Experimental Economics

What is it?

?• How does experimental economics fit into economics?

– What are we testing in an experiment (discuss)?• How does experimental economics compare to other

experimental sciences?– Physics– psychology

• Experimental psychology– Focus on cognitive process not choice and market outcomes– Economists are interested in the effects of institutions– Psychologists are interested in intrinsic behavior – institution free– Economists test theory, psychologists infer theory

• What is the relationship between experimental economics and behavioral economics?

Emergence of Experimental Economics

• Key variables recognized by discipline must be amenable to experimental control

• Depends on current state of the underlying theory

• Micro economics – virtually impossible to ensure that the abstract assumptions of optimization and equilibrium are met in the laboratory

• Emergence of new paradigms introduced new competing theories– Walrasian general equilibrium – competitive markets– Strategic interaction – Nash equilibrium and game

theory

Game theorists and “gaming”

• 1950s Princeton• John Nash, Lloyd Shapley, John Milnor• RAND corporation Santa Monica• Conference Santa Monica 1952• Jacob Marschak, Roy Radner, Herbert

Simon• Substantive and procedural rationality• Use of math in social sciences

Pioneers

• William Estes 1954– Bernoulli choice experiments– Convergence to true probabilities– Probability matching– No salient rewards

• Sidney Siegel– Experimental design and procedures– Boredom and lack of salience

Germany

• Reinhard Selten

• Bounded rationality

• Not much published in english

Vernon Smith and Charlie Plott• Edward Chamberlin classroom markets at Harvard

– Poor support for competitive market solutions• 1940s Vernon was a student of Chamberlin’s – went to Purdue• Double Auction institution with public information and stationary

repetitions• 1962 JPE• Stanford 1961 influenced by Siegel• Plott to Purdue 1960s – Caltech 1971• Fiorina and Plott committee decision making published 1978 (long

publication lag)• 1973-4 Smith visits Caltech• 1975 Smith moves to Arizona – Jim Cox, Arly Williams (PLATO)• 2002 Nobel Prize Vernon Smith and Daniel Kahneman• 1994 Reinhard Selten and John Harsanyi and John Nash

Handbook Ch 1

• A Brief History of Experimental Economics• The Uses of Experimentation• Some Series of Experiments

– PD and public goods games– Coordination– Bargaining– Competitive markets– Auctions – Individual choice

A Brief History

• Early Experiments 1930-60– Fitting indifference curves– Test EUT– Testing NE in PD games– Testing competitive market hypothesis

– Fitting indifference curves• Thurstone (1931) Journal of Social Psychology

– Hats, coats, shoes, hypothetical, repetitions

• Rousseas and Hart (1951) JPE– Bacon and eggs, between subject

– Test EUT• Lottery choices

– Systematic violations – Allais paradox (Allais 1953 Econometrica

– Testing NE in PD games• PD games, Dresher and Flood (1950s), Nash on repeated

games• Kalisch, Milnor, Nash, and Nering (1954) Santa Monica

conference volume– Avoid repeated game designs

– Avoid symmetric payoffs that lead to fair divisions

– Schelling – focal point theory

– Suppes and Atkinson, learning rather than equilibrium theories

– Testing competitive market hypothesis• Chamberlin 1948 JPE – bilateral search• Induced values – reservation prices• Siegel and Fouraker (1960) bilateral monopoly bargaining –

information conditions– Equal divisions and pareto optimality depend on information

1960s to the Present

• A hundred experimental papers published in 1960s

• Appearance of review articles• Vernon Smith’s response to Chamberlin

(1962)• Becker deGroot Marshak (1964) incentive

compatibility• 1970s NSF support of some labs, Dan

Newlon and Jim Blackmun

Uses of experiments

• Speaking to Theorists

• Searching for Facts

• Whispering in the Ears of Princes

Some Series of Experiments

• Prisoners’ Dilemmas and Public Goods Provisions

• Coordination Games• Bargaining• Markets and Competition• Auctions• Individual Choice• What do theorists tell us?

Prisoners’ Dilemma – inefficient equilibria

• b > a• c > d• Confess = not contribute• Not confess = contribute

Confess Not Confess

Confess c, c b, d

Not Confess d, b a, a

Findings

• Learn to cooperate• Then learn the dangers of not defecting first• Cooperation unravels over time• Restarting game restarts cooperation in early

rounds• Kreps, Milgrom, Roberts, and Wilson (1982) JET

Rational cooperation in the finitely repeated prisoners’ dilemma

• Axelrod tournament: tit-for-tat

Voluntary Contributions to Public Goods – Free Riding

• One-shot with homegrown values– Bohm (1972) EER TV show

• Free riding is not a serious problem

• Induced values– Emergence of free riding– Mechanisms: provision is sum of contributions, or

auction mechanism where both contribution and quantity of public good is proposed

– Approx 50% of endowment contributed

• Repetitions– Contributions deteriorate over time

Coordination Games

• Multiple equilibria

• Cooper, DeJong, Forsythe, and Ross (1990) AER

1 2 3

1 350, 350 350, 250 1000, 0

2 250, 350 550, 550 0, 0

3 0, 1000 0, 0 600,600

• Van Huyck, Battalio, and Beil (1990) AER• Guessing game

– Guess a number between 1 and 7– P=0.6 + (0.2*m-0.1*e)– If everyone guesses 7: 0.6 + 0.1*7 = 1.3– If somebody else guesses 6 but I guess 7: 0.6

+ (0.2*6-0.1*7)=0.6+1.2-0.7=1.1– If I then switch to 6 also : 0.6 + 0.1*6=1.2– Game unravels in out of equilibrium play

• Theoretically irrelevant factors matter (presence of dominated strategies)

• Theoretically important factors fail to show strong influence on equilibrium selection (Pareto dominance)

Bargaining

• The core consists of many possible bargaining outcomes• Nash axiomatic bargaining solution• Nash equilibrium of a bargaining game• Risk preferences matter

– Inducing risk neutrality through a binary lottery games• Roth and Malouf (1979) Psychological Review• Full or partial information about payoffs from tokens,

symmetric or asymmetric payoffs• Payoffs to other person matters

– Not predicted by theory• Test of role of risk attitudes vs. information conditions

– Predicted effect of risk attitudes not found– Is this due to small payoffs?

Markets and Competition

• Chamberlin and Smith– Double Auction market

• Convergence to equilibrium• Asymmetric markets

– Distribution of surplus asymmetric

• Asymmetric market power in markets with many buyers and sellers– Market power moves convergence away from

competitive equilibrium

Zero Intelligence Traders

• Gode and Sunder (1993) JPE

• Choose offer and bid randomly but constrained by non-negative profit requirement

• Convergence to equilibrium price and high levels of efficiency

• Properties of competitive markets are due to the profit constraint

Market experiments with policy advice

• Hong and Plott (1982) Bell Journal of Economics (Rand Journal)– Effects of price posting in barge operation

• Grether and Plott (1984) Economic Inquiry– Effects of price posting in tetraethyl and tetramethyl

lead markets

• Posting prices cause higher prices, smaller quantities, and lower efficiency

• Facilitate cooperation to raise prices

Iowa Forecasting markets

• Forsythe, Nelson, Neumann, and Wright (1992)

• Asset trading in presidential candidates

• http://www.biz.uiowa.edu/iem/

• Traders purchase shares in candidates at fixed price

• Dividend is proportion of popular vote times the fixed price

Auctions

• Common value auctions

• First price private value auctions

• Second price private value auctions

Common Value Auctions

• Winner’s curse– Object has common but uncertain value– Bidders have private value signals– Winning based on private value signal implies highest

signal wins• Loss since bid exceeds true common value

• Field data– Oil field bidding– Kagel and Levin (1986) AER

• Profits positive for small groups but negative for large ones• Problem diminishes with experience and feedback

Private value auctions

• First price– Risk neutral vs. risk averse– Payoff dominance, Harrison (1989) AER

• Second price– Incentive compatible– Kagel, Harstad and Levin (1987), Econometrica– Over-bidding– Earlier experiments showed under-bidding

• Restricted bids to be no higher than value

Individual Choice

• Axioms of Expected Utility Theory

• Independence axiom– Substitution axiom– Reduction axiom

• Preference Reversals– Choice and pricing task

• WTP-WTA disparity

Preference Reversals

• P-bet: .99 win $4, .01 lose $1 EV=$3.95 VAR=0.0895• $-bet: .33 win $16, .67 lose $2 EV=$3.94 VAR=50.518• P-bet chosen over $-bet 50% of the time• $-bets are priced higher than P-bets when selling the

bets• BDM mechanism: Becker DeGroot Marschak (1964)

Behavioral Science• Originally discovered in hypothetical setting, Grether and

Plott (1979) AER used monetary payoffs

Other anomalies

• Allais paradox

• Common ratio

• Common consequence

• WTA > WTP – Endowment effect, Kahneman, Knetsch, and

Thaler (1990) JPE

Preference elicitation

• Risk and time preferences

• Estimating parameters of utility functions

• EUT, Prospect Theory, Rank-Dependent Utility Theory

• Binswanger (1980) AJAE, farmers in India

• Heterogeneity in risk attitudes, but less so at higher stakes

• No wealth effect at higher stakes

My research• Public goods contributions and punishment mechanisms

– Are societies with punishment mechanisms desirable? Does desirability depend on ability to solve Free Rider problem or on profitability?

• Income distribution and reciprocity– Do people have a taste for equality in income distribution – are they willing to give up their

own money?– Do people display a taste for reciprocity after some common history of negative externality

game?• Rent seeking

– When taxes and subsidies are endogeneous will subjects engage in costly rent seeking activies?

• Learning and belief elicitation in interactive games• Value elicitation

– Extent of hypothetical bias– Calibrating hypothetical bias– Comparison of instruments for elicitation valuations

• Elicitation of risk and time preferences– Denmark field subjects

• Virtual experiments