An Introduction to

Experimental Economics
John Hey

First presentation to the Doctoral Students, University of

Bari
October 2023
Information

 I am John Hey, Emeritus Professor of Economics and

Statistics at the University of York.
 I have constructed a site for this course of lectures at
https://www.york.ac.uk/economics/exec/universityofbari/
 I am visiting the University of Bari, where I was
Ordinario for 5 years, taught Microeconomia and Social
Choice, and founded the Bari centre of experimental
economics, to convince you all of the value of
Experimental Economics , and to encourage you to use
it.
 You can find my webpage at
 https://sites.google.com/york.ac.uk/john-hey/home
 You can send me emails at [email protected]
Experimental Economics
and
Behavioural

Economics
These are very closely interlinked. Each feeds into the
other.
 Behavioural Economics is a branch of Economics which
describes the economic behaviour of human beings.
 (This really is what economics ought to be about, but conventional (neoclassical)
economics has too strong assumptions about human rationality. Behavioral economics
relaxes these assumptions.)

 Experimental Economics is a method by which economic

theories (both behavioural and conventional) are tested
for their validity.
 If the test shows that the theory is valid, all well and
good.
 If not, the theory is revised…
 … and then tested again, and so on, until it is valid.
Preamble

 This is a lecture on experimental economics,

 And not on experimental psychology
 Or experimental anything-else.

 I presume a basic understanding of economics.

 Stop me if I am assuming too much.
This lecture

 This is an overview lecture giving you a glimpse of

what experimental economics is about and what
an economics experiment looks like.
 I give detail and practical advice in the other
lectures of the course.
Overview

 I first look at markets

 Then games
 Then static individual decision-making
 Then dynamic individual decision-making

 Then a very brief overview of other experiments.

 But first, three questions for you…

A first question for you

 What would you think about a scientist who

wants to test the efficiency of a drug
 who collects data on the sale of the drug (in some
town or region or country) and data on the
incidence of the problem that the drug is
supposed to cure (in that town or region or
country),
 and statistically looks at the relationship between
the latter and the former?
A second question for you

 What would you think about a scientist who

wants to test whether a new brand of tyres is
safer than the old one
 who collects data on the sales of the tyre (in
some town or region or country) and data on
motor accidents (in that town or region or
country)
 and statistically looks at the relationship between
the latter and the former?
A final question

 What would you think about a scientist who

wants to test whether raising interest rates
increases saving
 who collects data on interest rates over time in
some country and saving in that country,
 and statistically looks at the relationship between
the latter and the former?
The answers in each case?

 We would not be impressed.

 One problem is that there are many other factors

which may affect the relationship.
 In the first two cases the scientist would conduct a
laboratory experiment.
 Keeping all other factors (not of interest) fixed.

 Why cannot economists do the same?

 Well, experimental economists do.
Economics

 Economics is theory driven and based on axioms.

 Economics has strong notions about rationality,
particularly about rational expectations and
dynamic behaviour.
 Central to economics is equilibrium.
 Economics usually relies on indirect tests of
theories (using data from the economy with many
uncontrolled factors) rather than direct
experimental tests under controlled conditions.
Experimental economists’
claims
 All theory is built on top of individuals (usually
maximising their own self-interest).
 Theory does not specify which individuals.
 We can test/investigate most economic theories,
including macro models and those of international
trade ‒ as these usually involve a small number of
(representative) agents.
 Experiments enable us to find what is wrong with
existing theories and to suggest new ones.
 This appears to us to be scientific progress.

 Let me start with an example.

“Equilibrium”
A familiar text-book figure
“Comparative statics”
A familiar text-book exercise
What does the theory say?

 That equilibrium exists.

 It is an equilibrium in the sense that once we are there, no
individual can gain by changing his or her decision.

 That if there is an upwards shift in the demand curve then the

equilibrium price and quantity increase.

 Does it say that the equilibrium will be attained?

 No.
 Does it say that the price will move upwards?
 No.

 It cannot – because there is no-one to set the price.

So why not see what
happens?
 We need to give the agents the ability to
announce prices (not necessarily set them).

 This is what Vernon Smith (Nobel Prize Winner in

2002) did in his path-breaking experiments in the
1960’s.

 We need to give incentives to the agents/subjects

to act as in the theory.
How we set up a market
experiment

 Notice that this is a market for a hypothetical

good.
 We need to answer the following questions:

 How do we get people to act as potential buyers?

 How do we get people to act as potential sellers?

 How is the price formed?

 What might the experiment tell us about the

theory?
Demanders

 What is a demand curve?

 What are reservation prices?
 What does a demand curve for a discrete good
look like?

 Suppose an individual wants to buy at most one

unit of a discrete good and his/her reservation
price* for the one unit is 6. What does his/her
demand curve look like? what does it tell us?
 * The maximum that he/she is willing to pay.
Demand curve of this
demander
Aggregate demand curve
Suppose now there are five demanders, each wanting to
buy at most one unit, with reservation prices 10, 9, 6, 5
and 2. What does their aggregate demand curve look
like?
Inducing subjects to act as
demanders

 How do we do this?
 We tell each subject that they are potential buyers
of a hypothetical good that will be traded in the
experiment, and that if they buy they will be paid
by the experimenter a given sum of money (their
reservation value – but we do not use this word)
and that they will have to pay the price agreed
out of this money.
 An obvious incentive mechanism. They get their
surplus.

 We can obviously generalise this.

Suppliers

 What is a supply curve?

 What are reservation prices?
 What does a supply curve for a discrete good look
like?

 Suppose an individual wants to sell at most one

unit of a discrete good and his/her reservation
price* for the one unit is 5. What does his/her
supply curve look like?
 * The minimum that he/she is willing to accept.
Supply curve of this
supplier
Aggregate supply curve
Suppose now there are five suppliers, each wanting to sell
at most one unit, with reservation prices 1, 4, 5, 7 and 9.
What does their aggregate supply curve look like?
Inducing subjects to act as
suppliers

 How do we do this?
 We tell each subject that they are potential sellers
of a hypothetical good that will be traded in the
experiment, and that if they sell they will receive
the price agreed and that they will have to pay to
the experimenter a given sum of money (their
reservation value – but we do not use this word)
out of this money.
 An obvious incentive mechanism. They get their
surplus.

 We can obviously generalise this.

The market
Who trades?

 Do all in the competitive equilibrium?

 Can all outside competitive equilibrium?
 Why do we like competitive equilibrium?
Trading mechanisms?

 In the theory? In the real world?

 I list some here.

Double Auction
Walrasian Auctioneer
Clearing House
Bilateral Bargaining
Sellers set prices
Buyers set prices
…
Double auction

 The market period lasts a pre-determined time.

 At any point buyers can make bids: a price at which
they are willing to buy.
 At any point sellers can make asks: a price at which
they are willing to sell.
 Bids and asks are posted.
 At any time a buyer can accept a posted ask of a
seller – and then a trade takes place at that price.
 At any time a seller can accept a posted bid of a
buyer – and then a trade takes place at that price.
 There is no communication between the subjects and
they do not know each others reservation prices.
The classic example from smith
1962
11 potential buyers
with reservation
prices from 3.25 to
0.75.

11 potential sellers
with reservation
prices from 0.75 to
3.25.

Equilibrium price
2.00.
What happened in period 1?
What happened in period 2?
What happened in period 3?
What happened in period 4?
What happened in period 5?

Magic!?
The theorists are
vindicated!
But…
A repeated market – repeated 15 times.
From Smith, Suchanek and Williams 1998

All subjects endowed at the start with units of an asset that paid a
random dividend with mean 24 cents each period. Endowed also
with ultimately worthless experimental money with which to trade.

Note what should be the equilibrium price of the asset:

At the start with 15 periods to go, in each of which the

expected dividend is 24, the price should be the value of the
asset=15*24=360. (This assumes that subjects are risk-
neutral.)

Then the price should fall 24 cents each period.

What happened

We observe a bubble and a crash!

What was happening?
Game theory

 Again here theorists are obsessed with equilibrium

– here the Nash Equilibrium…
 … in which everybody is doing the best for
themselves given what everyone else is doing.
 It is an equilibrium in the sense that once we are
there, no individual can gain by changing his or
her decision.

 But is it attained?
 Only experiments can tell us.
Setting up an experiment to
test the equilibrium of a game

 Decide the number of players in the game.

 Show them all the Payoff ‘Matrix’ which specifies,
for each player, the payoff he/she would get for
each set of decision of all the players.
 Get them all (in a simultaneous play game) to
simultaneously take their decision.
 Use the Payoff ‘Matrix’ to determine the payoff of
each player.
 Pay them.
 End of experiment.
Setting up a test of Game
Theory (2-person game)
 Invite 2 people to the lab.
 Show them the payoff matrix

 Tell them the ‘rules of the game’.

 If a simultaneous play game, get player A to
choose a row and Player B a column
simultaneously and without communication. Pay
them their payoffs and let them leave.
That was a symmetric
game
 The two players move simultaneously.

Player B B
1 2
Player A 1 £10, £10 £12, £0
2 £0, £12 £11,
£11
 First number – payoff to A; second - payoff to B.
 What would you do?
 What does the theory predict?
 The theory works! Experiments with real money
prove it.
But…

 The two players move simultaneously

Player B B
1 2
Player A 1 £1, £1 £1001, £0
2 £0, £1001 £1000,
£1000

 First number – payoff to A; second - payoff to B.

 What would you do?
 What does the theory predict?
 The theory does not work! Experiments with real
money prove it.
What does this tell us?

 Game theory ‘predictions’ are satisfied sometimes

but not always.
 It depends on the out-of-equilibrium payoffs –
which are irrelevant to the theory.
 Is out-of-equilibrium play a sign of trust, other-
regarding preferences, or better-than-Nash
rationality?
 Other experiments can tell us.
A sequential-play game

 A simple sequential one-shot Trust Game.

 Two players, A and B. A has some money given to
him/her by the experimenter; he can pass some
to B and the amount becomes quadrupled.
 Then B has to decide how much to pass back to A.
 What is the Nash Equilibrium?
 What do experiments show?
 That Player A does pass some money – often 50%
of the given amount.
 Trust? Other-regarding preferences? Better-than-
Nash rationality?
Axioms
 Economists love axioms – definitions of ‘rationality’.
 They are beautiful and intellectually appealing.
 Consider this axiom – which is called the Independence Axiom.
 Suppose you prefer A to B, where A and B can be anything.
 Now suppose you are offered the following risky choice: between
Left and Right. Which would you choose? C is anything. p is
anything.

p A B
Left Righ
1-p C t
C
These are both risky
choices with
probabilities p and 1-p.
Now a test

What would you choose here? £400

0.8
£300 0.2 £0

And here?
0.25 0.2

0.75

Are your decisions consistent with the Independence Axiom?

This is the Allais ‘paradox’

 The Independence Axiom is the crucial part of

Expected Utility theory.
 Experimental tests of this axiom and others have
led to the development of new theories of
behaviour under risk, most notably Prospect
theory and Rank-Dependent Expected Utility
theory.
 Allais (Nobel Prize 1988) was an early
experimenter in the field.
Dynamic choice

 Dominated by strong ideas of rationality,

particularly that of solving dynamic problems by
backward induction (underlies rational expectations).
 Consider the following dynamic problem.
 In these green squares are decision nodes and red
squares are where Nature moves, moving Up or
Down with equal probabilities.
 The amounts at the end are payoffs.
 What would you do at the first decision node?

 This is from an experiment of The Three Johns.

The Experimental Design

 The payoffs in the top half of the tree are

8, 13,16, 8, 6, 20, 6,18
 The payoffs in the bottom half of the tree are
 15, 17, 2, 4, 29, 8, 8, 0
 The ordered payoffs in the top half of the tree are
 20, 18, 16, 13, 8, 8, 6, 6
 The ordered payoffs in the bottom half of the tree are
 20, 17, 15, 8, 8, 4, 2, 0
 Top dominates bottom …
 … but this ignores the second decision.
The Second Nodes

 The decision maker would choose Down, Up, Up and

Down (assuming dominance) therefore eliminating 8,
13, 6, 8, 2, 4, 8 and 0, leaving
 16, 8, 6, 20 in the top (ordered 20, 16, 8 and 6) and
 15, 17, 20, 8 in the bottom (ordered 20, 17, 15 and 8)
 Now bottom dominates top.
 Playing Down at the first node is a dominant strategy.
 The experiment showed that well under half the
subjects chose wrongly…
 …and even forcing them to pre-commit to the second
decision did not push the right choice to over 50%!
What the experiment
shows
 People do not plan ahead – even in the context of
this simple example.
 People do not backwardly induct.
 What does economists’ theory of saving assume?
 … backward induction from the date of death.
Savings

 Economists, with their life-cycle theory of saving,

assume that agents backwardly induct from the
date of their death.
 How do you do an experiment to test this?
 An experiment with a finite number of periods in
each of which the agent gets an income in tokens.
Savings earn interest. Each period they have to
decide how much of their wealth to convert into
money – through a conversion scale u(.).
 What do such experiments show?
 That people under-save in early periods. Myopia?
So what have we learnt?

 That spontaneous action can lead to equilibrium.

 That equilibrium may not be achieved; that other
factors are at play.
 That the concepts of rationality used in much of
economics are too strong.
 People are myopic and do not use backward
induction.
 That people care about other people and trust
them.
 Experiments have led to new theories.
What has been learnt
elsewhere?
 People are different. Interesting?
 Cultures are different. Interesting?
 The more micro you look the more the differences.
 People have noise in their behaviour but are not
completely random.
 Emotion seems to affect behaviour.
 The environment seems to affect behaviour.
 If we are interested in aggregate micro behaviour
perhaps these differences cancel out?
 But the behaviour of the average is not the
average of behaviour.
Other experiments

 I have not mentioned Field Experiments as I do

not do them.
 They are experiments carried out ‘in the field’
with perhaps the subjects not knowing that they
are in an experiment.
 Some experiments are carried out in low-income
countries as one can provide higher incentives.
What non-experimenters
say
 “We know that the  No comment.
theory is true.”
 Economics is about  Why are your theories
aggregates not
about individuals?
individuals.
 Your incentives are
not large enough.  We have tested
whether their size
makes a difference.
 These axiomatic  How do you know?
violations cancel out.
The end

 Many thanks for listening.

 My thanks to the University of Bari for inviting me
to give this presentation.
 I would be happy to answer any questions, either
now or in the future.

 Please send any messages to me at

[email protected]