A Gift-Exchange With Probabilistic Payoffs

2. Theoretical Background

Since the gift-exchange game first introduced by Fehr et al. (1993) a large number of experiments thereafter demonstrate that individuals are willing to sacrifice money to benefit another person in exchange for a high wage. In addition, there is a large body of evidence showing that reciprocity facilitates bilateral gift-exchange transactions where the returns from the worker’s effort are not subject to uncertainty (see Fehr and Falk, 2008 for a comprehensive overview). People tend to make decisions which are costly to themselves but that are beneficial for others, in the expectation that these will be reciprocated. An explanation of this deviation from the standard theory is provided by the Akerlof’s (1982) gift-exchange model. Here, the offer of employment represents an invitation to “exchange gifts”, while the worker’s effort choice indicates the size of the reciprocal gift.

However, the returns from reciprocal actions are often exposed to risks and uncertainty. The “gifts” can experience gains, but also losses. While experimental studies demonstrate that people care more about losses than gains (from Kahneman & Tversky, 1979 and subsequent evidence), theory suggests that people form expectations and anticipate potential feelings of disappointment if their effort results in low payoffs. Thus, one would minimize the loss by reducing their effort to the point they feel that a lower payoff justifies the associated costs¹. This is potentially detrimental to situations where the outcomes of reciprocal actions are conditional to exogenous factors, and with some probability, experience losses.