What is Experimental Economics?

Experimental economics applies laboratory methods of inquiry to the study of motivated human interactive decision behavior in social contexts governed by explicit or implicit rules. The explicit rules may be defined by experimenter-controlled moves and information events, or the rules may be those at an auction or other market institution in which cash-motivated people buy or sell abstract rights (to consume or produce) commodities and services (e.g. transportation) within some particular technological context. Implicit rules are the norms, traditions and habits that people bring to the laboratory as part of their cultural and biological evolutionary heritage; they are not normally controlled by the experimenter. By devising and running markets and other exchange systems in the laboratory, and through the use of actual people, experimental economics helps us better understand why markets and social exchange systems work the way they do.

Quite generally we can think of experimental outcomes (the observed replicable order in final allocations) as the consequence of individual choice behavior, driven by the economic environment and mediated by the language and rules governing interactions supplied by the institution. The economic environment consists of agent preferences, knowledge, skill endowments, and resource constraints. Abstractly, institutions define the mapping from agent choice of messages (e.g., bids, asks, acceptances, words, actions) into outcomes. Under the operation of these rules, or of norms, people choose messages given the economic environment.  A well-established finding in experimental economics is that institutions matter because the rules matter, and the rules matter because incentives matter. But the incentives to which people respond are sometimes not those one would expect based on the canons of economic theory. It turns out that people are often better, and sometimes worse, at achieving gains for themselves and others than is predicted by standard forms of rational analysis. These contradictions provide important clues to the implicit rules that people may follow and can motivate new theoretical hypotheses for examination in the laboratory.

The design of experiments is motivated by two quite distinct concepts of a rational order.  Rejecting or denying either of these concepts should not be construed as irrational. Thus, if people in certain contexts choose outcomes yielding the smaller of two rewards, we ask why, rather than conclude that this is irrational.

The first concept of a rational order derives from today’s standard social-economic science model (SSSM) going back to the seventeenth century. The SSSM is an example of what Hayek has called, constructivist rationalism, which, in its modern forms and power, stems from Descartes, who believed and argued that all worthwhile social institutions were and should be created by conscious deductive processes of human reason.   For tractability, Cartesian rationalism provisionally requires agents to possess complete information - far more than could ever be given to one mind. In economics the resulting analytical exercises, while yielding insightful theorems, are designed to aid and sharpen thinking in the form of “if-then” parables. Yet, these exercises may not approximate the level of ignorance that has conditioned institutions, as abstract rules independent of particular parameterizations that have survived as part of the world of experience.

Our theories and thought processes about social systems involve the conscious and deliberate use of reason. Therefore, it is necessary to constantly remind ourselves that human activity is diffused and dominated by unconscious, autonomic, and neuropsychological systems that enable people to function effectively without always calling upon the brain’s scarcest resource: attention and reasoning circuitry. This is an important economizing property of how the brain works. These considerations lead to the second concept of a rational order, an undesigned ecological system that emerges out of cultural and biological evolutionary processes: home grown principles of action, norms, traditions, and morality. Thus, “the rules of morality…are not the conclusions of our reason.” According to Hume, who was concerned with the limits of reason and the boundedness of human understanding, rationality was phenomena that reason discovers in emergent institutions. Context matters because autobiographical experiential memory matters, and experiential memory matters because cultural and biological evolutionary processes matter. This is why context surfaces as a nontrivial treatment in small group experiments.

Adam Smith expressed the idea of emergent order in both The Wealth of Nations and The Theory of Moral Sentiments.  It is the antithesis of the Cartesian belief that if an observed social mechanism is functional, somebody in the unrecorded past must have used reason consciously to create it to serve its currently perceived intended purposes. In experimental economics the Scottish tradition is represented by the discovery of emergent order in numerous studies of existing market institutions such as the double auction. To paraphrase Adam Smith, people in these experiments are led to promote welfare enhancing social ends that are not part of their conscious intention.  This principle is supported by hundreds of experiments whose environments and institutions exceed the capacity of formal game theoretic analysis. But they do not exceed the functional capacity of collectives of incompletely informed human decision makers whose mental algorithms coordinate behavior through the rules of the institution--social algorithms--to generate high levels of measured performance. Acknowledging and recognizing the workings of unseen processes are essential to the growth of our understanding of social phenomena, and we must strive not to exclude them from our inquiry, if we have any hope of understanding data inside or outside of the laboratory.

Copyright © 2006 Vernon L. Smith and Bart J. Wilson