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Economics as an experimental science

Econ 333

Fall 2014

Copyright James J. Murphy. Material may not be reproduced or redistributed without permission.

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Today’s agenda

History of Experimental Economics

Economics as an experimental science

Controversies

The scientific method

Designing an experiment

History of Experimental Economics

Very early history Bernoulli (1738) -- St Petersburg Paradox

Toss a coin repeatedly until a heads appears Count number of tails Begin with $1, amount doubled with each coin toss

Winnings = $2(k-1), where k is number of tosses Expected Value:

People not willing to pay infinite amount to play Introduce concept of expected utility and diminishing marginal

utility of money to resolve paradox

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Modern Experimental Economics

Thurstone (1931) Individual choice / consumer theory Traced out indifference curves

von Neumann and Morgenstern (1944) Theory of Games and Economic Behavior “Gaming” was common at Princeton to illustrate puzzles

and guide intuition Not a systematic test of hypotheses

John Nash (1950-1) Non-cooperative game theory

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Modern Experimental Economics

Edward Chamberlin (1948) Proponent of monopolistic competition as alternative to perfect competition Assigned values/costs to subjects and had them trade Weak market institution – prices did not converge to competitive eq. Results not well-received because no tradition of experimentation

Lawrence Fouraker & Sidney Siegel (1950s) Bargaining behavior Used real financial incentives Between-subject anonymity

Reinhard Selten (1950s) Game theorist interested in generating empirical evidence to test theory 1994 Nobel prize with John Nash

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3 broad classes of early experiments

1. Individual decision making St. Petersburg Paradox (Bernoulli, 1738) Thurstone – indifference curves Allais’ paradox Kahnemann & Tversky (Prospect Theory)

2. Game theory (strategic interactions) Von Neumann & Morgenstern Fouraker and Siegel Selten

3. Markets / Industrial Organization Chamberlin, 1948 Smith, 1962

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2002 Nobel Prize

Vernon Smith Daniel Kahneman"for having established

laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms"

"for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty"

Vernon Smith

2002 Nobel PrizeShared with Daniel Kahnemann “for having established laboratory

experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms”

UAA Rasmuson Chair in Economics, 2002-2005

Currently at Chapman Univ.

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Vernon Smith

Participant in Chamberlin’s market experiments

1962 – An Experimental Study of Competitive Market Behavior. Journal of Political Economy

Centralized exchange, prices did converge to perfect competition

Also noted that: Convergence to equilibrium influenced by shape of

supply and demand curves Rules of trade may affect outcomes

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Other Nobel Experimentalists

Reinhard Selten (1995)

Al Roth (2012)

(with J. Nash and J. Harsanyi) "for their pioneering analysis of equilibria in the theory of non- cooperative games"

"for the theory of stable allocations and the practice of market design"

Elinor Ostrom(2009)

“for her analysis of economic governance, especially the commons"

Some other notable modern experimentalists

Charlie Plott (CalTech) Some contend he should have shared Nobel

John List (U Chicago) Field Experiments

Ernst Fehr (U Zurich) Lots of stuff, including other regarding preferences &

neuro-economics

Jason Shogren (U Wyoming) current UAA Rasmuson Chair of Economics Environmental & behavioral

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Is Economics an Experimental Science?

Unfortunately, we can seldom test particular predictions in the social sciences by experiments explicitly designed to eliminate what are judged to be the most important disturbing influences. Generally, we must rely on evidence cast up by the “experiments” that happen to occur.

Milton Friedman, 1953

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Is Economics an Experimental Science?

“One possible way of figuring out economic laws is by controlled experiments. … Economists … unfortunately cannot perform controlled experiments.” (page 8)

-- Samuelson/Nordhaus, 1985

Experimental economics is an “exciting new development”

-- Samuelson/Nordhaus, 1992

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More quotes

"...unlike physics, economics yields no natural laws or universal constants" it follows that "...with or without experiments, economics is not and never can be a proper science.”

The Economist, May 8,1999

Are there “universal constants” in economics? Is that the litmus test for whether a discipline is a proper science?

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Experimental sciences

In any discipline, meaningful experiments are possible only when key variables are amenable to experimental control The key variables change over time as theory changes

Amenability to experimentation is not inherent in a discipline Aristotle and Greeks viewed physics as natural

philosophy and the theory had no room for experiments Newton changed that view

Identified variables suitable for controlled manipulation

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Economics and experiments

Until the 1960s, key economics paradigms had no room for experiments

Division between micro- and macroecon.Scale of macro made exps inconceivable

Exps could have been run in micro sooner, why not?Little interest in testing whether people

maximized utility, firms maximized profits,…Focus on implications given these assumptions

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The 1960s as a turning point

Changes in the key paradigms of micro Social choice theory (experimental & social psychology) Game theory Industrial org

Competing theories

Alternative concepts of “equilbrium” Competitive equil., Nash equil., etc Multiple Nash equil.

Which of these models predicts best in simple experimental economies?

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1960s-1970s

Vernon Smith and Charlie Plott at Purdue UniversityHard to get work publishedOK to work in exp econ as long as you did

something elseVernon Smith – investment and capital theory, natural

resources

1975 – Smith goes to U of AZ, starts working on computerized markets

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Exponential Growth in Research

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Phases in experimental econ methods

Lab experiments Usually with students at western universitiesNeutral language “Sterile”

Lab experiments with “richer” context

Field experiments playing same “lab” gamesWith and without context

Natural field experiments

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Types of experiments

1. “Speaking to Theorists”Test a theory or discriminate between theories Compare theoretical predictions with experimental

observations

Explore the causes of a theory’s failure If what you observe in the lab differs from theory, try to

figure out why. Is my experiment designed correctly? What caused the failure? Theory stress tests (boundary experiments)

from Smith 1994. Also see Davis & Holt section 1.5

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Types of experiments (cont.)

2. “Searching for Facts”

Establish empirical regularities as a basis for new theory In most sciences, new theories are often

preceded by much observation. “I keep noticing this. What’s going on here?”The Double Auction

Years of experimental data showed its efficiency even though no formal models had been developed to explain why this was the case.

Behavioral Economics

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Types of experiments (cont.)

3. “Whispering in the Ears of Princes”

Evaluate policy proposals Alternative institutions for auctioning emissions permits Allocating space shuttle resources

Test bed for new institutions Electric power markets Water markets (California, Georgia, Chile) Pollution permits FCC spectrum licenses Auctions for ITQs in New Zealand Space on Cassini mission to Saturn

New areas of experiments

Mechanism Design & Policy Analysis / “windtunnel” Emissions trading, FCC spectrum auctions

Biology Neuro-economics Biometrics: eye tracking, pulse, measuring blood content Drug and hormone injections

Behavioral economics

Field experiments, development economics, randomized field trials

Virtual reality, Second-life

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Distinguishing features of experiments

1. ControlParticularly over preferences (in the lab)

Induced Value TheoryAlso

Institution (rules / instructions)Environment (parameters / “the numbers”)

2. ReplicationAny experiment should be replicable

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Experimentalists as control freaks…

Control over preferences is the single most significant element distinguishing lab experiments from other methods of economic inquiry. “I know what the supply and demand curves look

like because I drew them.” (and because my experimental design meets the 5

precepts – coming up…) In the “real” world, do we always know exactly

what these curves look like?

What is a Controlled Experiment?

As much as possible, the experiment controls all elements of the environment in which the experiment takes place. The experimenter determines the rules

what choices are available to subjects when decisions are made what the consequences of these decisions will be.

The experimenter controls subjects’ payoffs as a function of the actions they take.

The experimenter controls the information that is available to subjects.

Basic elements of an experimentLaboratory experiments defined by an environmentEnvironment specifies factors that motivate decisions &

exchangeInitial endowmentPreferencesCosts

Environment is controlled using salient rewards (usu. monetary)

Experiments implement an institution that defines:Language (messages) of market communicationRules that govern exchange of informationRules that map messages into binding contracts

Institution is defined by the experimental instructionsDescribe types of messages and the procedures of the

market

Parameters

Essential goal lab experiments – comprehending the task!

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Reward structure and property rights to induce values in the lab

How can the experimenter be sure that the subjects value the good being traded the way he thinks that they do?Or…How does the experimenter know what the

true supply and demand curves are? IMPORTANT: It is NOT enough for the

experimenter to simply tell the subject that his cost is $10, or her resale value is $40

There’s got to be more…

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Five Precepts

5 precepts that constitute sufficient conditions for a valid controlled microeconomic experiment:Non-satiationSaliencyDominancePrivacyParallelism

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1. Non-satiation

Subjects must prefer more reward medium to less, and never become satiated “More reward medium ($$) is better” “You can never have too much money.”

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2. Saliency

The reward received by the subject depends on her actions and those of the other agents as defined by the institutional rules that she fully understands.Good outcomes = more moneyPeople understand:

Decision or action Outcome Reward ($$)Not all rewards are salient (e.g. show-up

payment)

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3. Dominance

The reward structure dominates any subjective costs (or values) associated with participation in the experiment.Changes in the subjects’ only utility come from

the reward medium (cash), and other influences are negligible

Pay the subjects enough to careWhat if you only offered someone a nickel? Do you

think they’d take their decisions seriously? What about $100 for the same decision?

Not playing for “just for fun”

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4. Privacy

The subjects in an experiment each receive information only on his/her own reward schedule.Used to provide control over interpersonal utility.

May experience negative or positive utility from the rewards of others.

Want to avoid this since we do not know what that utility is.

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5. Parallelism

Propositions about the behavior of individuals and the performance of institutions that have been tested in laboratory microeconomies apply also to non-lab microeconomies where ceteris paribus conditions hold.External validityApplicability of lab results to ‘real’ world

Practical Implications of Induced Value Theory

(for lab experiments)

Pay cashPromotes non-satiation and salience

Average payment should exceed opportunity costsPromotes dominance

Create simple environmentsPromotes salience and reduces ambiguity

Practical Implications of Induced Value Theory

Try increasing cash rewards for same experimentTests dominance (should not affect outcomes).

NEVER, EVER LIE…Maintains salience and dominanceYou will never get an experimental econ paper

published if it uses deception

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What is science?

Science is best defined as a careful, disciplined, logical search for knowledge about any and all aspects of the universe, obtained by examination of the best available evidence and always subject to correction and improvement upon discovery of better evidence. What's left is magic. And it doesn't work. -- James Randi

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The scientific method

http://www.sciencebuddies.org/mentoring/project_scientific_method.shtml

A key component of scientific inquiry is that the procedures should be carefully controlled and results should be replicable.

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The scientific method

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What is a hypothesis?

A tentative explanation for an observation, phenomenon, or scientific problem that can be tested by further investigation.

– American Heritage Dictionary

For a hypothesis to be useful, it must make predictions that could be falsified (Karl Popper)Not scientifically valid if impossible to be proven

false

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What is a theory?

A set of statements or principles devised to explain a group of facts or phenomena, especially one that has been repeatedly tested or is widely accepted and can be used to make predictions about natural phenomena.

– American Heritage Dictionary

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Theory vs. Hypothesis

A theory is a more or less verified, established explanation accounting for known facts or phenomena.

A hypothesis is a conjecture put forth as a possible explanation of phenomena or relations, which serves as a basis of argument or experimentation to reach the truth.

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“Truth” in science

A theory is said to be “true” if it is consistent with all known experimental evidence.

But theories can change as new evidence emergesMore precise measurementsNew experiments

Researchers work to construct a new theory

Can identify discrepancies