Experimental Research in Social Sciences: Economics

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Experimental Research in Social Sciences: Economics Shyam Sunder. Yale University Conference on Social Science Research: Issues, Challenges and Strategies Institute of Public Enterprise, Hyderabad, India January 10-11, 2013

An Overview Economics shares the challenges before other social sciences in identifying universal, replicable, stable laws that have significant predictive content in order to justify the endeavor as a science I shall use this limited time to give two examples of research which has succeeded in identifying such laws. If time permits, I shall touch on some major challenges before us

Economics as an Experimental Science Only a little over half-a-century old Experimental method is valued for allowing manipulative control over conditions of observation, repeatability, and predictive power at expense of some external validity (to overcome self-selection problems of field data) In the panel session I mentioned three challenges facing social sciences: transience, robustness and ethical Social sciences’ object of interest are sentient beings (awareness, learning, willful reaction to treatments): difficulty of finding universal laws Questions about robustness of any discovered “laws” to their own discovery Difficulty/ethics of manipulative control, e.g., in legislation, macroeconomics, race relations (but also in astronomy, geology, and meteorology) Focusing attention on aggregate level (market) phenomena which may be less susceptible to the first two problems (drawing a crude boundary between psychology and economics)

Properties of competitive markets Vernon Smith (JPE 1962) 22 student traders (11 buyers and 11 sellers Double auction (both sides can propose prices; bids or asks) Price improvement rule (higher bids and lower asks count) Profit Value – price for buyers Price – cost for sellers

Results: Convergence to Equilibrium The double oral auctions tend to converge rapidly towards equilibrium and achieve high levels of efficiency. Also holds when either demand or supply shifts over time. Competitive market equilibrium, a central concept which is not generally observed in the field) can work (but not necessarily, and needs time to adjust

Competitive Equilibrium: Convergence Path and Division of Surplus (Source: Vernon Smith 1962) When equilibrium division of surplus is unequal Convergence from the direction of greater surplus From above in the top panel From below in the bottom panel Convergence slow and far from perfect Empirical properties affected by design of market institutions

Dissemination of information in asset markets As with properties of competitive equilibria (and their dependence on market institutions), it was difficult to examine the information processing properties of asset markets from field data because we know little about information in possession of traders, and equilibrium prices under alternative theories of information dissemination Experimental methods have allowed us to gain additional insight into these properties A few examples

Table 1. Information Dissemination Equilibria in a Simple Asset Market (Source: Plott and Sunder 1982)   State X Prob. = 0.4 State Y Prob. = 0.6 Trader Type Expected Dividend I 400 100 220 II 300 150 210 III 125 175 155 PI Eq. Price Asset Holder I Informed I Uninformed RE Eq. Price

Figure 4: Dissemination of Insider Information in Rational Expectations Equilibrium (Source: Plott and Sunder JPE 1982)

Investment Horizon and Price Indeterminacy Asset markets with investors having term horizons matching the maturity of the security Asset markets with investors having short term horizons: horizon ends before the security matures

Figure 4: Stock Prices and Efficiency of Allocations for Session 4 (Exogenous Terminal Payoff Session) Source: Hirota and Sunder JEDC 2006)

Figure 11: Stock Prices and Efficiency of Allocations for Session 9 (Endogenous Terminal Payoff Session) Source: Hirota and Sunder JEDC 2006

Equilibrium selection When two or more equilibria are mathematically plausible, human experiments can help choose among them For example, in overlapping generations models of money, there are typically an infinity of equilibria, including one competitive and a range of strategic (for small number of agents) stationary equilibria—all mathematically plausible Do economies populated with human agents choose stationary or non-stationary equilibria?

Source: Marimon and Sunder Econometrica 1993

Source: Marimon and Sunder Econometrica 1993

Public goods Free rider problem and under-production of public goods Voluntary anonymous contribution literature We examine public good financing in a general equilibrium economy by taxation Rate set exogenously Rate set by vote (median proposal) Choose between voluntary contribution and taxation by vote (and choose tax rate)

T1: Tax rate fixed, starting level of public good at optimum

Optimization in economics

Optimization in Economics Adam Smith: It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages. (I.2.17) 7/15/2019 Decoupling Markets

Background Competitive equilibrium Jevons Pareto efficiency Convexity Maximization Uniqueness (?) in presence of wealth effects 7/15/2019 Decoupling Markets

Background Herbert A. Simon (with Newell, 1959) Limited human cognition Bounded rationality and satisficing instead of maximization Means-end heuristic as a descriptive model of human behavior (~ first order adaptive process) in General Problem Solver (GPS) Selten 7/15/2019 Decoupling Markets

Background Gary S. Becker (JPE 1962) Distinguish rationality at market and individual levels Negatively-sloped demand curves result from the change in opportunities sets alone, largely independent of the decision rule; derivable from maximizing as well as random behavior 7/15/2019 Decoupling Markets

Background Vernon L. Smith (JPE 1962) In a double auction Profit motivated human traders Only 10-20 traders Observed market outcomes close to competitive equilibrium (derived from maximization and atomistic competition) 7/15/2019 Decoupling Markets

Background Gode and Sunder (JPE 1993): Combine Double auction market institution (without randomization in Smith), and Budget constrained random choice (without market institution in Becker) With zero-intelligence (ZI) traders, market outcomes approximate predictions of competitive equilibrium Allocative efficiency of markets populated by “zero-intelligence” traders is high, and comparable to efficiency of markets populated with profit-motivated human traders 7/15/2019 Decoupling Markets

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Theoretical Derivation vs. Actual Attainment of Equilibria Equilibrium results mostly derived by assuming optimization by agents populating the model economies At least since Simon, cognitive limitations of intuitive human behavior have been well-documented, raising doubts about the descriptive validity of such derived results Given rise to a critique of rationality assumption as outdated psychology, lightning-fast calculation, perfect anticipation, perfectly ordered preferences, hedonistic motivation, and other presumably unrealistic individual behavior Defense of economic theory from cognitive sciences critique of rationality assumption has often relied on: Rationality as a broad tendency, need not apply to all Selection and survival of the fittest (Alchian) Proof of the pudding in the eating (empirical evidence) Some important results (e.g., downward sloping demand functions) are robust, derivable not only from rational but also from non-rational behavior 7/15/2019 Decoupling Markets

Equilibria as Basins of Attraction Powerful results of economic theory have been derived from “a very approximate, simplified, abstracted characterization of the system at the level next beneath.” Simon and Selten’s bounded rationality of individual behavior, and Smith and Plott’s markets may not be mutually inconsistent after all, even under uncertainty, information asymmetry, and heterogeneous preferences The “economic man” is maligned by a misunderstanding of its scientific purpose and role Economics borrowed optimization from physics as a structural principle to identify basins of attraction (not as a behavioral description) Adam Smith may not have gone far enough; a large part of economic efficiency is generated by common-sense constraints on economic choices, not because people are smart Perhaps we have evolved social institutions such as markets to compensate for our cognitive limitations 7/15/2019 Decoupling Markets

Seven Challenges Ahead Half a century after its introduction, experimental method in economics has to take responsibilities of “adulthood” Addressing core concerns of economic discipline (in addition to methodology): What is the question? Constructive mutual interchange with sister methodologies of the discipline: Why an experiment? Sources of research questions Time Institutions Simplicity: What is essential? And Not? Robustness check 7/15/2019 Design of Experiments

Shyam.sunder@yale.edu www.som.yale.edu\faculty\sunder\research Thank You. Shyam.sunder@yale.edu www.som.yale.edu\faculty\sunder\research