LABORATORY EXPERIMENTS FOR ECONOMIC POLICY MAKING

doi: 10.1111/j.1467-6419.2008.00567.x

LABORATORY EXPERIMENTS FORECONOMIC POLICY MAKING

Hans-Theo Normann

Royal Holloway College, University of London

Roberto Ricciuti

University of Florence

Abstract. In this paper, we assess the scope and the specific contribution oflaboratory experiments for economic policy making. We review experimentswhich have addressed a specific problem, institution, mechanism design or toolrelevant in economic policy. We have two research questions. What type of policyquestions can be addressed in the laboratory? And what is the specific value addedof economic experiments for policy making. The survey contains experiments oncompetition policy, auctions, regulated markets, and emission permits.

Keywords. Experimental economics; Policy experiments

1. Introduction

In this paper, we try to assess the scope and the specific contribution of laboratoryexperiments for economic policy making. To this end, we survey explicitly policy-oriented experimental papers from such diverse areas of economics as competitionpolicy, auctions, regulated markets and permission permit markets. Despite thelarge number of experimental papers that have attempted to support policy making,to our knowledge, no systematic survey of policy-relevant experiments exists.

What exactly makes an experiment policy relevant? Many laboratory experimentsare designed to test some economic theory and so the experimental results willinevitably have some policy relevance – just as the underlying theory itself haspolicy conclusions. Explorative experiments which do not test a specific theory willalso typically reach a policy conclusion. In our selection of experimental papers,we want to be more restrictive and therefore mainly include experiments whichhave addressed a specific problem, institution, mechanism design, or tool relevantfor economic policy. As a guiding rule, we have given priority to experimentalpapers that have addressed policy issues in a concrete and operational way ratherthan in abstract terms.

Two key questions also influenced our choice and discussion of experimentalpapers. First, we want to clarify the type of policy questions that can be addressed.We provide an account of the kind of policy experiments that have been done and

Journal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd, 9600 Garsington Road,Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

408 NORMANN AND RICCIUTI

their success in terms of policy impact. Second, we want to answer the questionabout the exclusive contribution of economic experiments for policy making. Areexperiments needed at all for policy advice, and, if so, what is it that distinguishesexperiments from other kinds of economics, say theory or empirical field-dataanalysis, applied in policy making?

When discussing an experiment, we will outline the policy problem whichmotivated the experiment, the experimental results and the policy conclusion. Thefocus of our paper, however, is not the experimental results or policy conclusionsas such. Rather, we wish to concentrate on the suitability of the experiment forsolving the policy problem and on the interaction between policy decision makingand experimental research. Wherever possible, we will report on any kind ofinvolvement by institutions (governmental and others) in initiating, funding andconducting the experiments in addition to their policy impact.

We will not discuss general objections to experimental methods as this hasbeen done elsewhere. Plott (1989) lists the most common objections, for examplenonrepresentative student subject pool, lack of ‘real’ monetary incentives andsimplistic design. Plott rejects these objections and the research in experimentaleconomics produced since then rather strengthens Plott’s defense of laboratoryexperiments.

We will start our survey with competition policy experiments. Section 3 looksat research on auctions. Regulated markets (utilities of electricity, water, gas) andpollution permit markets constitute Sections 4 and 5. Section 6 concludes.

2. Competition Policy

2.1 Rate Filing Policies for Inland Water Transportation

Hong and Plott (1982) was one of the first papers studying a concrete policyproblem. Several rate publication policies had been proposed in the late 1970sfor the transportation of dry bulk commodities on US inland waters. Among thepolicies considered was the requirement that a carrier must file a proposed ratechange with the Interstate Commerce Commission at least 15 days before the ratechange becomes effective.

Hong and Plott (1982) ran laboratory markets with, and without, the advancednotice requirement. They concluded that, in the laboratory markets, the rate filepolicies cause higher prices, lower trade volume, and reduced efficiency. Thespecific contribution of this experiment arises from the fact that the consequencesof the proposed new policy were not known. Theoretical arguments could be madeboth in favor of and against the policy, and previous experience with the policywas not available. The experiments conducted by Hong and Plott (1982) filled thisgap and lead to a clear-cut and useful policy conclusion.

Hong and Plott (1982) experiments have several distinctive features which areinteresting with regard to the design of policy experiments. First, they madeconsiderable effort to ensure that the laboratory markets shared essential economicfeatures of the barge industry. For example, they used actual demand data fromJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd

LABORATORY EXPERIMENTS FOR ECONOMIC POLICY MAKING 409

the industry for a representative time period and product, matching the cyclicalnature of demand in that industry. Demand elasticities were obtained from previousempirical field studies of the barge industry. Similarly, they were able to getindustry data estimations on cost and slopes of the supply function. The designof the experiments further ensured that boat capacity, shipping time etc. matchedthose of the barge industry. Second, Hong and Plott’s (1982) subject pool includedengineers, secretaries, housewives and university faculty members in addition tothe usual student participants. The paper does not report any subject-pool-specificresults but still, the inclusion of participants other than students was an importantdeparture from the usual procedures at the time. A more recent investigation aboutsubject-pool effects by Ball and Cech (1996) showed that there are almost nosystematic differences between student and nonstudent subject pools. The subjectsin Hong and Plott (1982) agreed to participate for 3 hours per night for four nightswhich differs again distinctly from the usual 60–90 minute sessions of the commonexperiment.

The authors also comment on the applicability of experimental results in themore complex field markets (‘the big question’). While conceding that only actuallyimplementing the policy in the barge industry can show what will happen, theyconvincingly argue that the burden of proof is on the advocates of the rate filingpolicy. Given the experimental evidence, proponents of the new policy must identifyspecific features of the barge industry which are not implemented in the experimentsand which may reverse the policy conclusion. Given the care with which theexperiments were designed, this seems an unlikely event.

2.2 Market Practices in the Ethyl Case

Grether and Plott (1984) report on market experiments concerning a US antitrustcase. The background is the allegedly anticompetitive behavior of firms in the ethylcase. The ethyl industry produces lead-based antiknock compounds used as petroladditives. In 1979, the US Federal Trade Commission filed a complaint against thefour producers in this industry. Basically, three market practices were challenged:(i) advanced notice and price announcements, (ii) most favored nation, and (iii)delivered pricing. There was no doubt that the practices were actually used: thequestion was the effect of the practices on competition. The debate between theeconomic experts in the litigation was whether markets structure accounts for firms’conduct or whether these practices facilitate supra-competitive prices.

Grether and Plott (1984) investigate these issues by running experimental marketswith a structure similar to those in the ethyl industry. Experiments have theadvantage that they can analyze the anticompetitive impact of various combinationsof practices – something difficult to achieve with other forms of antitrust analysis.Grether and Plott (1984) have four treatments variables. The first concerns thenature of price announcements (no announcements, all sellers make announcements,only large sellers make announcements). The second treatment variable denotedwho received the price announcements (all participants or only buyers). The thirdindicated whether or not most favored nation was at work. If it was not, firms couldJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


give discounts to announced prices and therefore deviate from delivered pricing.The final variable showed whether price increases were to be notified in advance.Grether and Plott (1984) did not run all possible combinations of treatments but sixtreatments of major interest (most importantly including the one with no practicesat all and the one where, as in the ethyl case, all practices are used).

The main result is that taken together all facilitating practices indeed cause higherprices; industry structure alone is insufficient to explain industrial performance.Interestingly, Grether and Plott (1984) could not confirm the additivity of individualpractices. Public price announcements alone have an insignificant positive effecton prices but the most favored nation clause alone seems to cause slightly lowerprices. They conclude from this that measurement of the effects of the practiceswith industry data might encounter difficulties.

Regarding the relevance of the experimental study to the ethyl case, Gretherand Plott (1984) note that even experimentation with the industry itself would notindicate with certainty whether the practices caused higher prices. The industry isso complex that the inherently dynamic changes would make a definite conclusiondifficult. For the controlled experimental environment, the claim made during theethyl case litigation that the practices had no effect at all was clearly rejected.

2.3 The Antitrust Logit Model (ALM)

Davis (2002) and Davis and Wilson (2005) come up with an interesting shiftin focus for policy relevant experiments. They do not analyze a concrete policydecision or a specific antitrust case but rather a policy tool.

The tool is the US Department of Justice’s ALM. The ALM is a mergersimulation model proposed by Werden and Froeb (1994, 1996). Its purpose isto screen mergers in markets with differentiated products where concentrationmeasures may be less relevant than in markets with homogeneous goods. Theinformational requirements of the ALM are modest. The investigating competitionpolicy authority only needs to know prices, market shares, demand elasticities andthe rate of product substitutability. The first step of the model is to gather orestimate this very information. In the second step, the ALM package is used tosimulate the implied unit cost of the firms involved and the predicted price effectsof the merger.

The ALM is simple and convenient to use. As Werden and Froeb (1996) argue,‘even if considered unrealistically simplistic, merger simulation may provide a littlelight in a very dark place’. However, underlying the model are some very strongassumptions. Demand is assumed to be of a specific form – logit demand – andfirms are supposed to be price setters. Both these assumptions will often be violatedin field markets. Demand may simply be of some other form and firms’ behaviormay correspond instead to the Cournot quantity-setting oligopoly model (in fact, al-most all merger analysis with homogeneous goods assumes quantity-setting firms).Violations of these assumptions may significantly restrict the relevance of the ALM.

The experiments by Davis (2002) and Davis and Wilson (2005, 2006) are wellsuited to investigating the predictive power of the ALM. The experimenter canJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


control for all underlying parameters of an ALM simulation, including demandand cost values that are often unknown or difficult to estimate in the field. On theone hand, one can test the ALM under ideal conditions where the experimentaldesign conforms strictly to the assumptions of the model. On the other hand,experiments can analyze the relevance of the model in controlled environmentswhere the assumptions are systematically violated.

Davis and Wilson (2005) vary the functional form of the demand function of theirlaboratory markets (logit versus linear). They also choose two sets of parameters.In the first, mergers induce ‘large effects’ likely to be challenged by authorities.In the second, ‘small effects’ occur, which would typically not be viewed astroublesome. Davis (2002) uses markets similar to those in Huck et al. (2000).These experiments first analyze price versus quantity competition, and secondvary the information provided to subjects (basic aggregate market information asopposed to firm-specific information on prices/outputs and profits). The resultsindicate that the ALM screens out nonproblematic mergers rather well, even ifdemand or the strategic variables are misspecified and even though outcomes oftendeviate from the prediction. However, for the latter reason, they conclude that itwould be problematic to use the pre-merger prediction as a basis for challenging amerger.

Regarding the applicability of their results, Davis and Wilson (2005) argue thatobserving predicted behavior in the experiments may say little about the relevanceof the ALM in the field. However, failure to observe predicted behavior raisesserious doubts about the usefulness of the ALM in richer and more complexenvironments.

2.4 Predatory Pricing

The significance of predatory pricing is still a controversial policy issue (‘rare likean old stamp or rare like a unicorn?’ Elzinga, cited in Goeree et al., 2004). Withregard to this potentially abusive pricing practice, it is not the lack of theoreticalinsight or empirical evidence which suggests the use of experiments, it is the factthat economists cannot agree on how to interpret data in alleged cases of predation.Even apparently clear-cut cases of predation can often be justified as legitimatefirm behavior as long as the underlying cost data are not known. In controlledlaboratory experiments, cost schedules are known to the experimenter. Therefore,experiments can provide useful insights into the nature of predatory pricing andthereby make a specific and novel contribution to this policy question.

The experimental literature on predation started with the provocative finding ofIsaac and Smith (1985) that predatory pricing basically does not occur at all inlaboratory markets. Though they ran several experimental treatments intended tobe favorable to such pricing (‘in search of predatory pricing’), it essentially neveroccurred. Harrison (1988) replicated their design and also allowed for multiplemarkets. He found instances of predatory pricing but only the further modificationof the design by Goeree and Gomez (1998) led to a clear and statistically significantpattern of predatory pricing (see also Goeree et al., 2004). Predatory pricing alsoJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


occurred in the markets with incomplete information conducted by Jung et al.(1994).

It seems that there is no unique conclusion from these experiments. Just as intheory, the existence of predatory pricing seems to depend on intricate details of themarket structure. In our view, this is actually a point in favor of more (and morespecific) experiments. Perhaps an experimental result either completely refutingor generally proving the possibility of predation cannot be expected. But it doesseem conceivable that carefully designed experimental markets closely resemblinga concrete allegedly predatory market could give useful insights in a policy case.

2.5 Other Competition Policy Experiments

There are abundant industrial organization experiments (see Plott, 1989; Holt,1995; Davis and Wilson, 2002; Normann, 2008; for surveys). While many ofthem will have policy implications, the experiments often ‘only’ test theoriesrather than a specific policy problem. Here, we list only a few papers with morepronounced policy orientation. See also the Hinloopen and Normann (2009) volumeon competition policy experiments.

Much in line with the above papers by Hong and Plott (1982) and Grether andPlott (1984), there is experimental literature on facilitating devices. The effectsof price ceilings are analyzed in Isaac and Plott (1981) and Smith and Williams(1981). Price announcements in oligopoly are studied in Holt and Davis (1990)and Harstad et al. (1998). Information provision in the form of firm-specific priceand profit data is the subject of Huck et al. (2000). Davis and Holt (1998) studythe effects of secret price discounts. Further, changes in market structure have beenanalyzed. Huck et al. (2004) provide a meta-study and new data on the effect thenumber of firms has in oligopoly experiments. Vertical mergers and other verticalrestraints are analyzed in Martin et al. (2001) and in an experiment on the gasolinemarket by Deck and Wilson (2008). Interestingly, Normann’s (2009) experimenton vertical mergers is among the five papers that have been acknowledged to haveinfluenced the revision of EU’s nonhorizontal merger guidelines (IIOC, 2008).

3. Auctions

Economic experiments have had a remarkable impact on the development ofmarket-based mechanisms used for the allocation of resources governed by thestate authorities. Experiments have helped to replace the previous bureaucraticprocedures with more efficient auction formats. We discuss three groups ofexperiments here. Other variants of auctions are discussed in the following sectionon regulated markets.

3.1 Airport Slot Allocation

Grether et al. (1981, 1989) analyze the allocation of US airport landing slots. In thelate 1970s, slot allocation was a policy concern as many airports faced access orJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


capacity problems. Further, because of deregulation, new entrants had to be dealtwith and this would reinforce existing problems.

At the time, slots were allocated on the basis of committee decisions involvingone representative from each airline. Decisions had to be unanimous. If thecommittee failed to reach a decision, the allocation would be decided by the FederalAviation Administration (FAA) as a default. Behavior of airline representatives inthe committee therefore depended on the default option. The FAA had not decidedwhich default to use but Grether et al. (1981) consider four options: (i) a lottery,(ii) an auction, (iii) grandfathering of slots, and (iv) an administrative process. Inaddition to attending four committee meetings, they ran laboratory experiments.

The experimental results confirm the economics of the institution used (acooperative unanimity voting game without side payments). More importantly,Grether et al. (1981) recommend that the Civil Aeronautic Board abandon thecommittee process and use the one-price sealed bid auction with after marketsand contingent bids. They also recommend using the revenues from the auctionsto invest in airport capacity (see also Rassenti et al., 1982). The experimentpioneered the market-based allocation mechanisms of airport slots which havebecome common practice.

3.2 NASA’s Allocation Mechanisms for Resources in Space Missions

The North American Space Agency (NASA) has partially funded experimentalresearch about the allocation of resources on the Space Shuttle, the InternationalSpace Station and other space missions. The experiments are reported in Banks et al.(1989), Plott and Porter (1996), Wessen and Porter (1997), Ledyard et al. (2000),and Healy et al. (2007) and they involved, at least to some extent, employees,engineers and other decision makers of NASA Jet Propulsion Laboratories asexperimental participants.

There are various reasons why the allocation of resources in space missions hasthus far been administrative and committee based. Historic and political reasonsmay explain this but the formidable complexity of the resource allocation problemsmay also have played a role. The allocation of resources in space missions is, byall standards, very intricate. It involves various resources (volume, mass, power,manpower etc.) the availability of which in space will be highly uncertain. Itinvolves both governmental and commercial projects lack of which may havedifferent priorities. While administrative procedures may overcome some of thesecomplexities, economists naturally expect inefficiencies from such procedures andit appears that, in the 1990s, government officials felt the need to adopt moremarket- or business-oriented approaches.

Banks et al. (1989) ran experiments which illustrate the problems that arise in theallocation of Space Shuttle resources. The experiments are simple compared to thesituation in the field but they are very complex compared to a standard laboratoryexperiment. Demand involves indivisibilities and the supply is both unresponsive(fixed capacity and no inventories) and uncertain. Technically speaking, theauthors created an environment in which a competitive equilibrium does not existJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


because of nonconvexities. They analyze six different allocation mechanisms:two administrative processes (one with and one without prices), a market-based approach (the double auction), an iterative Vickery–Groves mechanism(i.e. a modification of the second-price auction), and two adaptive user selectionmechanisms (AUSMs, a modification of an ascending-bid auction, with and withoutqueue). The two administrative processes performed low in efficiency, not evenbetter than a random allocation of resources. More surprisingly, the marketsperformed no better than these processes. Double auction markets usually are veryreliable in yielding very high efficiency levels. The Vickery–Groves mechanismperformed significantly better but the AUSMs were clearly the best. Among otheradvantages, they allow for mistaken guesses which can swiftly be changed asa response to the tentative allocations and this appears to be important in suchcomplex environments.

Plott and Porter (1996) analyze resource allocation for the International SpaceStation. The authors made considerable effort in making the experimental marketsresemble the resource allocation for the International Space Station as closely aspossible. As a result, the experiments are extremely complex. The experimentalprocedures illustrate this. Participants were instructed a day in advance and thenthey were given time to study the instructions at home and ask questions viatelephone before the experiment started. The experiments themselves went overfive days with a 4-hour session per day. Plott and Porter (1996) compared fourmechanisms: an administrative cost-based procedure, barter trade of resources,double auction markets, and a variant of the above AUSMs. They found that themarket performs best here, the AUSM does slightly worse than markets but stillbetter than barter and administrative procedures.

Ledyard et al. (2000) experiments are about payload allocation on the SpaceShuttle. More specifically, they are about secondary payload in lockers of certainsize and weight. Traditionally, these resources (lockers, power, crew) have beenallocated by a committee which based its decisions on the priority ranking ofeach user’s projects. Ledyard et al. (2000) compare the administrative process to abidding process (with a token currency), which again resembles the mechanismproposed by Banks et al. (1989). There were administrative constraints: theyhad to use priority classes and side payments were impossible. With the biddingmechanism, most subjects were better off. The subjects who were worse off sufferedonly small losses, while those who improved their situation made significantimprovements.

There are several conclusions from these experiments. First of all, independentlyof the allocation mechanisms the decision makers can decide among, theexperiments turned out to be useful in providing a ‘wind tunnel’ (Ledyardet al., 2000, p. 180) within which to test the mechanisms. With a lack of empiricalevidence and with theoretical predictions being difficult if not impossible to derive,experiments are helpful in identifying potential design flaws. Second, and somewhatsurprisingly, the considerable complexity of these experiments reveals anotheradvantage of running experiments. ‘The very act of creating an experiment meansthat issues of timing, systems for gathering and reporting information, methods forJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


resolving conflicts and uncertainties, and other institutional details that give a policylife are specified in operational (rather than abstract) terms’ (Plott and Porter, 1996,p. 237). Third, the results taken together support the conclusion that market basedmechanisms and bidding systems work better than existing administrative processes.Ledyard et al. (2000) write that the experiments did have an impact for the methodsof resource allocation on various space missions or that the mechanisms proposedare, at least, currently considered and evaluated among other proposals.

3.3 Spectrum Auctions

In the USA, auctions now have an established role in assigning licenses forthe spectrum. In Europe, spectrum auctions have become popular since theUMTS rights were licensed. In April 2000, the UK government managed to raise33 billion dollars, and four months later the German government raised 45 billiondollars. The US various spectrum auctions have raised altogether more than40 billion dollars.

The British government was advised by a group of academics led by KenBinmore and Paul Klemperer who have implemented different design proposalsin the lab. One of the firms involved in this auction asked a group of experimentaleconomists (Abbink et al., 2005) to run experiments on some possible alternativeauctions as material for discussion with the British authorities. More generally, wecan distinguish two different kinds of experiments in this field: ex ante experiments,designed to evaluate the possible outcomes of an auction before it takes place, andex post experiments, designed to evaluate the performance of existing auctions and,possibly, suggest ways to improve them.

Plott (1997) reviews the process that made experiments effective in determiningthe rules of the Personal Communication System auction in the USA in 1993–1994. His general understanding is that ‘the experimental methodology providesa noncontroversial, inexpensive, and fast method of getting data on how varioustypes of auctions might perform’. Indeed, he maintains that several drawbacks ofthe auction were detected only by careful experimentation, and that these problemswould have been otherwise undetected, and have led to serious efficiency andrevenue problems. In particular, the first issue that was experimentally tested was thechoice between a simultaneous, continuous, ascending-price auction for all items,and a sequential, continuous auction with a sealed bid for packages of predesignatedcollections of items. Under the first design, each license would be identified in aseparate market, and all markets were open simultaneously. Then, according to thebids, each firm could collect its favorite licenses. Under the second design, thepackages of individual licenses were predetermined by the public authority. Animportant issue is that the value of a collection of licenses may be superadditive,i.e. greater than the value of individual licenses.

Experimental results in these alternative environments can be evaluated asfollows. (i) The simultaneous auction with release (i.e. the possibility of sellinga license bought during the auction) is more efficient than the sequential auction.(ii) The existence of a sealed bid for a package creates an advantage for theJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


agent wanting the collection, and it creates a disadvantage for those wanting itemslate in the auction sequence (perhaps smaller agents). (iii) Inefficiencies in thesimultaneous auctions are due to the fact that agents who wanted to get an efficientcollection of licenses never attempted to assemble the package because of riskaversion.

As a result of these experiments, the Federal Communication Commissionadopted the simultaneous auction. Experimentalists also followed other steps ofthe design and implementation of the auction, on the basis of their experiencewith experimental auctions. Nevertheless, the conclusion by Plott is open todiscussion. He claims that the problem of superadditivity may be serious, and moreexperimental evaluation is needed to assess whether the rules helped to produce anefficient outcome. This calls for a wave of ex post experiments.

An example of this kind of experiment is the work of Banks et al. (2003).They were part of an independent evaluation, mandated by the US Congress, ofthe simultaneous multi-round auction (SMA) used by the federal communicationscommission to award spectrum licenses. The aim of the evaluation was tounderstand the problems and the complexities of the SMA and examine alternativesthat might better facilitate the acquisition of efficient combinations of theelementary licenses where complementarity is important. The study uses economicexperiments to examine the effect that two rules have on the performanceof the SMA. The first rule assigns unequal eligibility points to different licenses,and the second rule controls the amount of flexibility that the bidder maintainsduring the course of the auction for a given level of bidding activity. These tworules were collectively referred to as the eligibility rules.

The results of the experiments in Banks et al. (2003) indicate that there is nostatistically significant difference in the performance of the alternative eligibilityrules when the value a bidder places on any set of licenses is ‘additive’ (equal tothe sum of the values of the individual licenses that comprise the set). Moreover, inthe additive valuation environment, neither of the eligibility rules has a statisticallysignificant effect on auction revenue or on the level of bidder losses that occurred.Under both eligibility rules, bidder losses were either zero or negligible. Whenlicenses are superadditive, the increased flexibility in eligibility has a positive effecton assignment efficiency. Moreover, the analyses reveal that assignment efficiencyis not affected by whether licenses are assigned unequal or equal points, and is alsoindependent of the level of superadditivity in the valuation that bidders place ona set of licenses. The analyses additionally reveal that flexible eligibility and theassignment of equal eligibility points across all licenses have significant positiveeffects on auction revenue. An increase in the average size of the packages oflicenses that generate superadditive value also increases auction revenue.

The other institution is the combinatorial multiround auction (CMA) proposedas an alternative to the SMA. Like SMA it proceeds in rounds. In each round,participants can submit a series of sealed single-item and/or packaged bids.Following the submission of such bids, an integer programming algorithm findsthe set of value-maximizing bids such that each license is allocated to only oneparticipant and all package constraints are not violated. Winning bids are posted forJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


all to see along with the best single license bids. The CMA yielded significantlyhigher efficiency, and significantly lower revenue in all superadditive environments,than did the SMA procedure. The higher revenue in the SMA was a consequenceof losses incurred by bidders in failed (package) license aggregations. The betterperformance of the CMA, however, was attained at a transaction cost of requiringthree times as many auction rounds to complete the auctions.

Binmore and Klemperer (2002) provide a discussion of their experience as UKgovernment advisers. They point out that one of the major objectives of the UKgovernment was to increase competition by favoring bidding from entrant firmsover incumbents in the GSM market. Among others advantages, incumbents havean established brand and investments in infrastructure that make their evaluationof the license under auction higher. Therefore a potential new entrant will not bidaggressively or will not participate in the auction at all. Clearly, this has an effecton the revenue that the government can extract.

Because four firms compete in the UK GSM market and the number of newlicenses was also four, Binmore and Klemperer decided that an Anglo-Dutchauction would have been preferable. An Anglo-Dutch auction is a hybrid consistingof an ascending bid (‘English’) first part and a sealed-bid (‘Dutch’) second part. Inthe first part, the price for a license is increased until all but five bidders have quitthe auction. In the second stage, each of the remaining five bidders submits onlyone best and final offer, where their bid must be at least as high as the last prevailingprice of the first stage. The licenses are then sold to the four highest bidders. Theauthors report that their experiments proved that it yielded efficiency almost equalto 100%. Eventually, for technical reasons, the UK government decided to award afifth license to a new entrant firm. The auction format chosen was the simultaneousascending auction.

In their evaluation of the UMTS auctions across Europe, Binmore and Klempererbelieve that favoring competition was the key to a successful process. This wasconfirmed by the auction in the Netherlands. The design used was the ascendingone with a number of licenses equal to the number of incumbents in the GSMmarket. This design did not favor new entrants: only one participated in the auction,and the revenue raised was only 2.5 billion dollars instead of the 8.5 forecast bythe Dutch government. The Turkish experience is even more instructive of how abadly designed auction can favor incumbents. The government decided to awardtwo licenses sequentially, with the provision that the second license should cost asmuch as the first one. The incumbent bid an extremely high price, incompatiblewith the value of two firms in the market. In fact no new entrant firm couldpay the same price, and the incumbent remained the monopolist in this market.Presumably experiments would have shown this behavior in the lab, and preventedthis design mistake. Binmore and Klemperer (2002) also report about an unexpectedadvantage of experiments for policy making: ‘We think that their experience inplaying the roles of bidders within our experimental software had a significanteffect on bolstering the confidence of noneconomists on the auction team in theworkability of the design. (By contrast, mathematical equations have very littlepersuasive power.’) (Binmore and Klemperer, 2002, p. C85).Journal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


Abbink et al. (2005) is another ex ante experiment. This group of experimentalistswas hired by one of the incumbents competing for the UK UMTS licenses duringthe process of definition of the auction rules that took place among the governmentand potential bidders. The objective of the contractor was to provide evidenceagainst the use of the Anglo-Dutch auction. They consider three designs, two ofwhich are variations of the Anglo-Dutch auction. In the discriminatory Anglo-Dutchauction, the four winners pay their respective bids. In the uniform Anglo-Dutch, allfour winners pay the lowest winning bid. The other auction was a simple Englishascending auction in which the first stage is extended until all but the four finalwinners have withdrawn. See also the related work of Abbink et al. (2002) on theGerman DCS-1800 auction.

The experiment mainly analyses data on total surplus in the auction, the numberof successful nonincumbent bidders, the auction revenue, and the avoidance of thewinner’s curse. These aspects of the outcomes are of particular interest becausethey are closely related to the goals of the British government. The main objectiverepeatedly stated was the government’s concern for overall efficiency and generalwelfare. Total surplus is a measure of efficiency. The total surplus is the sum ofthe four buyers’ valuations for the items, where a buyer’s valuation is the sum ofhis private value component and the common value component. Total surplus ismaximized when the licenses are awarded to the bidders with the highest privatevalue components.

All three formats are very similar with regard to the average total surplus:no significant difference can be detected in any pair-wise comparison of auctiondesigns. There is also no evidence that the two hybrid auctions give new entrantsa better chance of making a successful bid and entering the market instead of anincumbent. Binmore and Klemperer (2002) maintain that this result, that is in sharpcontrast with objective of the Anglo-Dutch auction, was mainly due to the choiceof parameters that was, in general, more favorable to the new entrants than in theirexperiments. Concerning revenue – the sum of the prices paid by the winners –at the beginning the discriminatory auction has a clear advantage over the uniformauction. The pure English auction yields weakly significantly higher revenue thanboth hybrids in the second phase. However, as bidders become experienced, thedifferences diminish. Toward the end of the experiment, no significant differencesin revenue can be detected between the three auction designs. A further similarresult was obtained for the winner’s curse, i.e. if the price paid is higher than hisevaluation of the auctioned object.

An ex post analysis of the UK UMTS auction and experimental auctions isperformed by Plott and Salmon (2004), though with different aims from those ofBanks et al. (2003). They start by noting that spectrum auctions often require severalstages to achieve an allocation, and that they may last months. Their policy questionis to define rules to enable the public authority to infer the length of the auction andthe possible final price from the pattern of early bids. This is an important issuein practical auction conduct as each day an auction continues can cost bidderssubstantial sums of money in terms of both cash outlays and opportunity costs.Proper conduct of an auction should seek to minimize this expense to the bidders.Journal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


Auctioneers have a number of tools at their disposal to impact pacing ofthe auction: setting minimum bid increments, round schedules, and determiningstage transitions. The most important information the auctioneer needs in makingdecisions on how to adjust these elements is how far the auction is from conclusive.If the current prices are in the hundred dollar range while the final prices areexpected to be in the billion dollar range, there is little reason not to set very highminimum bid increments. As the auction nears conclusion, however, one mightreasonably want to set lower bid increments in order to maximize efficiency andrevenue. Plott and Salmon (2004) develop a model to determine these rules, andfind encouraging evidence both from experiments and the actual UK spectrumauction.

Spectrum auction is probably one of the fields in which experiments hada significant impact on policy decision making. This market started in theUSA as the result of experimental testbedding between alternative hypotheses ofauctions. Moving to Europe, the design of spectrum auctions was preceded byexperimentation. There is now substantial evidence that, in auction design, one sizedoes not fit all, and, depending upon the goal of the government, different auctionscan be appropriate. However, more ex post evaluation is needed since efficiency inthis field is characterized by problems (for example, superadditivity, cycles of bidsetc.) that can prevent the existence of competitive equilibria.

4. Regulated Markets

4.1 Gas Networks

McCabe et al. (1989, 1990, 1994) proposed, in a series of papers, experimentalauctions for natural gas networks. In these papers, they developed ‘smart’ marketswhich combine decentralized trading with centralized computing power. A majoradvantage of these markets is that they can handle allocations of goods in multiplemarkets (for example, a good and the required network capacity). The smart marketshave also been applied to water and electricity markets (see below and McCabeet al., 1991, for a general discussion).

McCabe et al. (1989) proposed a new mechanism for coordinating resourceallocation in environments like gas pipelines. The so-called ‘gas auction net’ isbasically a modified uniform-price double auction. Agents send bids and offers tothe centralized computer. The computer algorithm allocates resources such that thegains from trade are maximized (if participants reveal their willingness to pay).Specific problems in gas markets arise as contracts to purchase gas may not belinked with the ability to transport gas. By allocating production and transportationsimultaneously, the proposed system insures that the gas can be delivered.

Rassenti et al. (1994) use the same gas auction net and computerized smartmarkets. The key feature of their experiment is to find out whether co-tenancyof pipelines can improve competition. The results in these papers indicate thatcomputer assisted markets can indeed lead to highly efficient markets results inJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


networks. The authors note that the system proposed in the earlier experimentshas been adapted in a limited form for application of the network of the Gas andElectricity Company.

4.2 Water Market Laboratory Experiments

Water supply has been a regulated monopoly in many countries. Murphy et al.(2000) use a smart market to combine the information and incentive advantages ofdecentralized ownership rights or responsibilities with the coordination advantagesof central processing (see also Dinar et al., 1998). Individual suppliers andconsumers submit bids and asks to a centralized computer system. The systemmatches these by means of complex optimization algorithms which also takeinto account network constraints, and it determines the prices and allocations thatmaximize the gains from exchange. The market institution is the sealed-bid uniformprice double auction (UPDA) mechanism for the simultaneous allocation of waterand transportation capacity rights between buyers, sellers and transporters. UPDA’sdistinguishing feature is that all accepted bids to buy are ultimately filled at a priceless than, or equal to, the lowest accepted bid price of buyers. Similarly, all acceptedoffers to sell water are filled at a price higher than, or equal to, the highest acceptedasking price of sellers.

The smart uniform price double auction in Murphy et al. (2000) yielded highlyefficient outcomes, despite a rather thin market characterized by a limited setof trading opportunities for each agent. The markets were somewhat volatile,especially in terms of quantity traded. Attempts to act strategically resulted in anumber of forgone trading opportunities. Duke and Gangadharan (2007) and Casonet al. (2007) examine double auctions for water and salinity rights in Australia’sMurray Darling Basin.

Reform in the water sector is particularly difficult. On the one hand, there is thecost of replacing large existing institutions. On the other hand, the implementationof new institutions is also costly and constitutes a cost that cannot be recovered ifthe new institution does not work. It may also cause large transaction costs derivingfrom the movement from monopoly to competition. The use of carefully designedexperiments that take into account the peculiarities of these markets (their publicgood nature, the externalities and the volatility of water supply) may save the costof ill-designed institutions.

We briefly discuss two more water market experiments. An Australian group,Tisdell et al. (2003), analyzes the impact of communication and information ona water catchment environment. Participants in the experiments acted as farmersfaced with monthly water demands, uncertain rainfall, possible crop loss and thepossibility of trading in water entitlements. Using various informational treatmentsand three trading rules, the authors show that the introduction of trade increasedenvironmental damage, environmental damage was minimized by providingaggregate environmental information and maximum average traders’ income wasachieved by providing information on aggregate extraction, environmental targetsand a forum for discussion in an open call market.Journal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


In Krause et al. (2003), subjects (students, workforce subjects, and pensionerresidents) had to decide on their consumption from a depletable common waterpool in a multi-period setting. It is known that factors like age, religion, incomeor household size affect consumption behavior. The purpose of the experiment wasto combine experimental and survey data in order to estimate demand for differentconsumption groups. Since the composition of the population changes with respectto the demographic factors, the data can help answer important policy questions.The paper highlights a simple, but important, advantage of experiments: one cancontrol very efficiently for the subject pool and generate both survey data andexperimental decision data in one act.

4.3 California Electricity Crisis

As is well known, California electricity markets were in serious turmoil in 2000.Blackout after blackout rolled through the state and some power distributors wereclose to becoming bankrupt. It is generally accepted that certain aspects of themarket’s regulation caused the crisis. The market is characterized by a ‘must serve’regulation, i.e. power distributors must serve their customers at a fixed rate whichis entirely independent of the general supply and demand situation. Triggered bya shortage of natural gas supplies, spot market prices soared and reached 10–100 times the normal level. However, these prices could not be passed on to theconsumers and this would have been the only way of reducing demand. Moreover,caps were imposed on spot market electricity prices. This made the situation worseas power generator companies reduced the supply during peak demand. In thepublic debate, it was the market power of electricity producers that was mainlyblamed for the crisis.

In a series of papers, Rassenti et al. (2001, 2002, 2003a) use experiments toinvestigate several aspects of the California crisis. Their experimental design reflectsthe main characteristics of electricity markets. The supply side is characterizedby low-price base-load generators, medium-priced ‘load follower’ generators andhigh-price generators used only during peak demand. Demand varies similarlybetween low off-peak demand, medium shoulder demand, and peak demand.The authors analyze two policy relevant aspects, market power and the effectof demand-side bidding. Market power can be induced in laboratory markets byconcentrating capacity on one or two suppliers while holding total industry capacityconstant compared to the ‘no power’ markets. Demand-side bidding involves activebidding by participants who may under-reveal demand and refrain from purchasingexcessively expensive units. In the absence of demand-side bidding, the demandside is represented by a robot bidder who bids nonstrategically up the maximumprice, in analogy with the must-serve feature of the market.

The experiments show that demand-side bidding reduces prices significantly. Italso reduces the volatility of prices. The extreme peaks and fluctuations that alsocharacterized the Californian electricity markets were reduced. Prices are generallyhigher in markets with market power but demand-side bidding can neutralize theeffects of market power.Journal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


The policy conclusion from these experiments is the need to focus on the demandside of electricity markets rather than (merely) blaming market power. Powerdistributors need to give incentives to the customers to reduce demand duringpeak times. At the extreme, customers can agree to be cut off voluntarily duringa shortage and are compensated for this. This is certainly an improvement on thesituation where everybody is cut off. As the effect of demand-side bidding was notpredicted by theory, the experiments are a useful platform to explore the potentialof such a trading institution.

4.4 New Electricity Trading Agreement for England and Wales

The New Electricity Trading Arrangements (NETA) for the England and Waleselectric power industry were implemented in autumn 2000. One of the key elementsof the reform was resolving the dissatisfaction with the previous central uniform-price rule. This pricing rule implies paying power generators the same per unitprice – the price equivalent to the bid of the most expensive offer which metdemand. The rule was abandoned for a system of decentralized bilateral forwardtrading between wholesale providers and distributors, combined with a voluntarylast-minute spot market as a balancing institution. The new system was basicallya discriminatory ‘pay as offered’ scheme. The goals for implementing the newscheme were reduced market power, lower prices, reduced collusion potential,reduced price volatility and increased demand participation (Abbink et al., 2003).The same issues were discussed in California at the end of 2000 before the demiseof California Power exchange where several parties had suggested switching fromuniform pricing to discriminatory pricing just as with the NETA.

Three experimental studies try to assess the effects of the regulatory changefrom uniform to discriminatory pricing. Rassenti et al. (2003b) analyze uniformversus discriminatory pricing in the context of market power. The supply anddemand schedules are similar to those in the papers about the California electricitycrisis discussed above, so, the design reflects important features of electricitymarkets in the field. The study finds that the discriminatory pricing system indeedlowers volatility but causes higher prices than uniform pricing does. Indeed, thediscriminatory system without market power led to prices which were as high asthose under uniform pricing with market power. The main explanation for thisresult provided by Rassenti et al. (2003b) is that the discriminatory rule facilitatesprice collusion.

Abbink et al. (2003) analyze the same issue in the context of asymmetricdemand information. Under asymmetric demand information, some sellers haveless information than in the complete demand information baseline treatment. Bothinformational treatments are studied with uniform and discriminatory pricing. Theresults show that prices and volatility are not significantly lower with discriminatorypricing. Under asymmetric information, markets with discriminatory pricing aresignificantly less efficient.

Staropoli et al. (2000) also use the England and Wales NETA as a reference.As in the first two papers, the market institution was varied and, as in RassentiJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


et al. (2003b), the effect of changes of market power is analyzed. The paper’senvironment allows both strategic pricing behavior and strategic withholding ofcapacity in order to drive up prices (strategic quantity bids) to be considered.Staropoli et al. (2000) find significant markups both with, and without, marketpower. Changes in the market structure also did not improve cost efficiency. Thereis no evidence of successful capacity withholding.

Economists both in California and England and Wales warned that newdiscriminatory pricing schemes might not lead to the improvements policy makersand customer groups were hoping for. While the experimental results justify thesewarnings, it appears that the experiments did not have a direct impact on policymaking as they were run while the electricity regulation was being reformed orafter it had happened.

4.5 A Field Experiment on Electricity Consumption

Battalio et al. (1979) ran an interesting field experiment designed to determinethe effects of various price and nonprice policies on electricity consumption. Withcooperation from the local utility, they recruited residents as (volunteer) participantsand used actual electricity consumption in the experiment. Five different pricepolicies were tested. There was a high price rebate group, a low price rebate group,detailed feedback on individual consumption, information on energy conservation,and a control group which received neither a rebate nor any information. After a4-week period, treatment conditions for the groups were changed. The results showthat price policies work much better than informational policies. Price rebates ledto a significant reduction in electricity consumption compared to the previous yearwhile the informational policies resulted in slightly more consumption. Whereasforecasts of consumer responsiveness outside the ranges of observed prices is anopen question in field-data studies, the controlled experiment provides a simpleand inexpensive way of analyzing price elasticities outside the current ranges ofexisting prices.

4.6 Other Electricity Market Experiments

There are numerous other experiments on electricity markets. The list includesBackerman et al. (2000, 2001), Dento et al. (2001), Kiesling and Wilson (2007) andpapers published in the proceedings of the Annual Hawaii International Conferenceon System Sciences: Bernard et al. (1998), Zimmerman et al. (1999), Ede et al.(2001), Thomas et al. (2002) and Adilov et al. (2004).

5. Pollution Permit Markets

5.1 Command and Control, Taxes, and Emission Permits

The typical approach to pollution control has been one of command and control.Under this mechanism, the regulator specifies the technology that must be usedJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


to comply with regulations. The first step is to establish ambient air or waterquality standards. The second step is to ensure that these standards are met, andthis is done by making particular forms of behavior or specific technologicalchoices mandatory. Another possibility is changing the price of the polluting input,technology or the product through taxes, to make them reflect the actual social cost.Issuing tradable permits is yet another kind of market-based mechanism. Thesepermits allow pollution up to the level of the predetermined standard. They can betraded between the polluters. So polluters whose abatement costs are relatively highhave an incentive to bid for the permits. Permit buyers therefore tend to pollutemore than permit sellers, yet overall environmental standards remain unalteredbecause just enough permits are issued to achieve the standard in aggregate. Tradingpermits between polluters thus minimizes the cost of complying with the standard.Marketable permits are generally thought of as quantity instruments because theyration a fixed supply of a commodity, in this case pollution.

The first experiment on permit markets starts was Plott (1983), in which thethree instruments for the internalization of a negative external effect are compared:taxes, command and control and emission trading. The permit market convergedquickly to the competitive equilibrium allocation, reaching efficiency equal to 0.96and outperformed the other two instruments. This experiment was institution-free,and many subsequent experiments analyze the efficiency of currently implementedmarkets for permits.

5.2 The EPA Auction

Many important experiences of the market approach to environmental policy havebeen made in the USA, and some experimental work has been aimed at testingthe efficiency of the current institutional arrangements in these markets. TheEnvironmental Protection Agency (EPA) market for sulfur dioxide emission rightsis of particular interest. The EPA auction uses a ‘high-bid-to-low-offer’ rule. Bidsand offers are first ordered by their price and the highest bid and the lowest offerare matched first, then the second highest bid and the second lowest offer and soon. In this discriminating auction, buyers pay their bid.

Cason (1995) analyzes the EPA auction for sulfur dioxide emission allowances.Under its rules, sellers receive the bid price of a specific buyer, and their askingprice determines their trading priority. Sellers with the lowest asking prices receivethe highest bid. Consequently, sellers have an incentive to submit offers that under-represent their true costs of emission control. Experimental results support thistheoretical prediction, seriously putting into question the efficiency of this auction.

In a subsequent paper, Cason and Plott (1996) compare the rules of the EPAauction with a discriminating uniform price auction (UPA). They replicate theprevious finding on the strong incentives for both buyers and sellers to under-report their true cost of emissions control to the auction. Consequently, comparedto more standard uniform price call auctions, the EPA auction generates lowermarket-clearing prices and extracts less gain from exchange. Efficiency increasesover time in the uniform price auction but not in the EPA auction. The EPA auctionJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


is also less responsive to, and recovers slowly from, changes in underlying marketconditions. The prices reported in the EPA auction, because they have been modifiedby its strategic considerations, are less accurate reflections of the true economiccircumstances than are the prices reported in the uniform price auction. Thisshortcoming is important, because emissions trading is expected to provide valuableinformation to utilities. Utilities need accurate and timely information concerningthe market value of emission allowances to ensure cost-effective investments inemission control. Cason and Plott conclude ‘our recommendation is that the EPAseriously consider adopting alternative rules such as the uniform price auctioninstitution’.

5.3 The Reclaim Program

A second permit market that has been investigated experimentally is the Reclaimprogram used to allocate NOx and SOx emission rights in the area of Los Angeles.In the Reclaim program, emission rights are differentiated by several criteria(emission zone, period, pollutant and cycle) into 136 different permits. There is noformal market design, i.e. Reclaim left the creation and operation of markets to theprivate sector. Cason and Gangadharan (1998) conducted an experiment in whichthey analyze an ‘electronic bulletin board’ (BBS). Buyers and sellers can use theBBS for trades of differentiated rights and the exchange of information which isthe institutional feature of the Reclaim program. The market was decentralized andthe experiment was run with the help of the internet over a period of 6 weeks.The authors find that the bulletin-board market performs well and that prices reflectmarket conditions as accurately as the continuous double auction trading institutiondoes.

The Reclaim program creates a large number of rather small markets and thismakes it difficult for traders to capture all possible efficiency gains. Ishikidaet al. (2001) tested two alternative market designs, a UPDA and a combined valuecall market (CVCM). The CVCM market allows emission rights packages andcombinations of packages to be traded. Offers and bids can be designed to be moreor less flexible. In the inflexible design, traders can only make ‘all-or-none’ bidsand offers; in the flexible design parts of the package can be realized. The tradingprocess itself is similar to the UPDA. Traders place bids and offers simultaneouslyand can replace them only by better quotations. After each bidding round, the brokercalculates the rent of a hypothetical best allocation and, if the rent has increased lessthan 5%, the market is closed and the most efficient allocation based on the standingbids and offers is realized. Two treatments are considered: in the ‘returns-to-scale’treatment marginal abatement costs are decreasing, in the ‘strong-complements’treatment pollutants have to buy fixed combinations of different emission rights,and in the ‘all-or-none’ treatment traders are endowed only with fixed pairs ofemission rights.

The experiments show that the CVCM design in all three treatments clearlyoutperforms the UPDA. In the ‘returns-to-scale’ treatment, the CVCM realized anefficiency level of 100% (UPDA, 87%) and in the ‘strong-complements’ treatmentJournal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


96% (UPDA, 60%). While the UPDA was unable to generate any trade in the‘all-or-none’ treatment, the CVCM was successful within three periods.

5.4 Market Power Issues in Permit Markets

Market power may emerge as an important issue when the number of traders issmall. Under perfect competition, permit markets generate an efficient emissionallocation independent from the initial allocation of emission rights. This result nolonger holds in a model in which all but one firm are price takers. Market powerwill be used to manipulate prices and this destroys efficiency.

Brown-Kruse et al. (1995) call this kind of market power simple manipulation(SM). Things can get worse if a pollutant has market power not only in the permitmarket but also in the output market. The hoarding of emission rights can beused by the market power firm in order to displace other firms. This is calledexclusionary manipulation (EM). In the case of EM, the market power firm willalways hold more permits than under SM because excluding other firms makesit necessary to hold a considerable fraction of the emission rights. The aims ofexperimental emission market investigations are, first, to test the SM and EMhypothesis and, second, to search for mechanisms or market designs that can helpavoid the negative effects of market power.

SM and EM are tested in the experiment of Brown-Kruse et al. (1995). Ten smallfirms and one large firm participate and a double auction is used for the permitmarket. In the monopolistic treatment only the large firm is endowed with emissionrights, and in the monopsonistic treatment all rights go initially to the small firms.After emission trading, firms decide about their output. While for the SM treatmentoutput prices are exogenous and fixed, in the EM treatment prices can be chosen byfirms. The results are straightforward. Deviations from the competitive allocationare small in the SM case (efficiency is 96% for the monopoly and 71% for themonopsony) and very large for the EM case where efficiency was below the levelcorresponding to a random allocation.

5.5 Emission Permits with Banking

Another area of active research has been the opportunity of implementing anothermarket for ‘shares’ to reallocate pollution permits over time. A share is the rightto buy a particular fraction of emission rights in future periods. Holding a shareinsures that firms will be provided with emission rights in the future and thereforereduces uncertainty without changing the time path of emissions.

Godby et al. (1997) find that uncertainty in the control of dischargesdemonstrably promotes instability in permit prices. Banking greatly reduces priceinstability and allows private gains from reallocating discharges over time at thecost of degrading market signals and reducing market efficiency. Share tradingenhances the precision of market signals and largely offsets the loss in marketefficiency caused by banking. Similar results are reported by Mestelman et al.(1999). Cronshaw and Brown-Kruse (1999) and Franciosi et al. (1999) find lessfavorable results on banking.Journal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


5.6 Policy Implications

The experiments show both the potential for emission permits, mainly incomparison with other instruments aimed at the same goal, and the abilityof experimental analysis to design new institutions that improve upon existingones. Markets for permits need to be carefully designed and implemented, andexperimental economics offers a first approximation of the real market which isquickly and cheaply available. This is particularly important when such a marketdoes not yet exist and has to be created by decision makers.

6. Conclusions

In this paper, we reviewed economic experiments with direct relevance for economicpolicy. We found experimental papers in basically all areas of economic policymaking: industrial and regulatory policy, auction design and environmental policy.(Readers interested in macroeconomic policy experiments are referred to Ricciuti(2008).)

Judging from the number of publications and the impact the experimental resultshad on policy, the most successful contribution is arguably the development ofmarket-based institutions for the allocation of various resources. In particular,auction and auction-like mechanisms have been proposed by experimentalists(and often been implemented in the field) for airport landing slots, allocationof resources on NASA’s space station and shuttle, emission permit markets andspectrum auctions. Smith (1994) notes that experimentalists also influenced thedesign of both Treasury security auctions and the Arizona stock exchange.

At a general level, we tried to answer two questions: (i) what type of policyquestions can be addressed in laboratory experiments and (ii) what is the specificadded value of economic experiments for policy making. Regarding the firstquestion, our survey shows that policy experiments are not restricted to certain areasof economics. In principle, all problems can be addressed. The suitability of anexperiment for guiding policy making may depend on the complexity of the policyproblem. Generally, as with theoretical and econometric research, it comes downto whether the experimenter can make a convincing case to the reader or policymaker that the environment and institution, along with the experimental procedures,are addressing an interesting question and deliver compelling conclusions. Thepower of the experimental method is that one can redefine counterfactually thetask to the participants, either through a change in the environment or theinstitution, to help understand the reasons why we observe the set of outcomesthat occurred and to sketch out an underlying principle for the outcomes thatwe did not observe. This can be helpful in any area of economic policymaking.

Regarding the second question, there are a few general conclusions from theexperiments discussed, although the experiments and their contribution for policymaking differ a great deal. We repeat and summarize the main points made in thepaper.Journal of Economic Surveys (2009) Vol. 23, No. 3, pp. 407–432C© 2009 The Authors. Journal compilation C© 2009 Blackwell Publishing Ltd


(1) Experiments can provide useful insights for policy making when there is a lackof other forms of empirical evidence and a lack of robust theory.

(2) A major advantage of experiments is that, in contrast to field studies, theexperimenter can control for all underlying parameters.

(3) Experimental economics provides a platform to test allocation mechanismswhich is easily, quickly and cheaply available to policy makers. This refersto both avoiding pitfalls with new mechanisms where no other experience isavailable and improving details of the design of existing mechanisms.

(4) The act of designing of experiments already forces the experimenter (andtherefore the policy maker) to think about issues of timing, information flow,conflict resolution in a pragmatic rather than abstract way.

(5) Experiments are well suited to study the effects of policy regime changes. Evenif a policy maker is convinced that a new policy is superior to the status quo,experiments are useful in gathering evidence about the duration and propertiesof the transition period.

(6) Finally, participation in a trial experiment may be better suited for convincingpolicy makers about the workability of a policy than an abstract theory is.

Acknowledgements

We are grateful to two referees and Jeroen Hinloopen for helpful comments. Financialsupport from ENCORE (the Economics Network for Competition and Regulation) isgratefully acknowledged.

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LABORATORY EXPERIMENTS FOR ECONOMIC POLICY MAKING