Examining models of social preferences and a generalized model of inequity aversion: An analysis and application

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 Sen's Weak Equity Axiom test (the S-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 passes the two tests and parsimoniously explains interior outcomes in the dictator game and dynamics of outcomes in other games. This is done through introducing 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 accept more (less) than fair distributions as equitable.