Hayat Khan Modeling Social Preferences: A Generalized Model of Inequity Aversion Economics and Econometrics Research Institute EERI

This paper argues that a generalized model of social preferences must simultaneously pass two tests; the Variety Test (explain outcomes under variety, the V-test) and the Psychological Test (conform to psychological intuition, the P-test). It is shown that none of the models proposed to date unconditionally passes these tests. The paper extends the Fehr and Schmidt model of inequality-aversion to a generalized model of inequity-aversion which parsimoniously explains interior outcomes in the dictator game and dynamics of outcomes in other games. This is done through introducing the equity-bias in the Fehr and Schmidt model. The paper postulates that a player’s idea of equitable distribution is state-dependent, where the state is determined by psychological and structural parameters. The state could be fair, superior or inferior. Individuals in a fair state have zero equity-bias and split the pie evenly. Those in a superior (inferior) state have positive (negative) equity-bias and value more (less) than fair distribution as equitable. JEL Classification: C69; C70; C91; D03; D63; D64