Experimental Economics: An overview and methodological issues by

1. Experimental Economics: An overview and methodological issues by Ragupathy V Madras school of Economics

2. What is Experimental Economics? • Experimental economics is the use of experimental methods to evaluate theoretical predictions of economic behaviour. • It uses controlled, scientifically-designed experiments to test economic theories under laboratory conditions

3. Why experimental economics • - Historical perception: Economics- Non experimental like Astronomy or Meteorology rather than physics or chemistry • - Essential difference- parallelism(hypothesis that same laws hold everywhere) • - Economists do not have a analogous body of tested behavioural principles that have survived controlled experiments • - Credibility of the data collected in economics, need to have reliable data

4. Replicability and control – two ways of reducing errors in our common knowledge of economic processes • - Do you observe what I observe? • - Do you interpret what we observe as I interpret it? • - Do you conclude what I conclude from our interpretation?

5. Vernon Smith – Nobel winner 2002

6. Unraveling in guessing games: an experimental studyRosemarie Nagel(1995) Vol 85, No 5, Dec,AER. • Description of the game : • Conventional game theoretic prediction: Unique Nash equilibrium both in single shot games and repeated games- dominant strategy value: zero • Backward induction • Do we decide this way? • Do player’s mental process incorporate the behavior of other players in conscious reasoning? • Zero, first and second order beliefs

7. Model of bounded rationality • Reference point 50 or 100. • Results: Deviations • Similarity to travelers dilemma game

8. Stackelberg vs Cournot: • Important implication of Stackelberg model is that it improves mkt eff. • Sequential moves are preferred to simultaneous move Cournot Markets. • Intuition: Holding the number of firms constant- aggregate output increases. Aggregate total welfare also increases. • So the idea is to whether observed efficiency relations resemble the theoretically predicted ones.

9. Experiment Design: • Questions : • Will Stackelberg markets yield higher ouputs at lower process compared to Cournot markets thus increasing total welfare? • Do we replicate earlier results of empirical cournot duopolies i.e. static Nash equilibrium Play for random matching and partial collusion for fixed pairs? • ANS: yes! Ref: Steffen Huck, Muller, and Theo Normann (2000)

10. Affect Framing in Joint and Separate Evaluation of Alternatives • cognitive load, affect framing and the evaluation mode were found to influence the attractiveness and affective reactions toward a stimulus. • . It is possible that individuals judge the same alternative as more attractive and affectively more positive when it is paired with an easier to judge alternative rather than evaluating it separately • Preference inconsistency!! • invariance principle: According to this principle, different but logically equivalent descriptions of the options should not influence the final choice and different, but equivalent, procedures used to elicit the preferences should lead to the same results

11. Economic theories of choice affirm that rational agents have stable preferences, consistent with the invariance principle • According to this principle, different but logically equivalent descriptions of the options should not influence the final choice and different, but equivalent, procedures used to elicit the preferences should lead to the same results.

12. Hsee (1996) proposed the “evaluability hypothesis”. • The evaluability hypothesis states that some attributes are easy to evaluate in SE, while other attributes are more difficult to evaluate independently. • As a consequence, easy-to-evaluate attributes have more impact than difficult-to-evaluate attributes in SE. • However, in JE it is possible to compare one option to the other and, doing this, difficult-to-evaluate attributes become easier to judge than in SE

13. model of contingent decision, which has the aim of describing how people select strategies to solve decision problems characterized by different levels of complexity • Stimuli could be described differently stating the positive features characterizing them or stating the negative features that do not characterize them. We will refer to these alternative descriptions of the same object as “affect framing”.

14. The hypotheses of Experiment 1 were the following: H1: In JE options described by the positive framing should be rated as significantly more attractive than those described by the non-negative frame. H2: If the non-negative framing is evaluated in SE then its attractiveness should be judged significantly higher than in JE. At the same time, in SE the attractiveness of the two frames should be judged as not significantly different.

15. The positive framing was created by telling people that an option “x” had some positive features (e.g., a cereal brand, which is characterized by having low carb), while the non-negative framing was induced saying that an option “y” did not have some negative features (e.g., a cereal brand, which is not characterized by having high carb). • Participants rated the attractiveness of the options on a 9-point scale ranging from - 4 to 4 • JE the rating of attractiveness given to the positively framed cereal brand was much higher than that given to the non-negative frame.

16. Results The importance of the environment in which the decisions are made being a important factor in determining preferences.

17. Neuroeconomics • Neural basis of economic decision in Ultimatum games: • Standard economic models of human decision making (such as utility theory) have typically minimized or ignored the influence of emotions on people’s decision-making behavior, idealizing the decision-maker as a perfectly rational cognitive machine – homo economicus • behavioral economists- identified additional psychological and emotional factors that influence decision-making and • Recently researchers have begun using neuroimaging to examine behavior in economic games

18. Neural basis of economic decision in Ultimatum games • In the Ultimatum Game, two players are given the opportunity to split a sum of money. • One player is deemed the proposer and the other, the responder. • The proposer makes an offer as to how this money should be split between the two. The second player (the responder) can either accept or reject this offer. • If it is accepted, the money is split as proposed, but if the responder rejects the offer, then neither player receives anything.

19. .. Neural basis of • The standard economic solution to the Ultimatum Game is for the proposer to offer the smallest sum of money possible to the responder and for the responder to accept this offer, on the reasonable grounds that any monetary amount is preferable to none. • But what does the experimental results show?

20. Neural basis of… • functional magnetic resonance imaging of Ultimatum Game players to investigate neural substrates of cognitive and emotional processes involved in economic decision-making. • In this game, two players split a sum of money;one player proposes a division and the other can accept or reject this. • players are scanned when they responded to fair and unfair proposals.

22. Neural basis of… • The rounds were presented randomly, and all involved splitting $10. Half of these offers were fair, that is, a proposal to split the $10 evenly ($5:$5), with the remaining half proposing unequal splits (two offers of $9:$1, two offers of $8:$2, and one offer of $7:$3). • Among the areas showing greater activationfor unfair compared with fair offers from human partners were bilateral anterior insula, dorsolateral prefrontal cortex (DLPFC), and anterior cingulate cortex (ACC). • Regions of bilateral anterior insula demonstrated sensitivity to the degree of unfairness of an offer,exhibiting significantly greater activation for a $9:$1 offer than an $8:$2 offer from a human partner

23. Neural basis of…. • Activation of bilateral anterior insula to unfair offers from human partners - This region’s oft-noted association with negative emotional states. • Anterior insula (associated with disgust) activated by an unfair offer provide additional support for the hypothesis that neural representations of emotional states guide human decision-making. • DLPFC usually has been linked to cognitive processes such as goal maintenance and executive control

24. Neural basis of… • DLPFC activation observed in response to unfair offers may relate to the representation and active maintenance of the cognitive demands of the task, namely the goal of accumulating as much money as possible • the hypothesis that this region may be competing with emotional areas in influencing the decision,balancing between activation in anterior insula and DLPFC for unfair offers. • Unfair offers that are subsequently rejected have greater anterior insula than DLPFC activation, whereas accepted offers exhibit greater DLPFC than anterior insula

25. Neural basis of… Results: • Unfair offers elicited activity in brain areas related to both emotion (anterior insula) and cognition (Dorso Lateral Prefrontal Cortex). • Further, significantly heightened activity in anterior insula for rejected unfair offers - important role for emotions in decision-making. • direct empirical support for economic models that acknowledge the influence of emotional factors on decision-making behavior • Models of decision-making cannot afford to ignore emotion as a vital and dynamic component

26. The bigger question on the philosophy behind the field of experimental economics:Is it aiming at falisification or verification of the existing theories? • General methodology: • Incentivize subjects with real monetary payoffs. • Publish full experimental instructions. • Do not use deception. • Avoid introducing specific, concrete context

27. Methodological Issues: • Experimenters’ Choices of Trust Experiments(Friedel Bolle and Jessica Kaehler) • Coleman’s hypothesis: In order to trust, the value of trust has to be larger than the value of mistrust. (The valueof mistrust is usually equal to an outside option which can be earned with certainty) • Alternative hypothesis: unreflective trust (neglect of risk due to naivity or cognitive dissonance), trust based on affect, trust based on routinized behaviour, and trust based on a default or norm. • We expect that the frequency of trust increases with the net profitability of trust.

28. Meta experiment and the results:

29. Meta experiment and the results:

30. Selection bias in trust experiments: • Krueger and Funder (2004) complain about researchers’ concentration on “negative results” in Social Psychology. This is a fundamental critic which accuses the mainstream research strategies of supporting ” … frequently erroneous imputations of errors, finding of mutually contradictory errors, incoherent interpretations of error, an inability to explain the sources of behavioural or cognitiveachievement, and the inhibition of generalised theory.

31. Real monetary incentives, its magnitude and its impact on outcomes: • A small Exercise

32. Methodological Issues: • What to report and What not to to? • Problems of generalization • Sample contamination • Randomization

33. Induction Vs deduction: • Deductive reasoning is reasoning in which the conclusion is necessitated by, or reached from, previously known facts. If the premises are true, the conclusion must be true. • Inductive reasoning, where the premises may predict a high probability of the conclusion, but do not ensure that the conclusion is true • How reliable are these deductive results?

34. Questions!