Introduction to Experimental Economicsuctpsc0/Teaching/ECON3020/Intro.pdf · Daniel Friedman and...

Introduction to Experimental Economics

Syngjoo Choi

January 11, 2010

Experimental Economics (ECON3020) exp January 11, 2010 1 / 50

Course Information

Instructor : Syngjoo Choi (syngjoo.choi@ucl.ac.uk)

TA: Andrea Locatelli (loc.andrea@gmail.com). He will deliver tutorialclasses four times this term for each tutorial group.

Contact Info. and Course Webpage

O¢ ce: Room 111, Drayton HouseThe course materials, including lecture notes, will be available athttp://www.homepages.ucl.ac.uk/~uctpsc0/Teaching/ECON3020.html/.O¢ ce hours: by appointment.

Two-hour exam with three compulsory questions and a choice of oneout of three. Sample exams in previous years are available in theteaching website.

Main Textbook

Charles Holt. Markets, Games, and Strategic Behavior.Pearson/Addison-Wesley, 2006.

Other readings

Daniel Friedman and Shyam Sunder. Experimental Methods: A Primerfor Economists. Cambridge, 1994.Colin Camerer. Behavioral Game Theory: Experiments in StrategicInteraction. Princeton, 2003.Nicholas Bardsley et al. Experimental Economics: Rethinking theRules. Princeton, 2009.

Lecture notes will be available in the website.

Course Outline

Week 1 - Introduction to experimental economics

Overview and historyMethodologyMarket experiments

Week 2 - Individual preferences: uncertainty and time

Theories on individual decision making under uncertainty (risk andambiguity) over timeAnomalies established by experiments and further issues on experiments

Week 3 - Introduction to experiments on game theory

Some simple games and their experimentsExperimental regularity and behavioral game theory

Week 4 - Bargaining and social preferences

Sel�sh preference vs. social preferences: ultimatum bargaining anddictator gameReciprocity: trust games

Week 5 - Coordination and Public Goods

Games with multiple equilibriaEquilibrium selectionPublic good games

Weeks 6 - More experiments on game theory

Mixed strategiesStrategic sophisticationCommunication

Week 7 - Auctions

Private value vs. common value auctionsOther issues

Week 8 - Information and Learning

Bayes�ruleLearning from others�decisions

Week 9 - Field Experiments

Week 10 - Students�presentations

Tutorial Classes

There will be four tutorial classes on Tuesdays (Jan. 26 / Feb. 9 /Mar. 2 / Mar. 16).

In the �rst three tutorials, the class teacher will go over problem setsthat will be handed out a week before. Students will need to work outeach problem set and submit their homework to the class teacherbefore tutorials.

In the last tutorial class and lecture, students will make grouppresentations for their own design of experiments.

Group Presentation

For the group presentation, you will need to form groups of fourpeople. Group formation will need to be reported to the TA by Feb.12 (Friday).

Each group will make 15~20 minute presentation for its own design ofexperiment. The presentation will consist largely of

research questions / hypotheses;related theories;related literature;experimental design

Each group is suppose to write an essay of 5 ~10 pages about theirown experimental design and submit it to the TA by March 15(Monday).

Submitted problem sets and essays will be used by the class teacherto write your class reports at the end of the term.

Experiments in Economics

The interaction between theory and empirical work is the engine ofprogress in most academic disciplines.

Data for empirical work can be drawn from several types of sources.

One distinction can be drawn between experimental data andobservational data.

experimental data are deliberately created for scienti�c or otherpurposes under controlled conditions;happenstance / observational data are a by-product of ongoinguncontrolled processes;

Another distinction can be drawn between laboratory data and �elddata.

laboratory data are gathered in an arti�cial, lab environment designedfor scienti�c or other purposes;�eld data are gathered in a naturally occuring environment.

Economics was traditionally taken to be a non-experimental science.For instance, Milton Friedman (1953) says:

Unfortunately, we can seldom test particular predictions inthe social sciences by experiments explicitly designed to eliminatewhat are judged to be the most important disturbing in�uences.Generally, we must rely on evidence cast up by the�experiments� that happen to occur

It implies that the methods of economics, like those of astronomy, arean adaptation to the practical impossibility of controlled experiments.

But, from the 1980s onwards, there has been an explosive growth inthe use of experimental methods in economics.

In terms of most obvious signals, these methods are now accepted aspart of the discipline.

In 2002, Daniel Kahneman and Vernon Smith were awarded theNobel memorial prize in recognition of their work as pioneers ofexperimental economics.

However, experimental methods remain controversial in economics.

Experimental economics is not a uni�ed, standardized researchprogram.

Indeed, the two Nobel memorial prize winners represent two verydi¤erent lines of research:

Smith is an economist who has developed novel experimentaltechniques to investigate traditional economic questions about markets;Kahneman is a psychologist who has used the well-establishedexperimental methods of his discipline to challenge economists�conventional assumptions about the rationality of economic agents.

There are still ongoing disputes about, for example,

what economics should learn from experimental results;whether (or in what sense) economic theory can be tested in laboratoryexperiments;how far traditional theory needs to be adapted in the light ofexperimental results.

This course intends to help you judge, for yourselves, the status ofexperimental methods by learning some key experiments in economics.

Some principles of economics experiments

Controls and inducing values;

Randomization and causality;

Incentives;

Validity;

No deception.

Controls

Control is the essence of experimental methodology.

An experiment takes place in a controlled economic environmentconsisting of individual agents and an institution through which theagents interact.

Agents are de�ned by economic characteristics such as preferences,resource endowments, and information.An insitiution speci�es the choices available to agents and theoutcomes resulting from each possible combination of agents�choices.

Experimental control over the institution is conceptuallystraightforward.

Individual subjects usually bring their own home-grown characteristicsin the lab. Sometimes you may want to measure such characteristics.

Other times you may want to control them and induce someprescribed characteristics to examine some theories.

Induced-value theory

Vernon Smith (1976, 1982) suggests the induced-value theory thatproper use of reward medium allows an experimenter to inducepre-speci�ed characteristics and make subjects�innate characteristicsbecome largely irrelevant.

monotonicity: more reward is better;salience: reward depends on actions chosen by subjects;dominance: reward medium dominantly determines changes in subjects�utility. Other in�uences (such as demand e¤ects and cares about othersubjects�rewards) are negligible.

To illustrate, suppose you want to induce some speci�c smoothpreferences represented by U (x , y).

Pick convenient objects such as colored slips of paper: x =(# of slips of red paper); y = (# of slips of blue paper), and explainto the subject that his payment will be ∆m = U (x , y).Then the induced preferences areW (x , y) = V (m0 + U (x , y) , z0 + ∆z), where (m0, z0) is thesubject�s unobservable initial endowment of money and everythingelse.

Two utility functions represent the same preferences if their marginalrates of substition always coincide:

MRSW =Wx

Wy=VmUx + Vz∆zxVmUy + Vz∆zy

= MRSU

The experimenter can freely choose any relationship betweenintrinsically worthless objects and the reward medium.

As long as he can explain the relationship clearly to the subject(salience) and subjects are motivated by the reward medium(monotonicity) and not other in�uences (dominance), then theexperimenter can control subjects�innate characteristics to inducepre-speci�ed characteristics.

Randomization and causality

Variables that are not directly controlled are typically controlled viarandomization (random recruiting of subjects).

The causal e¤ect of the treatment is the expected e¤ect on theoutcome of interest of the treatment as measured in an idealrandomized controlled experiment.

The role of random assignment can be considered in terms of asimple regression framework:

Yi = β0 + β1Xi + ui ,

where Xi is the treatment level and ui contains all other factorsdetermining the outcome Yi .

If Xi is randomly assigned, then Xi is distributed independently of ui .Thus,

E (Y j X ) = β0 + β1X .

The causal e¤ect on Y of the treatment level x is the di¤erence inthe conditional expectations:

E (Y j X = x)� E (Y j X = 0)

In the context of experiments, the causal e¤ect is called thetreatment e¤ect.

Incentives in experiments

Monetary incentives lie at the heart of controversies in experimentaleconomics and, even more markedly, between it and other disciplinessuch as psychology.

The two most common types of payments from experimenters tosubjects are �at-rate show-up fees and task-related payments.

Show-up fees are rewards for participation;task-related payments depend on what happens during the experiment,such as choices made by subjects, resolution of gambles, and so on.

A conventional wisdom of experimental economics is that tasksshould be incentive compatible.

Engineering incentive compatibility amounts to designing experimentsso that subjects are motivated to give truthful responses toexperimenter�s questions.

The mere presence of �nancial incentives, related to taskperformance, is clearly no guarantee of incentive compatibility.

For instance, suppose that subjects are endowed with a particulargood and an experimenter asks �what is your willingness to accept forgiving up this good?�

Now imagine a naive design in which subjects are paid an amountequivalent to the value they state. What do you expect?

Validity (or relevance)

An experimental study is internally valid if the statistical inferencesabout causal e¤ects through an experiment is valid for the populationbeing studied.

It is externally valid if the inferences and conclusions from anexperiment can be generalized to other populations and settings.

There are threats to internal validity:

failure to randomize;failure to follow treatment protocol;experimenter e¤ects.

There are threats to external validity:

nonrepresentative samples;

Other methodological considerations

Instructions tell subjects what they need to know. It is scienti�callyvery useful to have a clear instructional script that enables precisereplication.

Reading instructions out loud is a common practice to establish�public knowledge� (this is especially important in experiments ongame theory).

In �within-subjects�design, a single subject is observed in di¤erenttreatments. In a �between-subjects�design, di¤erent subjects aretested in di¤erent treatments. Within-subject designs are morestatistically powerful than between-subject designs because theycontrol for individual di¤erences.

A rich literature in economics and psychology documentspsychological aspects of decision making that may have strong e¤ectson economic behavior. These are sometimes called biases oranomalies.

Most relevant anomalies and biases are such as loss aversion, statusquo bias, endowment e¤ects, etc.

Unless they are of direct interest, one should try hard to control suchpsychological biases in experiments.

An important design decision pertains to the amount and richness ofcontext to provide. It is an accepted practice in economicsexperiments to strip away a lot of social conext that is not anessential part of the economic theories being tested.

Assumptions of perfect competition

The standard theory of competitive markets (based on supply anddemand curves) relies on several assumptions:

economic agents (buyers and sellers) are rational and self-motivated(either utility / pro�t maximization);a single homogeneous good is traded;there are a large number of buyers and sellers;economic agents behave as price-takers.

All these assumptions can be questioned

In many instances people are bounded rational and haveinterdependent utility functions;There are many markets with only a few �rms;In most markets there is no auctioneer but agents set prices.

It is often di¢ cult to test the theory with a naturally occuring marketdataset because

one needs to make strong assumptions to identify demand/supplycurves;it is di¢ cult to guarantee if equilibrium is achieved at a speci�c timepoint in the market.

In a laboratory setting, one can control the schedules of demand andsupply and trading institution. Earlier examples are Chamberlin(1948) and Smith (1962, 1964).

Questions

Do these deviations from the assumptions constitute negligiblefrictions or do they serious challenge the predictive power of themodel?

Are there �real�market institutions for which the competitiveequilibrum is a good predictor of price and quantity outcomes?

How do di¤erent market institutions a¤ect e¢ ciency and convergenceto the competitive equilibrium?

What constitutes a market experiment?

Two distinct elements are identi�ed in de�ning a Market experiment:environment and institution.

An environment is de�ned by a set of initial circumstances such asthe number of buyers and sellers, their preferences and initialendowments, which is a primitive in an experiment.

A market institution is a full speci�cation of the rules of trade: themessages of market communication (bids/asks) and a tradingprocedure (double auction / posted-o¤er auction).

Finally, there is the observed behavior of the participants in theexperiments as a function of the environment and institution thatconstitute the controlled variables.

Chamberlin�s Experiment

One of the earliest experiments was done by Chamberlin (1948),where he created an experimental market by informing each buyer andseller of his reservation price for a single unit of an indivisiblecommodity.

subjects were dividied equally into two groups, buyers and sellers;to induce demand and supply curves, each seller (buyer) was given acard with a cost (value) written on it;buyers and sellers mix together and negotiate bilaterally or in smallgroups in a trading �oor or �pit�.trading prices were written on the blackboard;

Chamberlin wanted to see whether this experimental market leads tothe outcome of a competitive equilibrium.

An Example: induced values and costs

An Example: competitive equilibrium

An equilibrium price can be anywhere between $4 and $8 and equilibriumquantity is 4 units. But there exist more feasible allocations.

Chamberlin�s Experiment: induced demand and supply

Chamberlin�s Findings

Vernon Smith�s Experiment

Vernon Smith (1962, 1964) introduced two changes fromChamberlin�s market experiment:

Instead of bilateral negotiation, he used a double (oral) auction;Trading was repeated in successive market periods or trading days inorder to have stationary replication.

Double Auction (DA)

Each buyer i is endowed with a maximum willingness to pay, Vi , andeach seller j is endowed with a reservation price, Uj .

Each buyer sets a bid price for the unit of the good, Bi , each sellersets an ask price for the unit, Aj , and all could see the highestoutstanding bid and the lowest outstanding ask.

Buyers could raise the current best bid at any time, and sellers couldundercut the current best ask at any time.

A trade occurs when these processes meet, i.e., when a buyer acceptsa seller�s ask (p = Aj ) or when a seller accepts a buyer�s bid (p = Bi ).

If a trade occurs, a buyer�s payo¤ is Vi � p and a seller�s payo¤ isUj � p. If not, the payo¤ for each is zero.If a trade occurs, a matched pair of buyer and seller is out of themarket. And the remaining buyers and sellers continue this processuntil the end of trading time.

A Price Negotiation Sequence in DA

A Classroom Experiment

Go to http://veconlab.econ.virginia.edu/login.htm

Session name is ___. And then register to participate in aclassroom experiment.

Research Questions

Do prices converge to a competitive equilibrium over time?

α = 100��

�, where pCE denotes the predicted equilibrium price

and σ denotes the standard deviation of prices around pCE .Does α decrease over time?

Does the e¢ ciency increase over time?

e¢ ciency can be de�ned by the ratio of the actual earnings of allparticipants with the maximum possible earnings.

Smith (1962)�s �nding: symmetric supply and demandcurves

Smith (1962)�s �nding: structural changes in demand andsupply

Smith�s Reaction

�I am still recovering from the shock of the experimental results. Theoutcome was unbelievably consistent with competitive price theory. ...But the result can�t be believed, I thought. It must be an accident, soI will take another class and do a new experiment with di¤erentsupply and demand schedules.� (Smith 1991)

Flat Demand and Supply Curves: quick convergence

Steep Demand and Supply Curves: less quick convergence

Excess Demand

Summary

Under weaker conditions than had traditionally thought to benecessary, the market converges rapidly to a competitive equilibriumunder the double auction institution.

a small number of market participants;not price-taking behaivor;

The double auction turns out be an extremely competitive institution,given the temptation for traders to improve their o¤ers over time inorder to make trades at the margin.

Another Market Institution: Posted-O¤er Market

Now we consider markets with posted prices (Bertrand orposted-o¤er) where sellers pre-commit to �xed, take-it-or-leave-itprices that cannot be adjusted during a trading period.

Speci�cally, at the beginning of a period sellers simultaneouslycommit to a price o¤er and �x the maximal quantity they are willingto sell at the o¤ered price.

The set of prices chosen by sellers is revealed to all marketparticipants.

Then buyers are randomly and sequentially selected. They can chooseamong the (still) available price o¤ers and can buy as many units asthey want.

Notice that sellers receive only very limited information about thebuyers�willingness to pay compared to the double auction.

Double Auction

Posted-o¤er Market

Summary of the comparison between double auction andposted o¤er

The results shown in the previous �gures are fairly typical inreplications in the literature.

Compared with double auctions, laboratory posted-o¤er marketsconverge to competitive predictions more slowly and less completely.

In the posted-o¤er markets, the e¢ ciencies are intially very low.

Introduction to Experimental Economicsuctpsc0/Teaching/ECON3020/Intro.pdf · Daniel Friedman and...

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