CONFLICT RESOLUTION: New experimental evidence sheds light on the eurozone negotiations

In seeking to resolve a conflict between two parties – say, the ”core” and ”periphery” countries in the eurozone – it would be useful to have a mechanism that encourages the parties to reveal their preferred solution and how strongly they feel about it.

New experimental research by Professors Dirk Engelmann and Veronika Grimm shows how difficult it is to achieve the ideal solution to such conflicts unless a central authority can enforce a policy that encourages honest statements. In more than nine out of ten interactions, they find that parties will exaggerate their preferences.

The results of their study, published in the September 2012 issue of the Economic Journal, contribute to the understanding of conflict resolution in joint decision-making – from marriages to political negotiations – and offer insights into Europe”s current crisis.

Consider a scenario where one country faces the risk of bankruptcy and another country has an incentive to bail it out – for example, because of strong economic integration of the two countries.

Despite the shared interest, the two countries might disagree on the conditions of the bailout. The recipient country will prefer an unconditional bailout while the donor country will prefer to provide help under conditions that discipline the recipient in the future.

A joint solution that is best for everyone naturally depends on costs and benefits to the donor and recipient countries. But while it may be known that both countries prefer bailout over bankruptcy and what solution each country prefers, it is probably unknown which country cares more strongly about its preferred way to realise the bailout.

The problem is thus how to find out about the costs and benefits. A first approach would be that the countries just both state them and then pick the solution backed by the stronger preference.

But to bias the decision in favour of their preferred option, recipient countries have an incentive to overstate potential damages from a conditional bailout, while donor countries have an incentive to overstate the damage they suffer in case of unconditional help.

One of the results of Engelmann and Grimm”s laboratory experiments is that participants indeed exaggerate their preferences in 93% of the cases in a stylised setting reflecting such situations.

Economists have derived various mechanisms to deal with such problems. One simple mechanism (suggested by Matthew Jackson and Hugo Sonnenschein in Econometrica in 2007) is based on the fact that people, organisations and countries often repeatedly interact with the same partners. For example, two countries may not only want to negotiate a bailout but also agree on joint policing of borders or coordinated agriculture policies.

Repeated interaction makes it possible to restrict the number of times that parties can state a strong preference. Rational players should then use their budget of strong preferences for the issues they indeed care a lot about.

Engelmann and Grimm find that this mechanism works extremely well in the laboratory. Take again the simple setting where both partners state their preferences and the stronger one is implemented: if this is coupled with a budget on the number of strong preferences each partner can state, the participants almost always state their preferences truthfully.

Indeed, the study finds that they exaggerate their preferences in fewer than 15% of the cases, much less than the 93% observed without budget restrictions.

But as Engelmann and Grimm argue, enforcing this mechanism requires a central authority, which may not exist. They investigate whether experimental participants are able to enforce a budget on strong preferences mutually in settings where reciprocity and reputation-building can matter because of repeated interaction.

These psychological mechanisms are important in many experimental settings but largely without impact in this research. Only in a setting where participants can choose their partner is there a non-trivial share of truthful statements of weak preferences (about 30%).

In future research, Engelmann and Grimm will further investigate the conditions that allow for mutual enforcement of honest statements of preferences and hence efficient joint decision-making.

Mechanisms for Efficient Voting with Private Information about Preferences” by Dirk Engelmann and Veronika Grimm is published in the September 2012 issue of the Economic Journal.

Dirk Engelmann

Department of Economics | University of Mannheim | +49 621 181 1894 | dirk.engelmann@uni-mannheim.de

Veronika Grimm

Friedrich-Alexander-Universitaet Erlangen-Nuernberg | +49 911 5302 224 | veronika.grimm@wiso.uni-erlangen.de