Laboratory experimentation in economics Laboratory experimentation in economics Six points of view Edited by ALVIN E. ROTH University of Pittsburgh T/ie r/gA/ o/ the University of Cambridge to print and sell all manner of books was granted by Henry VIII in 1534. The University has printed and published continuously since 1584. CAMBRIDGE UNIVERSITY PRESS Cambridge New York New Rochelle Melbourne Sydney CAMBRIDGE UNIVERSITY PRESS Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, Sao Paulo Cambridge University Press The Edinburgh Building, Cambridge CB2 2RU, UK Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9780521333924 © Cambridge University Press 1987 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 1987 This digitally printed first paperback version 2005 A catalogue record for this publication is available from the British Library Library of Congress Cataloguing in Publication data Laboratory experimentation in economics. 1. Economics - Experiments. I. Roth, Alvin E., 1951- HB131.L32 1987 330'.0724 87-10343 ISBN-13 978-0-521-33392-4 hardback ISBN-10 0-521-33392-X hardback ISBN-13 978-0-521-02281-1 paperback ISBN-10 0-521-02281-9 paperback Contents Acknowledgments page vii List of contributors viii 1 Introduction and overview 1 Alvin E. Roth 2 Bargaining phenomena and bargaining theory 14 Alvin E. Roth 3 Equity and coalition bargaining in experimental three-person games 42 Reinhard Selten 4 The psychology of choice and the assumptions of economics 99 Richard Thaler 5 Hypothetical valuations and preference reversals in the context of asset trading 131 Marc Knez and Vernon L. Smith 6 Economics according to the rats (and pigeons too): what have we learned and what can we hope to learn? 155 John H. Kagel 7 Dimensions of parallelism: some policy applications of experimental methods 193 Charles R. Plott Acknowledgments The chapters in this volume were commissioned following a confer- ence entitled "Laboratory Experimentation in Economics" at the University of Pittsburgh on May 16-18, 1985. I particularly want to thank President Wesley Posvar, Dean Jerome Rosenberg, and my colleague Professor Jack Ochs, all of the University of Pittsburgh, whose support was invaluable. vn Contributors JOHN H. KAGEL is Professor of Economics and Director of the Center for Experimental Economics at the University of Houston. He re- ceived his Ph.D. from Purdue University in 1970. He has been a National Fellow at the Hoover Institution and an Earhart Foundation Fellow. MARC KNEZ is a graduate student at the University of Pennsylvania. He began his collaboration with Vernon Smith when he was at the University of Arizona. CHARLES R. PLOTT is Professor of Economics and Director of the Program for the Study of Enterprise at the California Institute of Technology. He received his Ph.D. from the University of Virginia in 1965. He has been a Guggenheim Fellow and a Fellow at the Center for Advanced Study in the Behavioral Sciences and is a Fellow of the A A AS and the Econometric Society. ALVIN E. ROTH is A. W. Mellon Professor of Economics at the University of Pittsburgh. He received his Ph.D. from Stanford Univer- sity in 1974. He received the 1980 Founders' Prize of the Texas Instruments Foundation, has been a Guggenheim Fellow and an Alfred P. Sloan Research Fellow, and is a Fellow of the Econometric Society. REINHARD SELTEN is Professor of Economics at the University of Bonn in the Federal Republic of Germany. He received his Ph.D. in mathematics from the University of Frankfurt in 1961 and his habilita- tion in economics, also from the University of Frankfurt, in 1968. He is a member of the Northrhine-Westfalian Academy of Sciences and a Fellow of the Econometric Society. VERNON L. SMITH is Professor of Economics and Research Director, Economic Science Laboratory at the University of Arizona. He received his B.S.E.E. from the California Institute of Technology in 1949 and his Ph.D. in economics from Harvard University in 1955. He has been a Ford Foundation Fellow, Fellow at the Center for Ad- viii Contributors ix vanced Studies in the Behavioral Sciences, and Sherman Fairchild Distinguished Fellow (California Institute of Technology). RICHARD THALER is Professor of Economics at Cornell University's Johnson Graduate School of Management. He received his Ph.D. from the University of Rochester in 1974. He has been a visiting scholar at the National Bureau of Economic Research in Stanford, California, and a visiting professor at the University of British Columbia. CHAPTER 1 Introduction and overview ALVIN E. ROTH Each of the chapters in this volume concerns some aspect of econo- mists' use of controlled experiments. Since the mid-1970s this kind of work has been transformed from a seldom encountered curiosity to a small but well-established and growing part of the economic literature. This transformation has been rapid. For example, when I began my own experimental work about a dozen years ago, it was most conve- nient to publish the results in journals of psychology and business. Today it is no longer unusual for controlled experiments to be reported in any of the major American economics journals. Experimental work has become well enough represented in the literature so that, in 1985, the Journal of Economic Literature established a separate bibli- ographic category, "Experimental Economic Methods." However, as might be expected of any newly developing field of scientific endeavor, there are at least as many points of view about the role of experiments in economics as there are economists who conduct them. One of the reasons for this is that "economics" encompasses quite a diversity of activities and methodologies, and controlled experimentation appears to have the potential to play at least a supporting role, and in some cases a far larger part, in many of these. At the time that I was organizing the conference that led to the publication of this volume, I was preparing a paper on experimental economics to present at one of the symposia of the Fifth World Congress of the Econometric Society, which was held in the summer of 1985. (World congresses are held every five years and are organized around a group of symposia on significant recent advances. A sign of the times, and of the distance experimental economics has come in so short a time, is the fact that this was the first such symposium to be devoted to experimentation.) In that paper (Roth, 1985) I tried to organize some of the experiments that have been conducted by classifying them according to the kinds of dialogues they were a part of, that is, according to how they were motivated and who they were 2 Alvin E. Roth trying to persuade. Although it became increasingly evident that no classification scheme would be adequate to the task of demonstrating the relationships as well as the differences between different bodies of work, I organized the paper around three principal kinds of dialogues, which I referred to as "Speaking to Theorists," "Searching for Facts," and "Whispering in the Ears of Princes." The category "Speaking to Theorists" was meant to include exper- iments motivated by well-articulated formal theories. These experi- ments are designed to test the predictions of those theories, as well as to reveal unpredicted regularities, in a controlled environment where observations can be unambiguously interpreted in relation to theory and incorporated if necessary into the construction of new theory. The requirement that the observations be interpretable in relation to a particular theory or group of theories imposes constraints on the experimental designs that are perhaps the chief characteristic of these experiments. Such experiments are typically motivated by the theoret- ical literature and are intended to feed back into that literature; that is, they are part of a dialogue between experimenters and theorists. The category "Searching for Facts" includes experiments on the effects of variables about which existing theory may have little to say. These experiments are consequently often designed without reference to a specific body of theory, but might be motivated instead by some interesting unexplained phenomenon. They tend to be part of the dialogue that experimenters carry on with one another, and indeed many experiments of this sort are designed to help us understand earlier experimental observations. The category "Whispering in the Ears of Princes" deals with the dialogue between experimenters and policymakers. These experiments might be motivated, for example, by questions raised by government regulatory agencies about the effect of changes in the organization of some market. Their characteristic feature is that the experimental environment is designed to resemble closely the natural environment that is the focus of the policy question at hand. In my symposium paper, I wrote, "These investigations offer the possibility of bringing scientific methods to bear on one of the traditional nonscientific vocations of economists, which is whispering in the ears of princes who require advice about pressing practical questions whose answers lie beyond the reliable scientific knowledge of the profession." Although these categories seem useful for distinguishing different kinds of work, most extended experimental studies cannot be confined to a single category. Experiments that test formal theories may identify unanticipated phenomena for which existing theory offers no explana- Introduction and overview 3 tion and suggest other experiments designed to reveal more about those phenomena. Experiments that are not motivated primarily by theoretical considerations may eventually lead to the construction of new theories and to further experiments that test them. And experi- ments that are motivated by questions of policy may nevertheless have some (perhaps informal) theoretical motivation and may uncover empirical regularities that require further experimentation.