NSF CHAUTAUQUA SHORT COURSES FOR COLLEGE TEACHERS

1. NSF CHAUTAUQUA SHORT COURSESFOR COLLEGE TEACHERS Experimental Economics David Laibson, Robert Neugeboren, and Rajiv Shankar August, 2006 This course is a very brief introduction to experimental economics, its methods, and some of the major subject areas that have been addressed by laboratory experiments. We’ll try to concentrate on series of experiments, in order to see how experiments build on one another and allow researchers with different theoretical dispositions to narrow the range of potential disagreement.

2. Experimental Economics Why concentrate on series of experiments? Because we learn a lot more from a series of experiments than we do from the individual experiments in the series: "Another way of dealing with [experimental research] errors is to have friends who are willing to spend the time necessary to carry out a critical examination of the experimental design beforehand and the results after the experiments have been completed. An even better way is to have an enemy. An enemy is willing to devote a vast amount of time and brain power to ferreting out errors both large and small, and this without any compensation.

3. Experimental Economics Why concentrate on series of experiments? “The trouble is that really capable enemies are scarce; most of them are only ordinary. Another trouble with enemies is that they sometimes develop into friends and lose a good deal of their zeal. It was in this way that the writer lost his three best enemies." (von Bekesy, 1960, pp. 8-9) While the history of experimental economics can be traced back much further, only since the 1980’s have we begun to see many series of experiments, in which groups of experimenters with different theoretical predispositions looked at the same phenomena in the laboratory.

4. Experimental Economics What are some of the uses to which laboratory experiments have been put in economics? “Speaking to Theorists” testing theories under precisely controlled and/or measured conditions that are typically unavailable in field data The development of game theory gave particular impetus to experimental economics in the 1950’s, as game theory offered testable theories of economic behavior that depended on the fine structure of both the strategic environment and the preferences of the players.

5. Experimental Economics What are some of the uses to which laboratory experiments have been put in economics? “Searching for Facts” looking for regularities, and exploring and documenting unanticipated regularities (including those that come from violations of the predictions of existing theories)

6. Experimental Economics What are some of the uses to which laboratory experiments have been put in economics? “Searching for Meaning” formulating new theories, to explain newly observed regularities, and devising new experiments to help distinguish among such theories “Whispering in the Ears of Princes” policy oriented experiments (and now, particularly, market design…)

7. Experimental Economics “What is a good experiment?” The answer depends on what you are testing or exploring, and who you are talking to. Loosely speaking, a good experiment is one that controls for the most plausible alternative hypotheses that might explain what is being observed, and therefore allows you to distinguish among them. But what are the most plausible alternative hypotheses may depend on who you are talking to (which is why economists and psychologists sometimes run rather different experiments concerning roughly similar phenomena).

8. Experimental Economics “What is a good experiment?” The most plausible alternative hypotheses may also depend on recent developments in theory, in the laboratory (yours or someone else’s), or in the field. So a “good experiment” is a creature of its time (and may even make itself obsolete, as when it controls for a hypothesis which it discredits, making those controls unnecessary in future experiments).

9. Experimental Economics “What is a good experiment?” One of the first goals of experimental design is to protect ourselves from fooling ourselves into believing what we want to believe. Science is done by people who are following up on their intuitions, and (often) investigating hypotheses that they believe to be true. The same intuition that causes you to believe the hypothesis might give you a good idea of situations in which the conclusions of the hypothesis will hold. But if there are other reasons that those conclusions might hold, you have to make sure that you haven’t just created a situation that gives you the results you expect, but not for the reason that you believe.

10. Experimental Economics An Early Experimental Design: Judges (Shoftim) Chapter 6 And Gideon said to G-d: 'If You will save Israel by my hand, as You have said, look, I will put a fleece of wool on the threshing-floor; if there be dew on the fleece only, and it be dry upon all the ground, then shall I know that You will save Israel by my hand, as You have said.‘ And it was so; for he rose up early on the next day, and pressed the fleece together, and wrung dew out of the fleece, a bowlful of water. And Gideon said to G-d: 'Do not be angry with me, and I will speak just this once: let me try just once more, I ask You, with the fleece; let it now be dry only upon the fleece, and upon all the ground let there be dew.‘ And G-d did so that night; for it was dry upon the fleece only, and there was dew on all the ground.

11. Experimental Economics Are there any limitations to what parts of economics might benefit from controlled experimentation in the laboratory? I can’t think of any…☺ (-- Al Roth) Obviously, laboratory experiments will most directly address questions in microeconomics. But that doesn’t mean that experimental evidence won’t help us better understand even the largest scale macro phenomena. (Think of the analogy with biology, which has a comparable range, from molecular biology to medicine to the evolution of species. You can’t bring the fossil record into the lab, but our understanding of it and what it says about evolution is vastly increased by experiments on fruit flies, plant breeding, etc.)

12. Experimental Economics Let’s look at a short series of experiments by one group of experimenters. Van Huyck, Battalio and Beil "Tacit Coordination Games, Strategic Uncertainty, and Coordination Failure," American Economic Review, March 1990, 234-248. _______"Strategic Uncertainty, Equilibrium Selection, and Coordination Failure in Average Opinion Games,” The Quarterly Journal of Economics, 106(3), August 1991, 885-911. _______ "Asset Markets as an Equilibrium Selection Mechanism: coordination failure, game form auctions, and forward induction." Games and Economic Behavior, 5(3), July 1993, 485-504.

13. An Experiment A)Smallest Value of X 7 6 5 4 3 2 1 Your 7 1.30 1.10 0.90 0.70 0.50 0.30 0.10 Choice 6 - 1.20 1.00 0.80 0.60 0.40 0.20 of 5 - - 1.10 0.90 0.70 0.50 0.30 X 4 - - - 1.00 0.80 0.60 0.40 3 - - - - 0.90 0.70 0.50 2 - - - - - 0.80 0.60 1 - - - - - - 0.70 • Your Payoff = 0.10(Your Choice of X) - 0.20(Your Choice of X - Smallest X) + 0.60 • (Source: Van Huyck, Battalio and Beil, 1990)

14. An Experiment A)Smallest Value of X 7 6 5 4 3 2 1 Your 7 1.30 1.10 0.90 0.70 0.50 0.30 0.10 Choice 6 - 1.20 1.00 0.80 0.60 0.40 0.20 of 5 - - 1.10 0.90 0.70 0.50 0.30 X 4 - - - 1.00 0.80 0.60 0.40 3 - - - - 0.90 0.70 0.50 2 - - - - - 0.80 0.60 1 - - - - - - 0.70 7 is the efficient choice

15. An Experiment A)Smallest Value of X 7 6 5 4 3 2 1 Your 7 1.30 1.10 0.90 0.70 0.50 0.30 0.10 Choice 6 - 1.20 1.00 0.80 0.60 0.40 0.20 of 5 - - 1.10 0.90 0.70 0.50 0.30 X 4 - - - 1.00 0.80 0.60 0.40 3 - - - - 0.90 0.70 0.50 2 - - - - - 0.80 0.60 1 - - - - - - 0.70 1 is the secure (or prudent) choice

16. An Experiment A)Smallest Value of X 7 6 5 4 3 2 1 Your 7 1.30 1.10 0.90 0.70 0.50 0.30 0.10 Choice 6 - 1.20 1.00 0.80 0.60 0.40 0.20 of 5 - - 1.10 0.90 0.70 0.50 0.30 X 4 - - - 1.00 0.80 0.60 0.40 3 - - - - 0.90 0.70 0.50 2 - - - - - 0.80 0.60 1 - - - - - - 0.70 Multiple equilibria COORDINATION PROBLEM

17. An Experiment What happened when we played the game? What would happen if communication were permitted? Is there a rational way to play?

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21. Experimental Economics Procedures Series of games. The initial procedure will be, everyone writes down their choice on a piece of paper. Choices will be collected, and the minimum choice reported on the board. Everyone can then keep their own account of how much they earned, based on their choice and the minimum that anyone chose. In a real experiment, everyone would be paid based on their choices. But how to pay is still a design choice: In repeated game experiments, one design decision is whether to pay subjects the sum of their earnings in each period, or choose one period at random to be the payoff period. What are some reasons you might want to do one or the other? (How about other options, like paying only for the last period??)

22. Experimental Economics Let’s take a look at Van Huyck et al. experimental design. It is a complex (and atypical) design, that involves having the experimental subjects each experience a sequence of related environments. After the experiment was completed, a referee noted that the information passed to each player in the original experiment was simply the minimum choice in each period. He asked whether the results would be different if subjects saw the whole distribution

23. Experimental Economics Van Huyck and his colleagues have conducted a number of variations of their original experiment. Median games (payoff is maximized if you choose the median of the numbers chosen). Bidding for positions in the median game: (Earnings if one of these games is the payoff game will be zero for unsuccessful bidders, and earnings minus bids for successful bidders.

24. Experimental Economics What can we learn from these experiments? What new conjectures do they suggest? The Minimum game shows that we don’t always get Pareto optimality; that it takes time to converge to an equilibrium; that size and repetition interact (2 player repeated gets to Pareto optimal equilibrium, other conditions do not).

25. Experimental Economics What can we learn from these experiments? What new conjectures do they suggest? The Median game shows that the rules matter in a way they wouldn’t if only the equilibrium structure was important—games with the same equilibria can be very different. And history can be important. These two observations go together—if players don’t reach equilibrium immediately, then games with the same equilibria may be different because they are different out of equilibrium, and players learn from and react to their out of equilibrium experiences. (Another way to think about this is that we may need to consider rational behavior not just in the face of rational behavior by others, but also in the face of boundedly rational or irrational behavior by some members of the population.) .

26. An Experiment What happened when we played the game? What would happen if communication were permitted? Is there a rational way to play?