1 Facilitating Pareto-Optimal Coordination by Subsidies in Deterministic and Stochastic Payoff Settings Ming Gong, Geoffrey Heal, David H. Krantz, Howard Kunreuther and Elke Weber JAN 16 2011 Abstract Can subsidies promote Pareto-optimum coordination? We found that partially subsidizing 2 out of 6 players in a laboratory coordination game usually produced better coordination and higher total payoffs both with deterministic and stochastic payoffs. After removing the subsidy, high coordination continued in most groups with stochastic payoffs, but declined for groups with deterministic ones. A post-game survey indicated that decision justifications differ between deterministic and stochastic payoff settings. Temporary subsidies seem to promote lasting coordination in risk reduction, whereas in a deterministic setting, subsidy may be counterproductive, because it crowds out other rationales for coordination. 1. Introduction In many situations, individual agents in an interactive game or a social network reinforce each others’ decisions. Examples include Schelling’s (1978) tipping points on racial composition in a neighborhood, and Leibenstein’s (1950) “bandwagon effects” in which one agent’s demand for a good increases with others’ demand level. The existence of such mutual reinforcement has been captured by coordination games with multiple Pareto-ranked Nash Equilibria (NE). Interdependency among airlines with respect to luggage security (Kunreuther and Heal 2003) is an example of such coordination. Airline companies face the decision whether to invest in luggage security screening equipment. The new equipment will greatly reduce its risk of terrorist bombs, but the company still faces indirect risk of unsafe luggage transferred from other airlines who decide not to invest in the screening equipment. The Pareto preferable equilibrium is that all airlines invest and eliminate the risk. A second equilibrium is that no airline invests because of the high indirect risk from non-investing airlines. Other examples of interdependent security (IDS) include wildfire protection decisions (Shafran and Flores, 2008), computer network security update (Kearns 2004), and failure of divisions in organizations to invest in risk reducing measures (Kunreuther and Heal 2005; Kunreuther 2009) Another real-world coordination problem is the garbage disposal decision households face daily in some communities in China. Often 20-30 households share a garbage bin outside of their apartment building. For unknown reasons, some residents tend to leave their garbage outside of the bin. This behavior may affect others’ in at least two ways. First, once the garbage left outside accumulates, others need to step on those outside garbage in order to dump their own garbage into the bin, which Comment [K1]: There can be more than 2 equilibria if bags are transferred between more than 2 airlines. HK