Supply and Demand graph, illustrating one of
the most important economic principles
Experimental economics is the application of experimental methods to study economic questions. Data collected in experiments are used to estimate effect size, 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. Experimental economics have also expanded to understand institutions and the law (experimental law and economics).
One can loosely classify economic experiments using the following topics:
- Evolutionary game theory
- Decision making
- Social Preferences
- Field Experiments
Coordination games are games with multiple pure strategy Nash equilibria. 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. Under some conditions at least groups of experimental subjects can coordinate even complex non-obvious asymmetric Pareto-best equilibria. This is even though all subjects decide simultaneously and independently without communication. The way by which this happens is not yet fully understood.
In games 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.
Until the 1990s, simple adaptive models, such as Cournot competition or fictitious play, were generally used. In the mid-1990s, Alvin E. Roth and Ido Erev demonstrated that reinforcement learning can make useful predictions in experimental games. In 1999, Colin Camerer and Teck-Hua 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 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 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 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.
Edward Chamberlin is thought to have conducted "not only the first market experiment, but also the first economic experiment of any kind." Vernon Smith, drawing on Chamberlin's work, but also modifying it in key respects, 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 as well the English and Dutch auctions). 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, 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 of the California Institute of Technology 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) 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".
Experimental finance 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 about the holding value of a bond or a share on the pricing for those who don't have enough information, in order to study stock market bubbles.
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, the ultimatum game, the trust game, the public goods game, and modifications to these canonical settings. As one example of results, ultimatum game 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 computational modeling
Agent-based computational modeling is a relatively recent method in economics with experimental dimensions. Here the focus is on economic processes, including whole economies, as dynamic systems of interacting agents, an application of the complex adaptive systems paradigm. 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 by comparison as well as development of a common framework for empirical validation and resolving open questions in agent-based modeling.
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.
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.
- Behavioral economics
- Behavioral finance
- Behavioral Operations Research
- Experimental finance
- Experimental techniques
- Important publications in experimental economics
- Quantitative behavioral finance
- Reinhard Selten is another central figure in the foundation of experimental economics.
- Including statistical, econometric, and computational. On the latter see Alvin E. Roth, 2002. "The Economist as Engineer: Game Theory, Experimentation, and Computation as Tools for Design Economics," Econometrica, 70(4), pp. 1341–1378.
- See, e.g., Grechenig, K., Nicklisch, A., & Thöni, C. (2010). Punishment despite reasonable doubt—a public goods experiment with sanctions under uncertainty. Journal of Empirical Legal Studies, 7(4), 847-867 (link).
- • Vernon L. Smith, 2008a. "experimental methods in economics," The New Palgrave Dictionary of Economics, 2nd Edition, Abstract.
• _____, 2008b. "experimental economics," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
• Relevant subcategories are found at the Journal of Economic Literature classification codes at JEL: C9.
- J. DiNardo, 2008. "natural experiments and quasi-natural experiments," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
- • Vernon L. Smith, 1992. "Game Theory and Experimental Economics: Beginnings and Early Influences," in E. R. Weintraub, ed., Towards a History of Game Theory, pp. 241– 282.
• _____, 2001. "Experimental Economics," International Encyclopedia of the Social & Behavioral Sciences, pp. 5100–5108. Abstract per sect. 1.1 & 2.1.
• Charles R. Plott and Vernon L. Smith, ed., 2008. Handbook of Experimental Economics Results, v. 1, Elsevier, Part 4, Games, ch. 45–66 preview links.
• Vincent P. Crawford, 1997. "Theory and Experiment in the Analysis of Strategic Interaction," in Advances in Economics and Econometrics: Theory and Applications, pp. 206–242. Cambridge. Reprinted in Colin F. Camerer et al., ed. (2003). Advances in Behavioral Economics, Princeton. 1986–2003 papers. Description, contents, and preview., Princeton, ch. 12.
- Martin Shubik, 2002. "Game Theory and Experimental Gaming," in Robert Aumann and Sergiu Hart, ed., Handbook of Game Theory with Economic Applications, Elsevier, v. 3, pp. 2327–2351. Abstract.
- Gunnthorsdottir Anna, Vragov Roumen, Seifert Stefan and Kevin McCabe 2010 "Near-efficient equilibria in contribution-based competitive grouping," Journal of Public Economics, 94, pp. 987-994.
- Ross Miller (2002). Paving Wall Street: experimental economics and the quest for the perfect market. New York: John Wiley & Sons. pp. 73–74. ISBN 0-471-12198-3.
- Scott E. Page, 2008. "agent-based models," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
- Leigh Tesfatsion, 2003. "Agent-based Computational Economics: Modeling Economies as Complex Adaptive Systems," Information Sciences, 149(4), pp. 262–268. Abstract.
- • Leigh Tesfatsion, 2006. "Agent-Based Computational Economics: A Constructive Approach to Economic Theory," ch. 16, Handbook of Computational Economics, v. 2, pp. 831–880. Abstract/outline. 2005 prepublication version.
• Kenneth Judd, 2006. "Computationally Intensive Analyses in Economics," Handbook of Computational Economics, v. 2, ch. 17, pp. 881– 893.
• Leigh Tesfatsion and Kenneth Judd, ed., 2006. Handbook of Computational Economics, v. 2. Description & and chapter-preview links.
- Vernon L. Smith, 2008b. "experimental economics," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
- John Duffy, 2006. "Agent-Based Models and Human Subject Experiments," ch. 19, Handbook of Computational Economics, v.2, pp. 949–101. Abstract.
- • Leigh Tesfatsion, 2006. "Agent-Based Computational Economics: A Constructive Approach to Economic Theory," ch. 16, Handbook of Computational Economics, v. 2, sect. 5. Abstract and pre-pub PDF.
• Akira Namatame and Takao Terano (2002). "The Hare and the Tortoise: Cumulative Progress in Agent-based Simulation," in Agent-based Approaches in Economic and Social Complex Systems. pp. 3– 14, IOS Press. Description.
• Giorgio Fagiolo, Alessio Moneta, and Paul Windrum, 2007 "A Critical Guide to Empirical Validation of Agent-Based Models in Economics: Methodologies, Procedures, and Open Problems," Computational Economics, 30(3), pp. 195–226.
- Camerer, Colin F. (2011-12-30). "The Promise and Success of Lab-Field Generalizability in Experimental Economics: A Critical Reply to Levitt and List". Working Paper Series.
- Bastable, C. F., (1987). "experimental methods in economics," The New Palgrave: A Dictionary of Economics, v. 2, pp. 241. Reprinted from Palgrave's Dictionary of Political Economy, 1925.
- Battalio, Raymond C., et al., 1973. "A Test of Consumer Demand Theory Using Observations of Individual Consumer Purchases," Economic Inquiry, 11(4), pp. 411–428.
- Bayer, R. C., & Renou, L. (2011). Cognitive abilities and behavior in strategic-form games. Discussion Papers in Economics 11/16, Department of Economics, University of Leicester.
- Camerer, Colin, George Loewenstein, and Drazen Prelec, 2005. "Neuroeconomics: How Neuroscience Can Inform Economics," Journal of Economic Literature, 43(1), pp. 9–64.
- Coursey, Don (2008). "Experimental Economics". In David R. Henderson (ed.). Concise Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 978-0865976658. OCLC 237794267.
- Chamberlin, Edward H., 1948. "An Experimental Imperfect Market," Journal of Political Economy, 56(2), pp. 95–108.
- Davis, Douglas D., and Charles A. Holt, 1993. Experimental Economics, Princeton. Description, preview and ch. 1 (complete).
- Friedman, Daniel, and Shyam Sunder, 1994. Experimental Methods: A Primer for Economists, Cambridge University Press. Description/contents links and scrollable preview.
- Falk, Armin and Simon Gächter, 2008. "experimental labour economics," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract and galley proof.
- Grether, David M., and Charles R. Plott, 1979. "Economic Theory of Choice and the Preference Reversal Phenomenon," American Economic Review, 69(4 ), pp. 623–638.
- Gunnthorsdottir Anna, Vragov Roumen, Seifert Stefan and Kevin McCabe, 2010. "Near-efficient equilibria in contribution-based competitive grouping," Journal of Public Economics, 94, pp. 987–994.
- Guala, Francesco, 2005. The Methodology of Experimental Economics, Cambridge. Description/contents links and ch. 1 excerpt.
- Hertwig, Ralph, and Andreas Ortmann, 2001. "Experimental Practices in Economics : A Methodological Challenge for Psychologists?" Behavioral and Brain Sciences, 24(3), pp. 383–403.
- Holt, Charles A., and Susan K. Laury, 2002. "Risk Aversion and Incentive Effects," American Economic Review, 92(5) pp. 1644–1655.
- Kagel, John H. et al., 1975. "Experimental Studies of Consumer Demand Behavior Using Laboratory Animals," Economic Inquiry, 13(1), pp. 22–38. Abstract.
- Kagel, John H., and Alvin E. Roth, ed., 1995. The Handbook of Experimental Economics, Princeton University Press. Description/TOC and detailed contents.
- Kahneman Daniel, Jack L. Knetsch, and Richard Thaler, 1986. "Fairness as a Constraint on Profit Seeking: Entitlements in the Market," American Economic Review, 76(4), pp. 728–741.
- Plott, Charles R., 1982. "Industrial Organization Theory and Experimental Economics," Journal of Economic Literature, 20(4), pp. 1485–1527. Reprinted in Plott, 2001, Market Institutions and Price Discovery, pp. 18–59. Elgar. Description.
- _____ and Susan K. Laury, 2002. "Risk Aversion and Incentive Effects," American Economic Review, 92(5) pp. 1644–1655.
- Plott, Charles R., and Vernon L. Smith, 2008. Handbook of Experimental Economics Results, v. 1, Elsevier. Description and chapter-link previews.
- Roth, Alvin E., and Michael W Malouf, 1979. "Game-theoretic Models and the Role of Information in Bargaining," Psychological Review, 86(6), pp. 574–594.
- Smith, Vernon L., 1962. "An Experimental Study of Competitive Market Behavior," Journal of Political Economy, 70(2), pp. 111–137.
- ____, 1982. "Microeconomic Systems as an Experimental Science," American Economic Review, 72(5), pp. 923–955.
- _____, 1991. Papers in Experimental Economics [1962–88], Cambridge. Description and chapter-preview links.
- _____,  2008. "experimental methods in economics," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.