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Uniwersytet Warszawski
Experimental economics

Economics from the lab

The unpredictability of the economy is the bane of many analysts. The vast complexity of the economic system makes forecasting of economic phenomena and human behavior on the basis of a number of separate factors similar to the divination of tea leaves. None of the economic crises of the last decade has been predicted, the stock market is still a Russian roulette, and the exchange rates are less predictable than floods in Poland. Unsuccessful forecasts and lack of a theoretical justification for the ongoing phenomena cause the erosion of the paradigm of neoclassical economics. In all the fields where traditional approach is no longer viable, new and unorthodox methods, like experimental economics, come into play.

The history of scientific use of economic experiments is fairly short. Over the ages the life scientists have established a method of conducting scientific experiments aimed at verifying the hypothesis put forward by the investigator. Thus even astronomy could be considered an empirical science. Galileo used a model of Jupiter to estimate the position of its’ moons on the basis of their eclipses. Observation of reality has been the only tool available to researchers of the economy - an analysis of past processes and their extrapolation to future periods. However the method has been repetitively proven to be highly unreliable. Hence the need for new methods, such as experiments. Amazingly, world’s economist community shows high resistance in employing experiments in the analysis of economic phenomena. There are many explanations for this, but one of the foremost cited reasons is the fact that experiments undermine the foundations of the widely accepted theory of neoclassical economics.

Erosion of tradition

Neoclassical paradigm in economics emerged from the works of such figures as Adam Smith, Alfred Marshall and William Jevons. It assumes the rationality of human behavior, the striving of the economy to an equilibrium and the efficiency of markets among others. However on this basis it is difficult to explain the anomalies of the economy, such as undervalued shares, long-term unemployment, explaining human behavior with the so-called bandwagon effect rather than rational decisions, etc. The main drawback of neoclassical economics is the lack of predictability of results. In physics, it is easy to tell where a thrown ball will fall, because there is a model that shows how the ball acts with certain weight, the strength with which we throw, etc. In case of new markets, it is impossible to say anything on the basis of theoretical models, as a slight change in few parameters can lead to conflicting results.

A simple example to illustrate this could be the basic principle of economics: the law of supply and demand. It says that under certain conditions, the demand price equals the price of the supply, thus setting the market price and the amount of goods and services available. This model is the first step in learning the traditional economy, which despite the use of very sophisticated mathematical methods relies on the same pattern: the model, the balance, the result. It is somewhat paradoxical that both this simple model and its more complicated versions are in no way observable in the economic reality. The economy does not work this way. In fact, one can observe that for example as a result of collusion a monopoly is created with heightened prices, or as a result of the pressure of consumer lobby sellers are forced to lower prices below the equilibrium. Traditional economics does not deal with such minor details, but those and others that seem to be unexplainable are precisely the focus of experimental economics.

The creators of experimental economics

Nobel Prize in Economics in 2002 was an acknowledgment of the biggest disruption of the economic status quo. Vernon Smith and David Kahneman, from the very beginning of their professional careers were trying to undermine the foundations of modern economics, and they did it in a very unusual way. Rather than argue about the assumptions of models, they denied the veracity of the test method itself. In the 1950s both Nobel Prize winners began to conduct economic experiment designed to verify the commonly accepted "truths". The stimulus for creating economic experiments was to study individual human behavior, since it is extremely difficult to observe in natural conditions. The focus of the test was to determine whether the assumption of rationality is indeed consistent with actual human behavior. Economics is very skeptical towards the methods of measuring psychological thought, considering them to be too blurry. Homo oeconomicus is seen as a robot that works only when there is a desire for profit. For the psychologist, this assumption is not acceptable. In economics, the principle of rationality is the paradigm, and only the work of Kahneman significantly undermined that simple image of a man. Another focus of study were market structures, such as competition or monopoly, and the process of their evolution.

The research is based on the methods of experimental economics to the end of the 90 were treated as curiosities. However, away from the mainstream methodological principles have been developed for conducting and analyzing experiments. Experimental economics is currently enjoying great success. From day to day in reputable scientific journals appears more and more based on the results of experimental methods. Unfortunately, experimental economics is unfortunately still not very popular in Poland.

Up till the end of the century research based on experimental approach were considered as mere curiosities. However, on the side road to mainstream science methodological principles for conducting and analyzing economic experiments has been developed. Experimental economics is currently enjoying substantial success. On a daily basis major professional journals are publishing research papers reporting outcomes based on experimental methods. Unfortunately, experimental economics is still lacking in popularity in Poland.

The possibilities of new methods

Experimental economics provides market research under controlled conditions. The experiment is conducted on a group of people who, encouraged by a prize, react to the presented situation with well-established game conditions. By using experiments, it is possible to eliminate undesirable and inefficient system solutions. Laboratory testing avoids the problems of large losses and uncontrolled shifts in the economic environment. Repeatability of the test results enables tracking of the reaction mechanisms of people and the economy with changing "rules of the game" - laws, regulations and institutions. Currently, economic experiments are often used to analyze the supply and demand in the market, to simulate auctions, tenders and calculate the revenue they generate. Researched are also voting mechanisms, strategic interactions between several players (for instance negotiation), speculation, arbitrage and other decisions made under conditions of uncertainty and risk.

Progress in education

An experiment is being introduced as a tool for teaching in business schools with increasing frequency. Lectures on the theory of economics, which constitute a major part of curriculum, are considered by students to be boring subjects that introduce basic concepts. That results in the textbook knowledge being later neglected, not properly understood and rarely questioned. The process of education is more effective when students learn through experience, not by passively learning the economic mechanisms of action by heart. Students can learn about economics, not only in theory, but also by actively participating in the experiments. They can participate in a dual role: as an object of study and as experimenters. Firstly, as guinea pigs they have a chance to learn something about themselves. Secondly, as experimenters they get a chance to independently investigate economic problems. Experiments conducted in class provide concrete solutions that can be implemented.

What is an experiment?

Imagine that unsafe housing residents want to hire a security company, which will increase safety and housing prices. If payment for this purpose will be anonymous and not burdened with pain, most residents will not pay anything, hoping that others will finance the project. It is a fully rational human behavior as individuals, which, unfortunately, does not lead to the implementation of the project and the situation does not improve at all.

This problem can be analyzed by the experiment "public goods". It consists of several rounds. At the beginning of each turn players receive a pot of money. Part of this amount may be kept to themselves, another part may be contributed to the common fund. The experimenter adds up the money put into the common fund, doubles the amount and divides it equally among all the players. Usually in the first few rounds players will keep some of the money for themselves, and give some to the common fund. This is altruistic behavior, desirable to all of them as community. If everyone gave their entire pot of money into the common fund they would get back twice as much. However, there will always be people who exploit the situation and do not pay. These people are called free-riders. Their presence demoralizes the others. As a result, in later rounds the amount in the common fund decreases to zero. When people are rational as individuals they maximize their expected profit, and it does not lead to the social optimum. The aim of the experiment is to find institutional incentives that would eliminate free-riding and will effectively provide the public good. The experimenter can change the conditions of the game and examine how that affects the behavior of players, for example, they can introduce a system of penalties and rewards of social control. Surprisingly, in many experiments the system based on social control and transparency of the decision was more effective than the introduction of penalties. Experimental economics gives the opportunity to explore how the institutional environment, cultural and social factors affect the economy.