January 18, 2005 Experimental Economics 1 Outline  Introduction: Objectives and Course Expectation  Double Oral Auction Experiment: Observations  Foundations of experimental economics: Vernon Smith’s 1982 paper  Economic versus Psychological Experiments

January 18, 2005 Experimental Economics 2 Two Questions?  Why are you here?  What do you expect from this course?

January 18, 2005 Experimental Economics 3 Course Objectives  Understand the most important papers in experimental economics  Learn how to judge papers in experimental economics  Learn how to run good economic experiments (hand-on experience)  Run one in class using others’ design  Design and run one from scratch in a group project  Learn how to write a paper in experimental economics

January 18, 2005 Experimental Economics 4 Course Information  Course emphasis  Design of Market Institutions (Double Oral Auction Market, Posted Price Market, Asset Markets, Auctions)  Behavioral Game Theory (Dominance Solvable Games, Coordination Games, Public Good, Empirical Alternatives to Nash, Learning)  Neuroeconomics and Field Experiments  Learn to test economic theories experimentally  Teaching methodology  In-class experiments  Lectures (90%)  Two guest speakers (Colin Camerer and Andy Schotter)  Group project (hand-on experience) and presentation

January 18, 2005 Experimental Economics 5 Instructors & Contact Information  Professor Teck H Ho (Teck-Hua Ho)  A Singaporean, call me Teck (as in Hi Tech)  Research: Experimental and behavioral economics, quantitative marketing, and marketing and production interface   Professor Shachar Kariv  An Israeli, call him Shachar  Research: Microeconomic theory, experimental economics, and behavioral economics 

January 18, 2005 Experimental Economics 6 Course Expectation  Class participation (10%)  Attendance, participation, and running of an experiment  Five minor write-ups (20%)  2-page, double-space, Times New Roman 12-point Font  Critically evaluate one of the required readings  Due on the day before the class begins  NO LATE WORK IS ACCEPTED  Two major write-ups (20%)  4-page, double-space, Times New Roman 12-point Font  Suggest and justify a way to extend existing research (based on a required reading)  Due on the day before the class begins  NO LATE WORK IS ACCEPTED  Group Project (40%)  Two-member team (your buddy)  Provide project definition by February 24 th  Apply experimental protocol by March 17 th  Submit report by May 5 th  NO LATE WORK IS ACCEPTED

January 18, 2005 Experimental Economics 7 Outline  Introduction: Objectives and Course Expectation  Double Oral Auction Experiment: Observations  Foundations of experimental economics: Vernon Smith’s 1982 paper  Economic versus Psychological Experiments

January 18, 2005 Experimental Economics 8 Observations  What is the goal of the experiment?  What are the dependent variables?  What are the independent variables?  What are the control variables?

January 18, 2005 Experimental Economics 9 Buyers’ Value and Sellers’ Costs

January 18, 2005 Experimental Economics 10 Supply and Demand Curves

January 18, 2005 Experimental Economics 11 Outline  Introduction: Objectives and Course Expectation  Double Oral Auction Experiment: Observations  Foundations of experimental economics: Vernon Smith’s 1982 paper  Economic versus Psychological Experiments

January 18, 2005 Experimental Economics 12 Microeconomic System The environment (e) –A list of economic agents (e.g., Daniel, Grace, etc.) (1,..,N) –A list of commodities (e.g., an antique to be auctioned) –Each agent is characterized by her utility function (u i ), technology (knowledge) (T i ), and commodity endowment (  i ) The Institution (I) –Define the rules of private property under which agents may communicate and exchange or transform commodities for the purpose of modifying initial endowments in accordance with private tastes and knowledge

January 18, 2005 Experimental Economics 13 The Components of the Institution A language M = (M 1,…, M N ) consisting of messages m = (m 1, …, m N ) A set H=(h 1 (m), …, h N (m)) of allocation rules for each i as a function of the messages sent by all agents A set C=H=(h 1 (m), …, h N (m)) of cost imputation rules. The rule states the payment to be made by each agent in monetary units as a function of the messages sent by all agents A set G=(g 1 (t 0,t,T), …, g N (t 0,t,T)) of adjustment process rules. (A starting rule, a transition rule, and a stopping rule) (e.g., English auction)

January 18, 2005 Experimental Economics 14 Agent i’s characteristics and property rights Agent I is characterized by: ei = (u i,  i, T i ) Agent i’s property rights in communication and in exchange are defined by I i = (M i, h i (m), c i (m), g i (t 0,t,T))

January 18, 2005 Experimental Economics 15 Microeconomic System

January 18, 2005 Experimental Economics 16 Agent Behavior Outcome Behavior is defined by a function which yields the allocation-determining message m i sent by agent I with characteristic e i, given the property rights of all agents defined by I m i = m i (T) =  i (e i | I) Response Behavior (exchange of messages in M that precedes the final allocation-determining messages) is defined generically by a function which gives i’s message response m i (t), at time t, to earlier messages m(t-1) by all agents. m i (t) = f i (m(t-1) | e i, I)

January 18, 2005 Experimental Economics 17 System Performance Allocation Outcomes x i = h i (m) = h i (  1 (e 1 | I),…,  N (e N | I)) x 0 i = c i (m) = c i (  1 (e 1 | I),…,  N (e N | I)) Criteria –Pareto Optimality (Efficiency) –Division of Surplus

January 18, 2005 Experimental Economics 18 Microeconomic System

January 18, 2005 Experimental Economics 19 The Bottom Line Agents choose messages and institutions determine allocation via rules that translate messages into allocations Dependent variables: –What message m i does agent i send? (Outcome and Response) –System performance (X): Pareto optimality Division of surplus Independent/treatment variables: Rules of institution (I) Control variables: Environment, in particular preferences (e) (typically unobservable in the field)

January 18, 2005 Experimental Economics 20 An Example: English versus Dutch Auction The Environment –Agents –Endowment and Cost The Institution –Language –Allocation Rules –Adjustment Process Independent Variables Dependent Variables

January 18, 2005 Experimental Economics 21 Induced Value Theory (Smith, AER, 1976) Given a costless choice between two alternatives, identical except that the first yields more of the reward medium (usually currency) than the second, the first will always be chosen (preferred) over the second, by an autonomous individual, i.e., utility is a monotone increasing function of the monetary reward (non-satiation) Three qualifications: -There may be subjective costs (or values) associated with market decisions -Individuals may attach game value to experimental outcomes -Individuals may not be autonomous own-reward maximizers

January 18, 2005 Experimental Economics 22 Sufficient Conditions for a Microeconomic Experiment Non-satiation: Prefer more $$$ than less Saliency: Rewards must be associated with the message actions of subjects Dominance: A condition sufficient to guarantee that we have not lost control over preferences [e.g., the reward structure dominates any subjective costs (or values) associated with participation in the activities of an experiment] Self-interest Seeking: Subjects care only about their own- payoffs Parallelism: Propositions about the behavior of individuals and the performance of institutions that have been tested in laboratory microeconomic systems apply also to non- laboratory microeconomic systems where similar conditions hold

January 18, 2005 Experimental Economics 23 Purposes of Experimentation ?

January 18, 2005 Experimental Economics 24 Purposes of Experimentation “Weep out” bad theories Predict behaviors in the field Establish limits of theories (i.e., stress tests) Discover new empirical regularities

January 18, 2005 Experimental Economics 25 Outline  Introduction: Objectives and Course Expectation  Double Oral Auction Experiment: Observations  Foundations of experimental economics: Vernon Smith’s 1982 paper  Economic versus Psychological Experiments

January 18, 2005 Experimental Economics 26 Economic vs. Psychological Experiments ?

January 18, 2005 Experimental Economics 27 Economic vs. Psychological Experiments