Experimental Economics Methodological Paradigm

1. Experimental Economics Methodological Paradigm “Microeconomic Systems as an Experimental Sceince,” Smith ’82 AER

2. Elements of a Microeconomic System (The Enviroment) • List of N economic agents {1,2,…,N} • List of K + 1 commodities {0,1,2,…, K} • Defining characteristics of an agent i • ei=(ui, Ti, wi) • ui is utility function that maps from the commodity space to the real line • Ti is a technology (knowledge) function • wi is a commodity endowment

3. Elements of a Microeconomic System (The Enviroment) • An economic environment is an array ei=(e1, e2,…, eN) • Decentralized Private information assumption: All primal elements are indexed by i. This implies knowledge of these values is private information.

4. Elements of a Microeconomic System (The Institution) “It is the Institution that defines the rules of property rights under which agents may communicate for the purpose of modifying initial endowments in accordance with private tastes and knowledge.” “…property rights in messages are as important as property rights in commodities or ideas.” gi(t0,.,.)

5. Elements of the Institution • Language: A set M=(M1,…, MN) with element m=(m1,…, mN). mi Mi is the set of messages that can be sent by agent i • Allocation rules: H=(h1(m),…, hN(m)). The rule hi(m) states the final allocation to i as a function of the set of submitted messages. In a dynamic institution m refers to the final allocation determining message.

6. Elements of the Institution • Cost imputation rules: C=(c1(m),…, cN(m)). The rule ci(m) states the final adjustment in money or numeraire commodity. • Adjustment process rules: G=(g1(t0, t, T),…, gN(t0, t, T)). • gi(t0,.,.) is the starting rule which indicates when I can initiate sending messages • gi(.,t,.) the transition rule governing the sequence and exchange of messages • gi(.,.,T) stopping rule that specifies the termination of messages

7. Elements of the Institution • Agent i’s property rights in communication and exchange Ii=(Mi, hi(m), ci(m), gi(t0, t, T)). • A Microeconomic Institution is the collection of individual property rights. Ii=(I1, I2,…., IN)

8. Microeconomic System: Behavior and Outcomes • A Microeconomic System is the union of an economic environment and institution. S=(e, I) • S is closed by the agents’ selection of messages. • An final allocation behavioral rule is mi=bi(ei|I) • Response behavior in a dynamic setting mi=fi(m(t-1) |ei,I) • Behavioral rules are variables, theory can make predictions (positive) or suggestions (normative)

9. Microeconomic System Schematic • We can see how behavior interacts with environment to generate reallocation of resources • P denotes performance.We can now evaluate comparative statics of behavior and institutions against traditional benchmarks such at Competitive equilibrium and Pareto Optimality P X e xi=(b1(ei|I),…, bI(ei|I)) xi=hi(m) mi=bi(ei|I) M

10. Microeconomic System Schematic Let’s discuss what types of investigations one can conduct within this framework. • Theoretic • Econometric • Experimental • Simulation P X e xi=(b1(ei|I),…, bI(ei|I)) xi=hi(m) mi=bi(ei|I) M

11. The Controlled Economic Experiment Objectives • Control the elements of S • Observe and measure selected messages, m, so we can infer behavioral rules and conduct hypothesis tests on derived behavior from theories • Observe and measure the resulting outcomes, x, to evaluate system performance Laboratory experiments must satisfy a set of conditions or precepts, to achieve these objectives

12. Smith’s Precepts • Control over preferences and beliefs is most significant tasks and what separates Experiments from other forms of emperical enquiry. • We call this induced valuation Precept 1: Nonsatiation: Given a costless choice between two alternatives, indentical except the first yields more reward medium than the second, the first will always be chosen over the second by an autonomous individual.

13. Smith’s Precepts Precept 2: Saliency: Individuals have the right to claim a reward which is increasing in the good outcomes, xi, of an experiment; and how messages are translated into outcomes are defined by the institution of the experiment Let’s discuss reward mediums and what is salient and what is not.

14. Smith’s Precepts The first two precepts give rise to the existance of a microeconomic system. The next two ensure the control over preferences. Precept 3: Dominance: The reward structure dominates over any subjective costs (or values) associated with participation in the activities of an experiment. Precept 4: Privacy: Each subject in an experiment is only given information on his/her own payoff alternatives Let’s discuss the implications.

15. Smith’s Precepts The first two precepts give rise to the existence of a microeconomic system. The third and fourth precepts give control or make observable the microeconomic system. Precept 5: Parallelism: Propositions about the behavior of individuals and performance of institutions that have been tested in laboratory microeconomies apply also to nonlaboratory microeconomies where similar ceteris paribus conditions hold. This precept is often where experimental work is criticized and issue of sampling are raised. It has led to the recent popularity of “Field Experiments”

16. Induced Value theory • Study of decision behavior or suitably motivated individuals in the laboratory has important and significant application to the development and verification of theories • Results of laboratory tests can serve as rigorous empirical pretest of economic theory prior to the use of field data tests • Results of experiments can be directly relevant to the study and interpretation of field data

17. Induced Value theory • In many experiments the experimenter wants to control subjects preferences. How can this be achieved? • Subjects’ homegrown preferences must be “neutralized” and the • experimenter “induces” new preferences. Subjects’ actions should be driven by the induced preferences. Use of money as a reward medium: ∆m denotes the subject’s money earnings resulting from her actions in the experiment. m0 represents a subject’s “outside” money. Total money holdings are m = (m0 + ∆m). • Subject has unobservable preference V(m0 + ∆m, z) • z represents all other motives.

18. Induced Value theory 1. Monotonicity: V(m) exists and is strictly positive for any (m, z) combination. 2. Dominance: Changes in a subject’s utility from the experiment come predominantly from ∆m. The influence of z is negligible. • If monotonicity and dominance are met the experimenter has control over the subjects’ preferences, i.e., subjects face economic incentives for those actions that are paid and other motivators are negligible. • A flat payment for participation in the experiment does not establish control over preferences. This also holds for questionnaires.

19. Induced Value theory • Boredom – experiments with hundreds of periods are problematic. • Public information about individual payoffs may render relative comparison motives important (envy, fairness). • Experimenter demand effects – Subjects want to help or hinder the experimenter; they receive subtle hints what they should or are expected to do. • Solutions • Make ∆m sufficiently large. • Avoid public information about payoffs. • Avoid any hints regarding the purpose of the experiments. • Use neutral language in the instructions.

20. Induced Value theory • Experimenter wants to induce the utility function U(x,y) . • x: number of slips of red paper • y: number of slips of blue paper • The experimenter pays subjects according to the final holdings of red and blue paper slips. The monetary payoff function R(x,y) is identical to the utility function U(x,y). • Subjects have the following preference: V(m0+U(x,y), z)

21. Induced Value Theory • Since the MRS between x and y under the utility function V is identical to the MRS under the function U or R, respectively, V and U represent the same preferences with regard to x and y. • MRSV = (V1 * UX) / (V1 * UY) = UX /UY = MRSU = RX/RY = MRSR • Remark: Dominance ensures that z does not depend on x and y, i.e., homegrown preferences do not disturb induced preferences.

22. Classification of Experiments • Functional • Variation of environment • Variation of institution • Three Types of Research Questions • What is the system performance? (Our Double Auction experiment is a classic example) • What are the behavioral rules? • Can we identify elements of the environment? (Subject preferences and how the process information)

23. Purposes of Experiments 1. Testing theories 2. Elicitation of preferences Goods, risk, fairness, time 3. Exploring boundedly rational behavior 4. Establish empirical regularities as a basis for new theories 5. Theory free comparison of institutions 6. Wind tunnel experiments 7. Teaching experiments

24. Testing Theory • Economic theory provides the basis for experimental abstraction and experimental design . • Implement those conditions of the theory (e.g. preference assumptions, technology assumptions, institutional assumptions) that you do not want to check. Comparison of the predictions with the experimental outcome provides a test of those components of the theory that are established through the subjects’ behavior.

25. Testing Theory • Attention: often this comparison is a joint test of several assumptions. • When does the theory fail, when does it succeed? • Design proper control treatments that allow causal inferences about why the theory fails (example: bargaining experiments)

26. Elicitation of Preferences • How much money should be spent to avoid traffic accidents? (Involves risk preferences) • How much money should be spent on protecting the natural environment? (involves preferences for public goods) • Should the government subsidize savings? (involves time preferences)

27. Elicitation of Preferences • A nonarbitrary and nonpaternalistic answer to these questions depends crucially on one’s view about how much people value the above goods. • Measuring people’s values requires a theory of individual preferences and knowledge about the strength of particular “motives” (preferences). • This requires the testing of individual choice theories and instruments for the elicitation of preferences.

28. Exploring Bounded Rationality • Do people make systematic mistakes in risky decisions or inter-temporal choice? • To what extent do people apply backwards inductions? • How do people form beliefs about the behavior of others‘? • Are people prone to money illusion? • Above all: How does bounded rationality play out in strategic games, i. e. to what extent does it affect aggregate outcomes? • How and what do people learn?

29. Establish Empirical Regularities as aBasis for New Theories • Well established empirical regularities direct the theorists’ effort and can help develop empirically relevant theories. • Experimenter can implement important games for which no game theoretic predictions exist because the analysis is too complicated (example: double auction)

30. Theory Free Comparison of Institutions • To learn something about the efficiency properties of institutions it is not necessary to have a full theory that explains and predicts behavior • Welfare measure: total money earnings of all subjects in the experiment divided by the total earnings. • Example: double auction versus one-sided continuous auction • Check the robustness of institutions in different environments.

31. Wind Tunnel Experiments • The great thing about economic theory is that one can examine • What would happen if one changed policies or implemented new institutions. • Does the reduction of entry barriers increase aggregate welfare? • Which auctions generate the higher revenue for government securities? • Do tradable emission permits allow efficient pollution control? • How should airport slots be allocated? • How can the market for hospital doctors be organized efficiently? • Which institutions ensure an efficient provision of public goods? • The great thing about economic experiments is that they allow us to examine these questions empirically.