Introduction to Experimental Economics Rosemarie Nagel Universitat Pompeu Fabra, ICREA, BGSE BLEESS Summer School June 2012

What is an (economic) experiment Strategic game: Game theory Clear theoretic solution Choice experiment: no clear pre-theory Non-induces preferences;

A very modern experiment: an auction example Ebay-data created by ebay or by yourself Or the survey I send to you!!!!!! Please do it!!!!

Theodore Bergstrom and John H. Miller “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” Quote from “Experiments with Economic Principles”

Albert Einstein The formulation of a problem is often more essential than its solution which may be merely a matter of mathematical or experimental skill. To raise new questions, new possibilities, to regard old questions from a new angle, requires creative imagination and marks real advance in science.” Einstein and Infeld, p. 92, The evolution of Physics, (1938)

Sources for experimental economics Books and surveys (experimental economics-behavioral surveys): Collection of experimental facts: Davis&Holt (1992), Kagel & Roth (1995) Experimental methods: Friedman & Sunder (1994), Facts and models: Camerer (2003), Behavioral economics: Camerer & Loewenstein (2005); Field experiments: Harrison and List (JEL, 2005) Neuro economics: Camerer, Loewenstein, and Prelec (JEL, 2005) Soon to come: Kagel & Roth second volume! (see already Al Roth homepage) Especially Chapter by John Duffy on Macro economics Other sources Classroom experiments and webgames: Charles Holt (2006) Web experiments: Rubinstein, Plott etc. Field experiments: List’s webpage with papers Critics about experimental economics: Al Roth Working papers: Charles Holt Micro text books with experimental economics Schotter (1996) Bergstrom and Miller (1997)

Experimental Design Issues see Friedman and Sunder (1994), Davis and Holt (1992) Incentives simplicity of game and instructions (avoid formal, technical language) how to phrase the problem, economic context etc., abstract wording vs. "real world" wording example, questionnaire, test of understanding Pilot studies Trial rounds, Subject pools Subject experience within vs. between group effect matching procedure of subjects (e.g. random vs same subjects) number of periods, subjects information given to subjects controlling communication between subjects asking for comments no intentional deception of subjects strategy method vs. choices computer experiments vs. hand-run experiments Anonymity between subjects vs face to face

Historic facts: see Roth (introduction of handbook, 1995), Davis and Holt (1992) Bernoulli (1738): St. Petersberg Paradox Individual decision making: Thurnstorn (1931) indifference curve, Allais Paradox (1953). Chamberlin (1948): market experiment in class Vernon Smith (1962, 1964) devised a double oral auction Suppes and Atkinson (1958, 1959): learning in 2x2 games Oligopoly experiments by Sauermann and Selten (1959), Fouraker and Siegel (1960), (1963) and many others Prisoner´s dilemma experiments in the 50 and 60´s (e.g. Amnon Rapoport, psychologists, business schools, game theorists 1970 until now bargaining experiments by economists (Roth, Gueth, Selten and other) Al Roth – experimental lecture (2005): “While the history of experimental economics can be traced back much further, only since the 1980’s have we begun to see many series of experiments, in which groups of experimenters with different theoretical predispositions looked at the same phenomena in the laboratory.

Individual Decision making Expected utility vs non-expected utility Game theory, Applied game theory (espec. IO), Micro In general: Utility maximization Macro Economic questions Psychological questions Lab as test bed for new market design: e.g: FCC-auctions Individual Decision making Expected utility vs non-expected utility Field Data Field experiments: Auctions of sports cards, Newspaper experiments External validity Bargaining Fairness vs strategic behavior Auction Equivalence Happiness Behavioral economics Psychology based Descriptive models (high and low game theory) Learning Social utility function Levels of reasoning Quantal response eq. Hyperbolic discounting Behavioral finance etc Industrial Organization Competitive equilibrium Neuro economics: e.g experiments with patients with lesions, use of brain scans while being subject in experiment Public good Free riding Asset Markets Phenomena of stock market in lab ??? what is missing COMPLEX GAMES Coordination Multiplicity Macro experiments Experimental economics: topics

Classification according to the structure of the situation see outline in handbook of experimental economics, Kagel and Roth eds 1995): mainly experimental facts, little about explanations, predictions, clear separation between chapters through games or markets public good games: dominating strategies - free riding - cooperation coordination models: multiplicity of equilibria informal bargaining, cooperative game theory: bargaining models a la Rubinstein; subgame perfection – fairness; distributive justice Industrial organization: competitive equilibrium, cournot equilibrium - cooperation Asset markets: competitive equilibrium - low rationality Auctions: comparison of different auctions (equivalence) Individual Decision Making: expected utility maximization vs non-expected ultility – violations, (e.g. Allais paradox, Elsbergparadox);

NEW: (last 15 years, since 1995) Behavioral economics: stronger link with psychology (e.g. gender differences, biases, e.g. hindsight bias, risk aversion; different psychological personality tests); development of parsimonious models to explain or predict behavior (include fairness, non-bayesian learning, limited reusoning etc.) Field experiments: questions of external validity Neuro economics (neurological links with behavior, new subjects (e.g. with lesions)) Institutional design (e.g. FCC auction design, matching markets (Al Roth et al.)) Macro experiments (conference June 10/11/ 2011in UPF) Very new: complex situations Happiness related questions

“Speaking to theorists” Why we do experiments see also paper by Smith, 1992, and introduction of handbook experimental economics 1995 by Roth; introduction by Davis and Holt, 1992 “Speaking to theorists” What is the theoretic solution and does behavior conform with theory? (better use of theory: serves as benchmark) in the short run in the intermediate term (convergence) in the long run (convergence) what are the causes of this failure: bounded rationality, other regarding preferences, coordination failure, non expected utility, emotion, framing etc. Calculation costs; difficulty of task Also : bad design? => redesign of experiment

“Searching for facts” Establishing regularities - parsimonious models that describe deviation from theory? non-expected utility models models of fairness models of adaptation and learning models of reasoning (levels of reasoning), etc. models with error Note: model may or not be equilibrium model or have high or low rationality

what kind of information each subject has about environment Having control over important features of the environment and subjects what kind of information each subject has about environment how many players participate the subject pool composition separation, isolation of problems, etc. Communication Responses Replicability

“Whispering in the ears of Princes” Evaluation of policy proposal how to auction ‘runway rights’? FCC-auctions NASA: allocation access to space laboratory pollution rights, etc. Matching problems (schools-students)

Comparisons of environments bargaining with one or more stages different information structures low number of players vs. high number of players, etc. Comparison of institutions, use the lab as a test-bed for institutional design different auctions different mechanisms (e.g. for matching markets) different bargaining models, etc.

Possible Criticism of Experimental Economics: wrong incentives (e.g. the stakes are too low) experts behave differently than students (the usual subject pool); more heterogeneous subject pool (different ages, educational background etc) how can laboratory experiments help us decide in the real world? having many repetitions is unrealistic some mechanisms don't exist in the real world

What is a good experiment? (Al Roth) The answer depends on what you are testing or exploring, and who you are talking to. Loosely speaking, a good experiment is one that controls for the most plausible alternative hypotheses that might explain what is being observed, and therefore allows you to distinguish among them. But what are the most plausible alternative hypotheses may depend on who you are talking to (which is why economists and psychologists sometimes run rather different experiments concerning roughly similar phenomena). The most plausible alternative hypotheses may also depend on recent developments in theory, in the laboratory (yours or someone else’s), or in the field. So a “good experiment” is a creature of its time (and may even make itself obsolete, as when it controls for a hypothesis which it discredits, making those controls unnecessary in future experiments).

The Historical Context Of Behavioral Economics see: Advances in Behavioral Economics by Colin F. Camerer, George Loewenstein, Matthew Rabin Publisher: Princeton University Press, 2004. economics first, psychology did not exist as a discipline. the “Theory of Moral” by Adam Smith includes psychological principles of individual behavior that are arguably as profound as his economic observations. rejection of academic psychology by economists with the neoclassical revolution: economic behavior built up from assumptions about the psychology of homo-economicus. 20th century, economists hoped for economics like a natural science. psychology was at that time not very scientific. the economists thought it provided too unsteady a foundation for economics. exclude slowly the psychology from economics

How we start with an experiment Read surveys, major journals Participate in experiments Think of questions you have come up with during your studies Formulate an economic question Specify the area (e. g. Labor, Macro, Marketing) What is an important question in a given field Use your (theoretic) model/paper from other classes Use a nice game/situation/model (from class, literature) Use a technique: Eg. Comparison of learning models, then search for game Deviate from a given paper (add a new treatment) Ask your supervisor Know your limits

Guideline to prepare for your own experimental idea (adjusted from Shyam Sunder, Yale University) What is the question you would like to have answered after the experiment? (Your answer should be a single sentence with a question mark at the end.) What do you know already about the possible answers to the question you have stated above? What are the various possible ways of finding an answer to the question you have stated above? Include both experimental as well as any other methods you know about. What are the advantages and disadvantages of using an experiment to find an answer? How important is this question to YOU? What are the chances that the answer you get from the experiment will surprise you or others? What are the chances that it will change someone’s mind? How would you conduct the experiment? (Write down a design and instructions.) 7. Is your experimental design the simplest possible design to help answer the question you have stated? What are the (possible) outcomes of the experiment? Do the experiment with your class mates/students/friends. Do the (possible) outcomes include at least one outcome that will answer the question you stated above? What is the chance that you will observe this outcome? At any stage of your thinking, feel free to go back and revise your earlier answers if you wish to. COME AND TALK TO ME