Economics 430/530 EXPERIMENTAL ECONOMICS Fall 2009 Seda Ertac Koc University

Taking a course in experimental economics is a little like going to dinner at a cannibal's house. Sometimes you will be the diner, sometimes you will be part of the dinner, sometimes both. If you take a laboratory course in the physical sciences, you get to mix smelly chemicals, or monkey with pulleys, or dissect a frog, but you are always the experimenter and never the subject of the experiment. In the experiments conducted in this class, you and your classmates will be the participants in the markets as well as the scientific observers who try to understand the results. ~ Bergstrom and Miller (2000)

Introduction What is an experiment? Brief history of experimental economics Behavioral vs. experimental economics Main types of topics studied through experiments

Experiments and Econ One possible way of figuring out economic laws ... is by controlled experiments. ... Economists (unfortunately )... cannot perform the controlled experiments of chemists or biologists because they cannot easily control other important factors. Like astronomers or meteorologists, they generally must be content largely to observe.” (Samuelson and Nordhaus, Principles of Economics, 1985, p. 8)

Experiments and Econ Experimental economics is an “exciting new development”. -Samuelson and Nordhaus, Principles of Economics, 14th Edition, 1992, p.5

What is an experiment? An experiment is a replicable observation of a phenomenon under controlled conditions. “Control”=>The essence of experimental methodology (Smith, 1972). We want to: isolate the effect of variables of interest, keeping other things constant.

What is an economics experiment? Usually we want to test some theory: e.g. Does “competitive equilibrium” work? How do people behave in a prisoners’ dilemma? What is the observed equilibrium?

Behavioral Economics Incorporates psychological insights into economic models. For example, in economics we assume that people are rational, selfish, maximize expected utility. What if people are overconfident? What if people are time-inconsistent? What if people’s utility depends on others’ payoffs? How do we know=>Experiments Behavioral economicsExperimental Economics

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

The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 2002 Vernon Smith: “for the use of laboratory experiments as a tool in empirical economic analysis, in particular, for the study of different market mechanisms”. Founder of experimental economics. Daniel Kahneman: “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. Founder of behavioral economics.

.

Brief History Chamberlin (1948)—market experiments Vernon Smith… Game theoretic experiments (e.g. see if people cooperate in a prisoners’ dilemma)

Types of Experiments Laboratory Experiments -On student subjects Field Experiments -Different subject pool, natural context etc.

Why Experiments? Field data can be hard to interpret (e.g. selection, many factors change simultaneously, have to use complicated econometrics) e.g. supply/demand data Field data may not even exist (e.g. beliefs, reservation wages of workers).

With experiments, we can: Help economic theorists Gather new facts Help/influence policy-makers (Examples) Simpler statistical analysis Replicability and control

Main Topics Studied through Experiments Individual decision-making experiments Game theoretic experiments Market experiments

Advantages of (Lab) Experiments – Enhanced Control Subjects are randomly assigned to the treatment conditions – rules out selection bias. It is known which variables are exogenous and which are endogenous – allows to make causal inferences. Experimenter can make ceteris paribus changes in the exogenous variables – allows for the isolation of true causes. Many variables that cannot be directly observed in the field can be observed in the lab.

Advantages of (Lab) Experiments – Enhanced Control Information conditions and exogenous stochastic processes and factors can be controlled. Important for the testing of models with asymmetric information. Better direct controls are often a substitute for complicated econometric methods. Replicability – provides the basis for statistical tests. Critics can run their own experiments.

Advantages of (Lab) Experiments – Enhanced Control Enhanced control opportunities often imply that the experimenter knows the predicted equilibrium exactly. Equilibrium and disequilibrium actions can be explicitly observed. Quick or sticky adjustment can be explicitly observed Example: What are the supply and demand schedules that underlie observable price & quantity data? Is the observed price-quantity combination a competitive equilibrium?