May 19, 2022
Dissertation Title: “The Effect of Fairness Preferences on Individual Decision-Making in Inter-temporal, Risk Sharing, Credit and Asset Market Settings”
The dissertation is by Aneeka Kanwal, PhD Management Candidate and can be accessed on the following Zoom link:
Meeting ID: 932 5409 1131
The Dissertation Defence Committee consists of:
Dr. Saad Azmat – Supervisor & Chair
Dr. Syed Aun R. Rizvi – Associate Professor, SDSB
Dr. Muhammad Ghufran Ahmad ‐ Associate Professor, SDSB
Dr. Faiza Ismail – Assistant Professor, Shaikh Ahmad Hassan School of Law, LUMS
Dr. Mustafa Disli– External Examiner (HBKU, Qatar)
This dissertation explores the effect of fairness preferences on different decisions that individuals make as part of a household for their future, as entrepreneurs when choosing a venture to be financed with a certain contract, as borrowers making repayment and savings decisions, and as asset market participants.
Although the effect of fairness preferences on decisions involving the interaction between individuals has been studied in some detail, their effect on decisions involving the welfare of the same individual over time has been overlooked. For the first study, an experiment is conducted to examine whether individuals with certain types of fairness preferences choose specific risk and payoff distributions across time. The fairness preferences of the participants are measured using an ultimatum game whereas the choice of risk and payoff distributions is measured using a lottery choice experiment. In this experiment individuals had to choose between two pairs of lotteries where each pair consisted of one lottery for the current period and one lottery for the future period. The results suggest that individuals with inequity-averse preferences choose distributions with a higher payoff in the future compared to the present. Also, individuals who prefer an unequal split in the ultimatum game prefer a combination of risk and payoffs irrespective of the period in which they occur. Those who prefer to give more than an equal share to the other player prefer to take higher risk when the expected payoff is lower whereas those who prefer to give less than an equal share to the other player prefer to take higher risk when the expected payoff is higher. Another experiment, carried out one week after the first one, tests whether individuals punish their self for the decisions made by the past self by reviewing their decisions sub-optimally. The results for this experiment suggest that individuals who give a smaller share to the other individual in the ultimatum game are more likely to review their decisions sub-optimally as if to punish themselves.
The second study examines an entrepreneur’s financing choice and its impact on a new venture. Contract theory suggests that the venture characteristics should be independent of the terms of the contract. However, recent studies find that some of the venture characteristics like risk may be affected by the choice of financing resulting in an endogenous risk in a contract. This study conducts an experiment to test if risk taking in equity contracts is higher due to the risk sharing feature of these contracts and whether this higher risk taking is affected by the fairness preferences of the entrepreneurs. Since the risk structure of equity contracts has more positively correlated risk across the investor and entrepreneur, it may be perceived to be more fair resulting in higher risk taking. The study finds that the risk taking in equity contracts is significantly higher than debt contracts and is correlated with the fairness preferences of the entrepreneurs. The study also examines whether effort provision in equity contracts is affected by moral hazard. The results suggest that effort provision is reference dependent with the terms of the contract functioning as the reference point. That is, the terms of the contract identify a certain gain to be achieved or loss to be avoided that motivates the effort of the entrepreneur. Between a debt and an equity contract, the terms of a debt contract provide a stronger reference point which may be why effort provision in equity contracts is usually observed to be low.
Debt attitude of borrowers may be an important determinant of their repayment and saving behaviour. Attitude towards debt signifies how comfortable an individual is with having debt. Although debt attitude has been studied in relation to the amount of debt borrowed, its effect on more extensive borrower behaviours has been studied in less detail. These behaviours include borrowing for a variety of consumption and entrepreneurial purposes, repayment of debt and saving. The third study investigates the effect of debt attitude on the purposes that are deemed appropriate to be met with borrowed money, the repayment behaviour and saving behaviour of borrowers. In this study, a survey is carried out among the borrowers of a microfinance institute. The study finds that individuals with a positive attitude towards debt find it appropriate to borrow for a greater variety of purposes but are less responsible in repaying the debt. They, however, save more than those with a negative debt attitude. One explanation for these results may be that individuals with a negative attitude towards debt perceive debt differently because debt often has a notion of unfairness attached to it due to cultural and religious factors. Thus, individuals with strong fairness preferences may be more uncomfortable with debt and following the principle of mental accounting, may form a separate mental account for debt that they intend to close as soon as possible. This explanation is tested and we find that individuals who perceive interest on debt to be unfair are more likely to have a negative attitude towards debt. Thus, fairness preferences of borrowers may contribute to explain why some of them consider it important to repay the debt on time but postpone saving anything until the debt is repaid in full.
Fairness preferences may be an important motivator of behaviour in asset markets, especially in the case of speculative trading activities because such trades are a zero sum game with one party making a very high gain and the other party incurring an equivalent loss. The fourth study explores whether the fairness preferences of asset market participants motivate them to make sub-optimal decisions when they indulge in speculative trading. In this way, it also contributes to the literature on Islamic finance by providing a behavioural explanation for the prohibition of speculation in Islamic law. A theoretical model is developed to represent the decision making of an asset market participant from a low income group in the society. Such a participant may be operating in a loss frame when she compares her current position to the average income in the society. Since the probability of loss is higher in speculative trading, when she incurs a loss and compares her payoff to that of the counterparty in the trade who made an equivalent gain, she becomes inequity averse. The model suggests that the loss frame that she is operating in aggravates the inequity aversion that she experiences. This high inequity aversion then motivates her to make further sub-optimal decisions and invest in further speculative trades.