Experimental Economics

Experimental economics refers to the method of controlled experimentation applied to the investigation of economic phenomena. It is used to investigate (1) individual decision making, (2) the coordination of economic actors via market mechanisms, and (3) cooperation of economic agents in nonmarket environments. Experiments have helped in the study of consumption phenomena by shedding light on consumer preference structure, for instance, regarding time preferences, endowment effects, and contributions to public goods.

For long, it was accepted that economists cannot test their theories in laboratories. This has changed with contributions in game and decision theory that brought their hypotheses into the laboratory for testing. The first contribution in experimental economics was made by Edward Chamberlin in 1948. In 2002, Vernon Smith received the Nobel Prize “for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms.” Equally recognized was Daniel Kahneman “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.” Hypotheses tested in economic experiments are often derived from game and decision science or in the cooperation between economists and psychologists. Results coming from economic experiments have been integrated into game theory, decision science, and behavioral economics. A good overview of the method is given in Douglas Davis and Charles Holt's Experimental Economics.

The experimental method uses controlled environments for the investigation. Economic experiments tend to simplify the decision-making context and ways of interaction of economic agents to a large degree to identify structure-giving elements and causal relationships. Most often, economic experiments are conducted in computer labs. In experiments with interaction among experimental subjects, actors are anonymized. Individual decisions are transferred to the group, for instance, in form of individual bids they are willing to pay or for which they are willing to offer a good, and in experiments with feedback between several rounds, results are communicated to subjects, for instance, in form of resulting market prices.

Economic experiments have brought many insights that have been included in the advancement of economic theory. Important areas include the following: (1) role and efficiency of alternative market mechanism (Smith 1982); (2) altruistic behavior, human reciprocity, and inequity aversion as analyzed, for instance, in ultimatum and dictator games (Guth, Schmittberger, and Schwarze 1982) that analyze the level of cooperation between economic agents; (3) the rationality of economic decision making under uncertainty and the influence of loss aversion and endowment effects (Tversky and Kahneman 1991); (4) the rationality of economic decision making regarding intertemporal choice (Loewenstein and Prelec 1992); and (5) evaluation of goods and services in auction experiments measuring willingness to pay (Bohm 1972).

The experimental setup requires the definition of hypotheses to be tested, along with experimental subjects (students, consumers, business persons, etc.) and variations in the experimental conditions. Economic experiments work by posing economic (monetary) incentives in the decisions to be made. [Page 564]By defining these incentives, the experimenter can generate and test hypotheses on economic behavior. The framework of an experiment can be described in terms of the environment (initial commodity endowment, information, and knowledge), the institution (form of interaction, bids or offers, and rules for exchange) and behavior. Elements of the environment and institutions are control variables, and the observed behavior is hence interpreted as a function of the environment and the institution. Rewards for experimental subjects are explicitly linked to their decisions during the experiments. For the internal validity of an experiment, allowing the establishment of causal relationships, it is necessary that the reward schedule cannot be influenced by subjective costs or benefits regarding the participation in the experiment.

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