A Guide to Experimental Economics

“No Amount of experimentation can prove me right, but a single experiment can prove me wrong”'

- Albert Einstein

Since the dawn of man, the driving force of human civilization has been curiosity. This curiosity has manifested itself as Experimentation, the process of creating situations to observe phenomenon and draw conclusions from the same. 

 

Experiments have been the leading source of information for every science and are quite often the validating factor for any theories. The source of the Newtonian laws were experiments, and proving the earth round was too. All this points to the importance of experiments in human development, and economics is no different.

 

 

What is Experimental Economics?

 

Experimental economics refers to the economic theory where experiments are conducted to verify the validity of economic theories. It is a relatively newer concept that gained significance after its pioneer, Vernon Smith, won the Nobel Prize for Economics in 2002 for developing experiments to test policy changes.

 

Economics researchers design carefully controlled experimental set ups and invite participants to participate in the same. Participants are often told to behave exactly like how they would in a practical set up and are given incentives to the same. 

 

The primary differentiating factor between Experimental Economics and Conventional Economics is that Experimental Economics studies human behavior.


Just as Behavioral Economics established the failures of classical economics in predicting certain economic patterns, Experimental Economics proved to be the final nail in the coffin for conventional theories. 

 

With experiments revealing human nature such as brand loyalty and marketing over product, the field became all the more vital to understanding economies.

 

(Suggested Read - Austrian Economics)

 

 

Areas where Experimental Economics is applied

 

Experimental Economics is the process of using experiments to test economic theory. Based on the theory tested, experiments are designed to prove or disprove the concept involved. The following areas are usually where Experimental Economies applies:

 

1. Coordination Games: Coordination Games are experiments designed to test the extent of cooperation between participants and the role of cooperation in an economic set up. It all calls upon concepts such as Pure Strategy( where an outcome depends on not only one player but others as well).

 

Coordination Games is based out of a modern economic concept called Game Theory. According to Stanford, Game theory is the study of the ways in which interacting choices of economic agents produce outcomes with respect to the preferences (or utilities) of those agents.
 

Game Theory is often used to explain concepts such as how Oligopolies function and the market mechanism. It is through game theory that the fundamental concept of Price is experimentally verified.
 

For example, if one trader is willing to accept 100 rupees for his good while a buyer is willing to pay 80, the concept of Nash Equilibrium helps explain the mean price that the two arrive at. A Nash equilibrium is the mean benefit that both parties can equally derive without detriment to the other.
 

Economists use Game Theory and explain concepts of market prices, rates where both parties can derive mutual benefit, and competition, where firms can chart areas of influence to mutual benefit.

 

1. Learning Experiments: Learning experiments refer to continual experiments done over a period of time to measure a participant’s response to new information and how that affects future interactions. Learning experiments primarily encompass two methods of learning- Belief learning and reinforcement learning.

 

Belief learning refers to the learning a participant acquires through interactions with another and the changes they make accordingly while reinforcement learning refers to the practice of making similar decisions as one had made in the past that gave high payoffs.

 

Both these concepts can explain various economic theories. Belief Learning is a vital component in promoting customer loyalty and is the basis for Customer Retention and Relationship Marketing. The better you treat a customer in the past, the more likely they are to reuse your product. 

 

(Speaking of Customer Retention, check out Customer Retention Marketing Strategies)

 

Reinforcement Learning is a vital part of both customer retention and Business to Business (B2B) dealings. It lies in the fundamental theory that if something made you happy before, it probably will make you happy again. 

 

Both concepts are part of Behavioral Economics and play a vital role in understanding the consumer psyche. Without studying them, no marketing team can hope to develop a reasonable, loyal and powerful consumer base.

 

3. Information experiments: This type of experiment refers to the regulation of information and its effects on the factors of supply, demand and various other macroeconomic concepts. It covers various fields and provides an analysis for the stock market among others.

 

One of the biggest areas where information is important is the Stock Market. Information about when a company is expanding, when a company is launching a new product are just a few of the cases where information can cause a stock to go up or to go down. 

 

For example, over the past ten years, everytime Apple has released a new Iphone, they have seen an uptick in stock value.

Another example would be Tesla stock in the NASDAQ which has risen over 700% during 2020. The cause for this abnormal increase in stock was due to various factors, chief among them being consistent profits. Company profits are displayed through annual reports. In this case, the information was freely available. 

 

(Recommended blog - AI in Tesla)

In both the above cases, it is evident that the presence of the information and not the act itself can be of economic importance and investors with early knowledge stand to make a killing.

During an Information experiment, Computer simulations or study groups are subject to Information Asymmetry, where a few people know more than the others. This gives economists conclusive proof of the economic value of information.

The same is the basis for laws regarding Insider Trading. Insider Trading refers to trading based on information obtained through inside sources in companies. 

 

For example, if an Apple employee were to invest into Apple using information obtained by virtue of being an employee, it would be insider trading. Such acts are now deemed illegal in most countries.
 

 

Notable studies on Experimental Economics

 

Experimental economics has been featured twice in the Nobel Prize for economics. The first case being in 2002 where Vernon Smith won the coveted award for his work on Experimental Economics and the second in 2019 where Abhijeet Bannerjee won the award for his work on Randomised Control Tests.

 

Vernon Smith’s approach to experiments was a huge breakthrough in two aspects. One, they were more accurate than any before and two, they provided actual incentives to participants. The two aspects are interrelated to each other as the incentive element that was previously not properly established in a lab had now been developed.

Another breakthrough in Vernon Smith’s approach was the detection of Adam Smith’s Invisible Hand. As part of Adam Smith’s economic theory, he proposed that the existence of a market equilibrium is due to a theory called the Invisible Hand. Prices automatically match the demand and thus goes out the market rate.

 

(Speaking of economic theory, check out Neoclassical Economics)

As Part of Vernon Smith’s experiments, this effect was demonstrated in his experiments on oral auctions. Where one producer offers his goods for sale to multiple buyers and vice versa. It was eventually observed that the goods reached a mean value thus proving Adam Smith’s market hand.

 

Abhijeet Bannerjee, on the other hand, used Experimental Economics in Poverty Alleviation. He, along with his team, developed a system known as the Randomised Control Tests to measure the efficacy of poverty alleviation programs in Africa.

His approach revolutionised policy making as by using a Control group against an experimental group, the difference between the two was quantified for the first time which proved to be a huge leap forward in the field of experimental economies.

 

 

Conclusion

 

Ultimately, Experimental Economics is a huge step forward in understanding economics better. The various benefits range from aiding policy makers in assessing the effects of their policies before it is released, to helping companies understand their target audience better. 

 

With increasing use of Experimental Economics, companies and countries alike stand to gain from practical understanding of theoretical concepts. However, Experimental Economics also comes with a caveat. 

 

An improperly designed experiment will result in a skewed result, therefore great care must be taken to maintain an ideal set up such that the concept can be properly executed.