Experimental economics

Experimental economics

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Encyclopedia
Experimental economics is the application of experimental methods to study economic questions. Data
Economic data
Economic data or economic statistics may refer to data describing an actual economy, past or present. These are typically found in time-series form, that is, covering more than one time period or in cross-sectional data in one time period Economic data or economic statistics may refer to data...

 collected in experiments are used to estimate effect size
Effect size
In statistics, an effect size is a measure of the strength of the relationship between two variables in a statistical population, or a sample-based estimate of that quantity...

, test the validity of economic theories, and illuminate market mechanisms. Economic experiments usually use cash to motivate subjects, in order to mimic real-world incentives. Experiments are used to help understand how and why markets and other exchange systems function as they do.

A fundamental aspect of the subject is design of experiments
Design of experiments
In general usage, design of experiments or experimental design is the design of any information-gathering exercises where variation is present, whether under the full control of the experimenter or not. However, in statistics, these terms are usually used for controlled experiments...

. Experiments may be conducted in the field or in laboratory settings, whether of individual
Experimental psychology
Experimental psychology is a methodological approach, rather than a subject, and encompasses varied fields within psychology. Experimental psychologists have traditionally conducted research, published articles, and taught classes on neuroscience, developmental psychology, sensation, perception,...

 or group
Social psychology
Social psychology is the scientific study of how people's thoughts, feelings, and behaviors are influenced by the actual, imagined, or implied presence of others. By this definition, scientific refers to the empirical method of investigation. The terms thoughts, feelings, and behaviors include all...

 behavior.

Variants of the subject outside such formal confines include natural
Natural experiment
A natural experiment is an observational study in which the assignment of treatments to subjects has been haphazard: That is, the assignment of treatments has been made "by nature", but not by experimenters. Thus, a natural experiment is not a controlled experiment...

 and quasi-natural experiments.

Experimental topics


Economics experiments can be loosely classified into the following topics: Markets, Game
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

s, Decision making
Decision making
Decision making can be regarded as the mental processes resulting in the selection of a course of action among several alternative scenarios. Every decision making process produces a final choice. The output can be an action or an opinion of choice.- Overview :Human performance in decision terms...

, Bargaining
Bargaining
Bargaining or haggling is a type of negotiation in which the buyer and seller of a good or service dispute the price which will be paid and the exact nature of the transaction that will take place, and eventually come to an agreement. Bargaining is an alternative pricing strategy to fixed prices...

, Auctions, Coordination, Social Preferences, Learning, Matching
Matching
In the mathematical discipline of graph theory, a matching or independent edge set in a graph is a set of edges without common vertices. It may also be an entire graph consisting of edges without common vertices.- Definition :...

, and Field Experiments. Within Economics education
Economics education
Economics education or economic education is a field within economics that focuses on two main themes: 1) the current state of, and efforts to improve, the economics curriculum, materials and pedagogical techniques used to teach economics at all educational levels; and 2) research into the...

, one application of is in experiments used in the teaching of economics
Simulations and games in economics education
A simulation game is "a game that contains a mixture of skill, chance, and strategy to simulate an aspect of reality, such as a stock exchange". Similarly, Ruohomaki states that "a simulation game combines the features of a game with those of a simulation...

. An alternative approach with experimental dimensions is agent-based computational modeling
Agent-Based Computational Economics
Agent-based computational economics is the major aspect of computational economics that studies economic processes, including whole economies, as dynamic systems of interacting agents. As such, it falls in paradigm of complex adaptive systems...

.

Coordination games


Coordination games are game
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

s with multiple pure strategy Nash equilibria
Nash equilibrium
In game theory, Nash equilibrium is a solution concept of a game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his own strategy unilaterally...

. There are two general sets of questions that experimental economists typically ask when examining such games: (1) Can laboratory subjects coordinate, or learn to coordinate, on one of multiple equilibria, and if so are there general principles that can help predict which equilibrium is likely to be chosen? (2) Can laboratory subjects coordinate, or learn to coordinate, on the Pareto best equilibrium and if not, are there conditions or mechanisms which would help subjects coordinate on the Pareto best equilibrium? Deductive selection principles are those that allow predictions based on the properties of the game alone. Inductive selection principles are those that allow predictions based on characterizations of dynamics.

Learning experiments


In game
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

s of two players or more, the subjects often form beliefs about what actions the other subjects are taking and these beliefs are updated over time. This is known as belief learning. Subjects also tend to make the same decisions that have rewarded them with high payoffs in the past. This is known as reinforcement learning
Reinforcement learning
Inspired by behaviorist psychology, reinforcement learning is an area of machine learning in computer science, concerned with how an agent ought to take actions in an environment so as to maximize some notion of cumulative reward...

.

Until the 1990s, simple adaptive models, such as Cournot competition
Cournot competition
Cournot competition is an economic model used to describe an industry structure in which companies compete on the amount of output they will produce, which they decide on independently of each other and at the same time. It is named after Antoine Augustin Cournot who was inspired by observing...

 or fictitious play
Fictitious play
In game theory, fictitious play is a learning rule first introduced by G.W. Brown . In it, each player presumes that the opponents are playing stationary strategies. At each round, each player thus best responds to the empirical frequency of play of his opponent...

, were generally used. In the mid-1990s, Alvin E. Roth
Alvin E. Roth
Alvin E. "Al" Roth is an American economist currently serving as the George Gund Professor of Economics and Business Administration at Harvard Business School...

 and Ido Erev demonstrated that reinforcement learning can make useful predictions in experimental games. In 1999, Colin Camerer
Colin Camerer
Colin F. Camerer is an American behavioral economist and a Robert Kirby Professor of Behavioral Finance and Economics at the California Institute of Technology ....

 and Teck Ho introduced Experience Weighted Attraction (EWA), a general model that incorporated reinforcement and belief learning, and shows that fictitious play is mathematically equivalent to generalized reinforcement, provided weights are placed on past history.

Criticisms of EWA include overfitting
Overfitting
In statistics, overfitting occurs when a statistical model describes random error or noise instead of the underlying relationship. Overfitting generally occurs when a model is excessively complex, such as having too many parameters relative to the number of observations...

 due to many parameters, lack of generality over games, and the possibility that the interpretation of EWA parameters may be difficult. Overfitting is addressed by estimating parameters on some of the experimental periods or experimental subjects and forecasting behavior in the remaining sample (if models are overfitting, these out-of-sample validation forecasts will be much less accurate than in-sample fits, which they generally are not). Generality in games is addressed by replacing fixed parameters with "self-tuning" functions of experience, allowing pseudo-parameters to change over the course of a game and to also vary systematically across games.

Modern experimental economists have done much notable work recently. Roberto Weber has raised issues of learning without feedback. David Cooper and John Kagel have investigated types of learning over similar strategies. Ido Erev and Greg Barron have looked at learning in cognitive strategies. Dale Stahl has characterized learning over decision making rules. Charles A. Holt
Charles A. Holt
Charles A. Holt is a behavioral economist, the A. Willis Robertson Professor of Political Economy at the University of Virginia.Among others he has written the textbook Markets, Games & Strategic Behavior, ISBN 0-321-41931-6....

 has studied logit learning in different kinds of games, including games with multiple equilibria. Wilfred Amaldoss has looked at interesting applications of EWA in marketing. Amnon Rapoport, Jim Parco
Jim Parco
James Edward "Jim" Parco is a former United States Air Force lieutenant colonel who emerged as a leading voice in the 2005 religious intolerance crisis at the United States Air Force Academy in Colorado Springs, Colorado.-Background:...

 and Ryan Murphy have investigated reinforcement-based adaptive learning models in one of the most celebrated paradoxes in game theory known as the centipede game
Centipede game
In game theory, the centipede game, first introduced by Rosenthal , is an extensive form game in which two players take turns choosing either to take a slightly larger share of a slowly increasing pot, or to pass the pot to the other player...

.

Market games


Vernon Smith
Vernon L. Smith
Vernon Lomax Smith is professor of economics at Chapman University's Argyros School of Business and Economics and School of Law in Orange, California, a research scholar at George Mason University Interdisciplinary Center for Economic Science, and a Fellow of the Mercatus Center, all in Arlington,...

 conducted pioneering economics experiments on the convergence of prices and quantities to their theoretical competitive equilibrium values in experimental markets. Smith studied the behavior of "buyers" and "sellers", who are told how much they "value" a fictitious commodity and then are asked to competitively "bid" or "ask" on these commodities following the rules of various real world market institutions (e.g., the Double auction
Double auction
A double auction is a process of buying and selling goods when potential buyers submit their bids and potential sellers simultaneously submit their ask prices to an auctioneer, and then an auctioneer chooses some price p that clears the market: all the sellers who asked less than p sell and all...

 as well the English and Dutch auction
Auction
An auction is a process of buying and selling goods or services by offering them up for bid, taking bids, and then selling the item to the highest bidder...

s). Smith found that in some forms of centralized trading, prices and quantities traded in such markets converge on the values that would be predicted by the economic theory of perfect competition
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...

, despite the conditions not meeting many of the assumptions of perfect competition (large numbers, perfect information).

Over the years, Smith pioneered -along with other collaborators- the use of controlled laboratory experiments in economics, and established it as a legitimate tool in economics and other related fields. Charles Plott
Charles Plott
Charles Raymond Plott, born in 1938, is an American economist. He currently is Edward S. Harkness Professor of Economics and Political Science at the California Institute of Technology and a pioneer in the field of experimental economics....

 of the California Institute of Technology
California Institute of Technology
The California Institute of Technology is a private research university located in Pasadena, California, United States. Caltech has six academic divisions with strong emphases on science and engineering...

 collaborated with Smith in the 1970s and pioneered experiments in political science, as well as using experiments to inform economic design or engineering to inform policies. In 2002, Smith was awarded (jointly with Daniel Kahneman
Daniel Kahneman
Daniel Kahneman is an Israeli-American psychologist and Nobel laureate. He is notable for his work on the psychology of judgment and decision-making, behavioral economics and hedonic psychology....

) the Bank of Sweden Prize in Economic Sciences "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms".

Finance


Experimental finance
Experimental finance
The goals of experimental finance are to establish different market settings and environments to observe experimentally and analyze agents' behavior and the resulting characteristics of trading flows, information diffusion and aggregation, price setting mechanism and returns processes...

 studies financial markets with the goals of establishing different market settings and environments to observe experimentally and analyze agents' behavior and the resulting characteristics of trading flows, information diffusion and aggregation, price setting mechanism and returns processes. Presently, researchers use simulation software to conduct their research.

For instance, experiments have manipulated information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...

 about the holding value
Holding value
Holding value is an indicator of a theoretical value of the asset that someone has in his portfolio. It is a value which sums the impacts of all the dividends that would be given to players in the future, to help them to estimate a price to buy or sell assets...

 of a bond or a share on the pricing for those who don't have enough information, in order to study stock market bubble
Stock market bubble
A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation....

s.

Social preferences



The term "social preferences" refers to the concern (or lack thereof) that people have for each other's well-being, and it encompasses altruism, spitefulness, tastes for equality, and tastes for reciprocity. Experiments on social preferences generally study economic games including the dictator game
Dictator game
The dictator game is a game in experimental economics, similar to the ultimatum game. Experimental results offer evidence against the rationally self-interested individual concept of economic behavior, though precisely what to conclude from the evidence is controversial.-Description:In the...

, the ultimatum game
Ultimatum game
The ultimatum game is a game often played in economic experiments in which two players interact to decide how to divide a sum of money that is given to them. The first player proposes how to divide the sum between the two players, and the second player can either accept or reject this proposal. ...

, the trust game, the public goods game
Public goods game
The Public goods game is a standard of experimental economics. In the basic game, subjects secretly choose how many of their private tokens to put into the public pot. The tokens in the pot are multiplied by a factor and this "public good" payoff is evenly divided among players...

, and modifications to these canonical settings.
As one example of results, ultimatum game
Ultimatum game
The ultimatum game is a game often played in economic experiments in which two players interact to decide how to divide a sum of money that is given to them. The first player proposes how to divide the sum between the two players, and the second player can either accept or reject this proposal. ...

 experiments have shown that people are generally willing to sacrifice monetary rewards when offered low allocations, thus behaving inconsistently with simple models of self-interest. Economic experiments have measured how this deviation varies across cultures.

Agent-based modeling


Agent-based computational modeling
Agent-Based Computational Economics
Agent-based computational economics is the major aspect of computational economics that studies economic processes, including whole economies, as dynamic systems of interacting agents. As such, it falls in paradigm of complex adaptive systems...

 is a relatively recent method in economics with experimental dimensions. Here the focus is on economic processes, including whole economies
Economy
An economy consists of the economic system of a country or other area; the labor, capital and land resources; and the manufacturing, trade, distribution, and consumption of goods and services of that area...

, as dynamic systems of interacting agents
Agent (economics)
In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....

, an application of the complex adaptive system
Complex adaptive system
Complex adaptive systems are special cases of complex systems. They are complex in that they are dynamic networks of interactions and relationships not aggregations of static entities...

s paradigm
Paradigm
The word paradigm has been used in science to describe distinct concepts. It comes from Greek "παράδειγμα" , "pattern, example, sample" from the verb "παραδείκνυμι" , "exhibit, represent, expose" and that from "παρά" , "beside, beyond" + "δείκνυμι" , "to show, to point out".The original Greek...

. The "agent" refers to "computational objects modeled as interacting according to rules," not real people. Agents can represent social and/or physical entities. Starting from initial conditions determined by the modeler, an ACE model develops forward through time driven solely by agent interactions. Issues include those common to experimental economics in general and development of a common framework for empirical validation and resolving open questions in agent-based modeling.

Guidelines


Experimental economists generally adhere to the following methodological guidelines:
  • Incentivize subjects with real monetary payoffs.
  • Publish full experimental instructions.
  • Do not use deception.
  • Avoid introducing specific, concrete context.

Critiques


The above guidelines have developed in large part to address two central critiques. Specifically, economics experiments are often challenged because of concerns about their "internal validity" and "external validity", for example, that they are not applicable models for many types of economic behavior, so the experiments simply aren't good enough to produce useful answers. Interestingly, however, none of the critiques towards this methodology is specific to it, as they are immediately applicable to either theoretical or empirical approaches or both.

See also

  • Behavioural economics, Behavioral finance
    Behavioral finance
    Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...

    , Behavioral Operations Research
    Behavioral Operations Research
    Behavioral operations research examines the behavior of actual human agents in complex decision problems. BOR is the operations management analog of experimental economics and behavioral finance, and is part of the field known as management science....

  • Experimental finance
    Experimental finance
    The goals of experimental finance are to establish different market settings and environments to observe experimentally and analyze agents' behavior and the resulting characteristics of trading flows, information diffusion and aggregation, price setting mechanism and returns processes...

  • Experimental techniques
    Experimental techniques
    Experimental research designs are used for the controlled testing of causal processes.The general procedure is one or more independent variables are manipulated to determine their effect on a dependent variable...

  • Important publications in experimental economics
  • Quantitative behavioral finance
    Quantitative behavioral finance
    Quantitative behavioral finance is a new discipline that uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation. Some of this endeavor has been led by Gunduz Caginalp and collaborators including Vernon L...

  • Reinhard Selten
    Reinhard Selten
    -Life and career:Selten was born in Breslau in Lower Silesia, now in Poland, to a Jewish father, Adolf Selten, and Protestant mother, Käthe Luther. For his work in game theory, Selten won the 1994 Nobel Memorial Prize in Economic Sciences...

     is another central figure in the foundation of experimental economics.

Experimental economics organizations


Software


Education