School of Economics and Finance BEA 409. Special Topics in Economics INTRODUCTION Professor John Tisdell

Week 1 - Introduction to experimental economics Readings Smith, V.L. (1982). Microeconomic systems as an experimental science. American Economic Review 72: Smith, V. L. (1989); “Theory, Experiment and Economics”, Journal of Economic Perspectives,3(1), Smith, V. L. (1994); “Economics in the Laboratory”, Journal of Economic Perspectives, 8(1), Plott, C. (1991). Will Economics Become an Experimental Science?,” Southern Economic Journal 57: Roth, A. (1995). “Bargaining experiments,” Handbook of Experimental Economics, J. Kagel and A. Roth, eds. Princeton, NJ: Princeton University Press. Lecture notes will be available in the website.

What is an economic experiment? Study of economic behaviour under controlled conditions. Environment: initial endowments, preferences and costs controlled by monetary rewards. Institutions: to define the rules of communication and the rules under which messages are binding Observed behaviour of participants as a function of the environment and institution (the controlled variables).

Introduction The study of economics is moving from logic positivism and field observation to one of experimentation under controlled conditions. One of the problems with substantial institutional change is that modification and irreversibility makes the process slow, cautious and costly to society. Experimental economics yields a formal and replicable system for analyzing alternative market structures before they are actually implemented.

Why experiment with policy options Notion is to produce a formal and replicable system for analyzing alternative policy options and associated institutional structures before they are actually implemented. Examples in other areas: new drugs, crop varieties etc are all laboratory tested under controlled conditions prior to release … Why should policy options not face the same level of scrutiny?

Methodology Policy experiments, like any other scientific experiment, involves controlled experimental conditions to minimize variation. Experimental conditions = stylized environment where only the important characteristics of the situation and policy option at hand are included.

Outline of Lecture History of Experimental Economics A simple design for a market experiment Experimental methods: advantages and disadvantages Types of experiments Design and procedural considerations

The interaction between theory and empirical work is the engine of progress in most academic disciplines. Data for empirical work can be drawn from several types of sources. One distinction can be drawn between experimental data and observational data. –experimental data are deliberately created for scientific or other purposes under controlled conditions; –happenstance / observational data are a by-product of ongoing uncontrolled processes; Another distinction can be drawn between laboratory data and field data. –laboratory data are gathered in an artificial, lab environment designed for scientific or other purposes; –field data are gathered in a naturally occurring environment.

Economics was traditionally taken to be a non-experimental science. For instance, Milton Friedman (1953) says: Unfortunately, we can seldom test particular predictions in the social sciences by experiments explicitly designed to eliminate what are judged to be the most important disturbing influences. Generally, we must rely on evidence cast up by the “experiments” that happen to occur It implies that the methods of economics, like those of astronomy, are an adaptation to the practical impossibility of controlled experiments.

But, from the 1980s onwards, there has been an explosive growth in the use of experimental methods in economics. In terms of most obvious signals, these methods are now accepted as part of the discipline. In 2002, Daniel Kahneman and Vernon Smith were awarded the Nobel memorial prize in recognition of their work as pioneers of experimental economics.

Experimental economics is not a unified, standardized research program. Indeed, the two Nobel memorial prize winners represent two very different lines of research: –Smith is an economist who has developed novel experimental techniques to investigate traditional economic questions about markets; –Kahneman is a psychologist who has used the well-established experimental methods of his discipline to challenge economists’ conventional assumptions about the rationality of economic agents.

Nobel Prize in Economics, 2002 Daniel Kahneman (for behavioural), Vernon Smith (for experimental)

Video Link c86z7Mhttp:// c86z7M

The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 2002 Vernon Smith - Founder of experimental economics. : “for the use of laboratory experiments as a tool in empirical economic analysis, in particular, for the study of different market mechanisms”. Daniel Kahneman - Founder of behavioural economics : “for the introduction of insights from psychological research into economics, in particular with regard to judgements and decisions under uncertainty”. Kahneman’s research is based on psychological experiments and questionnaires.

History of Experimental Economics Experimental economics evolved in three areas: Market experiments Game experiments Individual choice experiments

Market experiments Chamberlin’s Theory of Monopolistic Competition Smith 1962 Double auction experiments

Edward Chamberlain, (1948), “An Experimental Imperfect Market,” Journal of Political Economy, 56, Induced Supply and Demand: Each buyer (seller) receives a redemption value (cost) for her or his single unit. Each trader knows her own redemption value (or cost), but not others’ costs or values.

Experiment: Subjects walk around, bargain in pairs, groups. Once a buyer and seller reach a deal, they drop out. The transaction price is recorded on the blackboard (in fact, not always…). Market operated for a single trading period. The competitive equilibria in this market have an equilibrium quantity of 15, and an equilibrium price of

Assumptions of perfect competition The standard theory of competitive markets (based on supply and demand curves) relies on several assumptions: –economic agents (buyers and sellers) are rational and self- motivated (either utility / profit maximization); –a single homogeneous good is traded; –there are a large number of buyers and sellers; –economic agents behave as price-takers. All these assumptions can be questioned –In many instances people are bounded rational and have interdependent utility functions; –There are many markets with only a few firms; –In most markets there is no auctioneer but agents set prices.

It is often difficult to test the theory with a naturally occurring market dataset because –one needs to make strong assumptions to identify demand/supply curves; –it is difficult to guarantee if equilibrium is achieved at a specific time point in the market. –In a laboratory setting, one can control the schedules of demand and supply and trading institution. Earlier examples are Chamberlin (1948) and Smith (1962, 1964).

Questions Do these deviations from the assumptions constitute negligible frictions or do they serious challenge the predictive power of the model? Are there “real” market institutions for which the competitive equilibrium is a good predictor of price and quantity outcomes? How do different market institutions affect efficiency and convergence to the competitive equilibrium?

What constitutes a market experiment? Two distinct elements are identified in defining a Market experiment: environment and institution. An environment is defined by a set of initial circumstances such as the number of buyers and sellers, their preferences and initial endowments, which is a primitive in an experiment. A market institution is a full specification of the rules of trade: the messages of market communication (bids/asks) and a trading procedure (double auction / posted-offer auction). Finally, there is the observed behaviour of the participants in the experiments as a function of the environment and institution that constitute the controlled variables.

Chamberlin’s Experiment One of the earliest experiments was done by Chamberlin (1948), where he created an experimental market by informing each buyer and seller of his reservation price for a single unit of an indivisible commodity. –subjects were divided equally into two groups, buyers and sellers; –to induce demand and supply curves, each seller (buyer) was given a card with a cost (value) written on it; –buyers and sellers mix together and negotiate bilaterally or in small groups in a trading floor or “pit”. –trading prices were written on the blackboard; Chamberlin wanted to see whether this experimental market leads to the outcome of a competitive equilibrium.

An Example: induced values and costs

An Example: competitive equilibrium An equilibrium price can be anywhere between $4 and $8 and equilibrium quantity is 4 units. But there exist more feasible allocations.

Chamberlin’s Experiment: induced demand and supply

Chamberlin’s Findings

Vernon Smith’s Experiment Vernon Smith (1962, 1964) introduced two changes from Chamberlin’s market experiment: –Instead of bilateral negotiation, he used a double (oral) auction; –Trading was repeated in successive market periods or trading days in order to have stationary replication.

Double Auction (DA) Each buyer i is endowed with a maximum willingness to pay, Vi, and each seller j is endowed with a reservation price, Uj. Each buyer sets a bid price for the unit of the good, Bi, each seller sets an ask price for the unit, Aj, and all could see the highest outstanding bid and the lowest outstanding ask. Buyers could raise the current best bid at any time, and sellers could undercut the current best ask at any time. A trade occurs when these processes meet, i.e., when a buyer accepts a seller’s ask (p = Aj ) or when a seller accepts a buyer’s bid (p = Bi ). If a trade occurs, a buyer’s payoff¤ is Vi

A Price Negotiation Sequence in DA

Smith (1962)’s Finding: symmetric supply and demand curves

Smith (1962)’s finding: structural changes in demand and supply

Smith’s Reaction “I am still recovering from the shock of the experimental results. The outcome was unbelievably consistent with competitive price theory.... But the result can’t be believed, I thought. It must be an accident, so I will take another class and do a new experiment with different supply and demand schedules.” (Smith 1991)

Flat Demand and Supply Curves: quick convergence

Steep Demand and Supply Curves: less quick convergence

Summary Under weaker conditions than had traditionally thought to be necessary, the market converges rapidly to a competitive equilibrium under the double auction institution. –a small number of market participants; –not price-taking behaviour; The double auction turns out be an extremely competitive institution, given the temptation for traders to improve their offers over time in order to make trades at the margin.

Smith (1962) on differences from Chamberlin: “The design of my experiments differs from that of Chamberlin in several ways. In Chamberlin’s experiment the buyers and sellers simply circulate and engage in bilateral haggling and bargaining until they make a contract or the trading period ends.

Game Experiments Tucker 1950 Prisoner’s dilemma. Nash Equilibrium – game theory.

The Prisoner’s Dilemma In 1950 Tucker, Dresher and Flood (1952,1958) developed what has become know as the prisoner’s dilemma:

In the prisoner's dilemma, two prisoners have escaped from jail and committed a robbery. The court is unsure that there is sufficient evidence to convict both prisoners of the robbery without a testimony from one.

If neither incriminates the other, both will receive a conviction of two years only for escaping from prison. However, as an incentive for one of the prisoners to testify against the other, the authorities offers a free pardon for such a statement. The prisoner convicted would then be imprisoned for, say, ten years.

If both prisoners confess then each will be given a reduced sentence of 6 years. The prisoners are not in communication with each other. The reward matrix is presented below:

Game theory - E.g. Prisoners Dilemma Prisoner A Prisoner B Confess Deny ConfessDeny -6, -60, , 0-2, -2

The prisoner's dilemma demonstrates two points. First, the equilibrium point, (-6,-6) is clearly not the optimal joint solution as both players are better off if neither testifies, for which the payoff vector is (-2, -2).

In other words, each of the players is better off if they choose the strategy which potentially results in the worst possible outcome (the dominated strategy) than if each player chooses the strategy with the least worst outcome (his or her undominated strategy).

Second, if an agreement were reached not to confess, either of the prisoners would be better off by then reneging on the agreement and incriminating the other. – Note: (-a,-b) means that Prisoner 1 receives a sentence of a years and prisoner 2 a sentence of b years.

As demonstrated in the prisoner's dilemma, players can often gain greater returns by reneging on agreements. Cooperation requires an assurance from each party that they will not renege on an agreement.

Nash equilibrium The equilibrium where both players, having assumed the strategy of the other player, are the same is known as a Nash equilibrium. A Nash equilibrium is one where it is not in the interests of either party to change their strategy knowing the strategy of the other player.

Video Link: Experiments in Motivation: Are we just motivated by money? PnuFjJchttp:// PnuFjJc

School of Economics and Finance BEA 409. Special Topics in Economics INTRODUCTION Professor John Tisdell