Experimental Economics As a Research Tool for Competition Economics

1. Experimental Economics As a Research Tool for Competition Economics Professor Daniel J. Zizzo University of East Anglia d.zizzo@uea.ac.uk http://www.uea.ac.uk/~ec601/

2. What Does It Mean To Run an Experiment? • Experimental participants make decisions on paper or on computer terminals • Decisions have relevance to their own monetary earnings and possibly those of others: they are economic decisions • Research question is of interest to economics, e.g. competition economics

3. Examples • Experimental economics as a method has been applied to most areas of competition & industrial economics, e.g.: • Competition, market power and market structure • Auction design • Collusion, cartels and leniency programmes • Predatory pricing, price discrimination • Vertical restraints and market foreclosure • Market contestability • Patent races and R&D races • Antitrust Logit Model for mergers by U.S. Department of Justice (Werden and Froeb, 1994) • …and so on…

4. Internal vs External Validity • Internal validity (iv): • “in an internally valid study, the researcher feels confident that the results, as measured by the dependent variable, are directly associated with the independent variable and not the result of some other, uncontrolled factor” (Goodwin, 1995, p. 145) • External validity (ev): • “ability to generalize from the research context to the settings that the research is intended to approximate” (Loewenstein, 1999, p. F26)

5. Internal Validity • Subject goes to the lab, sits at a (computer or plain) desk and receives a set of instructions and possibly practice for the decision task • Monetary payments that are a function of the experimental task… • …and other usual experimental tools such as the lack of deception (Hertwig and Ortmann, 2001)… • …are used to ensure a direct and salient connection between decisions taken and desired monetary outcome

6. Internal Validity • As a result, the experimenter has (almost total) control on the microeconomic system the subject operates within (Smith, 1976) • Therefore: • One can have a clear test of economic models by exactly identifying and applying the conditions under which they apply… • …and a clear test of their robustness by relaxing assumptions one at a time – e.g. how few firms do you need to get to a perfectly competitive market outcome in a double auction? • More generally, by manipulating a single variable, one can analyse its impact on outcomes and thus establish causal links

7. Internal Validity • A good experiment is like a good economic model: it is transparent, interpretable • Conversely, real world data on industrial economics tends to be murkier, less controlled… • …even when it can be obtained, which often it cannot (antitrust & sample selection issues, difficulty of identifying informational assumptions, etc.) Clear as mud

8. External Validity • What does an experiment teach us about the real world?

9. External Validity • What is it that makes, in any particular case, the experimental lab different from the real world? • Generic claims that they are inadequate are not sufficient • they boil down to Duhem-Quine thesis on the limitations of induction • impossibility of supporting or falsifying a theory by suitable revision of the auxiliary hypotheses on the basis of which results can be interpreted as a test of the theory • virtual empirical nihilism, applicable to any inductive process – including inference from field data

10. External Validity • Specific claims are necessary: • “an honest skeptic then has the burden of stating what is different about the outside world that might change results obtained in the laboratory” (Friedman and Sunder, 1994) • Examples of common criticisms for competition experiments: • Artificial tasks • Unrepresentative subject pools • Companies, not individuals

11. External Validity • Practical solutions to external validity problem of experiment E1: • Experimental evidence in parallel to field data (FD) • Field experiments (example: Lyons, Menzies and Zizzo’s ongoing study of decision making by competition authorities in merger decisions, run together with controlled laboratory experiment with students)

12. External Validity • Practical solutions: • Running additional experiments controlling for relevant factor • Duhem-Quine logic: list could be infinite… • …but in practice list of reasonable factors will typically be finite

13. Conclusions • Experimental research is used in all kinds of areas of competition economics • We have given a brief primer on experimental methodology: think of experiments as economic models and ways of collecting data • As any research method, experimental economics has strengths and limitations

14. Want to Know More? • Normann, H.T. (2006), Experimental Economics for Antitrust Law and Policy, SSRN working paper (http://ssrn.com/abstract=950206), forthcoming in W.D. Collins (ed.), Issues in Competition Law and Policy, American Bar Association • Holt, C.A. (1995), Industrial Organization: A Survey of Laboratory Research, in J.H. Kagel and A.E. Roth (eds.), The Handbook of Experimental Economics, Princeton University Press, 349-443 • For more general references on experimental economics, see my website