful institutions may be destabilized