BEEM109BEEM109Experimental Economics and Experimental Economics and

FinanceFinance20092009

Dieter BalkenborgDieter Balkenborg

Times and roomsTimes and rooms

Monday 11-13Monday 11-13 Friday 1-2Friday 1-2 Both in Xfi computer suiteBoth in Xfi computer suite I may want to use FEELE for some I may want to use FEELE for some

Finance and Game experiments Finance and Game experiments (Econport software does not run here.)(Econport software does not run here.)

FIVE lectures then your experiments FIVE lectures then your experiments and presentationsand presentations

Today’s lecture Today’s lecture

IntroductionIntroduction OrganizationOrganization How to run an experimentHow to run an experiment

Next lectureNext lecture

Markets 2Markets 2 Bertrand with complements / MonopolyBertrand with complements / Monopoly CournotCournot CollusionCollusion

Financial MarketsFinancial Markets

Further topicsFurther topics

Financial Market experimentsFinancial Market experiments Experiments in Game TheoryExperiments in Game Theory FairnessFairness NeuroeconomicsNeuroeconomics Anomalies in Decision making under Anomalies in Decision making under

uncertainty and behavioural finance uncertainty and behavioural finance

IntroductionIntroduction

Is economics a science?Is economics a science? The role model: physicsThe role model: physics

Main characteristics:Main characteristics: Rigid mathematical theoriesRigid mathematical theories Rigid experimentally testingRigid experimentally testing

Example: Galilei and the tower of PisaExample: Galilei and the tower of Pisa

s=-1/2ts=-1/2t22g, material not relevantg, material not relevant

And Economics?And Economics?

Rigorous mathematical models: Plenty!Rigorous mathematical models: Plenty! Core model: general equilibriumCore model: general equilibrium Conflict with institutionalists, example of Conflict with institutionalists, example of

economic historyeconomic history Empirical research: PlentyEmpirical research: Plenty

But it assumes rather than tests economic But it assumes rather than tests economic theory theory

Experiments:Experiments: A very recent developmentA very recent development

Need for experimentsNeed for experiments

Ways to evaluate theories: Ways to evaluate theories: plausibility, generality, predictive plausibility, generality, predictive successsuccess

Difficult to sort out cause and effect Difficult to sort out cause and effect when many factors change when many factors change simultaneouslysimultaneously

Arguments against Arguments against experimentsexperiments

Human behaviour not predictable Human behaviour not predictable because of their free willbecause of their free will

Laboratory situations do not capture Laboratory situations do not capture the real world (subjects are paid the real world (subjects are paid peanuts), but our models do.peanuts), but our models do.

Utility maximization is a tautologyUtility maximization is a tautology Utility is not the same as moneyUtility is not the same as moneyExperiments check the validity of Experiments check the validity of

argumentsarguments

Main ProblemMain Problem

Internal validityInternal validity External validityExternal validity

Applies to theory as well!Applies to theory as well!

PioneersPioneers

Chamberlain Chamberlain (Simon*: bounded rationality, satisficing, AI)(Simon*: bounded rationality, satisficing, AI) Nash* / Milnor, RandNash* / Milnor, Rand Sauermann / Selten*Sauermann / Selten* Smith* / PlotSmith* / Plot Allais*Allais* Kahneman* / TverskiKahneman* / Tverski Fouraker / SiegelFouraker / Siegel

How to conduct experimental How to conduct experimental researchresearch

Get an ideaGet an idea read the literature, but not too muchread the literature, but not too much

Get moneyGet money Design the experiment. Design the experiment.

What is the hypothesis to be tested? What is the hypothesis to be tested? Model the situation (like a mathematical Model the situation (like a mathematical

model)model) Simplicity over realismSimplicity over realism Arbitrary design decisionsArbitrary design decisions Programming / PresentationProgramming / Presentation Instructions: words can matterInstructions: words can matter

How to conduct experimental How to conduct experimental researchresearch

Sufficiently many repetitions / budgetSufficiently many repetitions / budget HonestyHonesty

Run pilot: back to the drawing board?Run pilot: back to the drawing board? Recruit subjectsRecruit subjects Run sessions (handrun / computerized)Run sessions (handrun / computerized) Pay subjectsPay subjects Prepare data for evaluationPrepare data for evaluation Evaluate beyond initial hypothesis. Data Evaluate beyond initial hypothesis. Data

study vs econometrics, Statistical methodsstudy vs econometrics, Statistical methods Find theoretical explanation.Find theoretical explanation.

Schools of thought Schools of thought (parody?)(parody?)

Read Selten (1991) on various positionsRead Selten (1991) on various positions Neoclassical economist / BayesianNeoclassical economist / Bayesian

Economics relies on very few psychological Economics relies on very few psychological assumptions which are self-evidently true. Hence assumptions which are self-evidently true. Hence there is not need to conduct experiments or to there is not need to conduct experiments or to change economics whenever there is a new fad change economics whenever there is a new fad in psychology. (Robbins)in psychology. (Robbins)

The neoclassical experimentalistThe neoclassical experimentalist Behavioural anomalies are short-run phenomena Behavioural anomalies are short-run phenomena

which vanish if people have the opportunity to which vanish if people have the opportunity to learn from mistakes and if the experiment is learn from mistakes and if the experiment is properly designed. (Binmore, Smith?)properly designed. (Binmore, Smith?)

Schools of thoughtSchools of thought

Behavioural economist (Fehr / Schmid / Behavioural economist (Fehr / Schmid / Camerer)Camerer) Adjust utility theory such that it fits data better Adjust utility theory such that it fits data better

(fairness) (fairness) Behavioural Finance (Thaler, Schleifer)Behavioural Finance (Thaler, Schleifer)

Find anomalies and behavioural biases in Find anomalies and behavioural biases in financial data which allow you to make moneyfinancial data which allow you to make money

Bounded Rationality / Cognitive Bounded Rationality / Cognitive psychology (Simon / Selten)psychology (Simon / Selten) Procedural models of thinkingProcedural models of thinking ““Bottom up” process of modellingBottom up” process of modelling

LiteratureLiterature

Friedman SunderFriedman Sunder GualaGuala Holt, Ch 1Holt, Ch 1 SeltenSelten

Let us run an experiment!Let us run an experiment!

Open web browserOpen web browser Type “FEELE kiosk” in search box top Type “FEELE kiosk” in search box top

rightright Etc.Etc. Experiment: Roise Nagel’s guessing Experiment: Roise Nagel’s guessing

gamegame

How to run an experimentHow to run an experiment

1.1. PurposePurpose2.2. DesignDesign3.3. SubjectsSubjects4.4. Instructions, test roundsInstructions, test rounds5.5. PilotsPilots6.6. RecruitmentRecruitment7.7. PaymentsPayments8.8. Statistical evaluationStatistical evaluation

Purpose (Roth)Purpose (Roth)

Speaking to theoristsSpeaking to theorists Forward vs backward inductionForward vs backward induction

Searching for factsSearching for facts Are economics students different?Are economics students different?

Whispering in the ears of princessWhispering in the ears of princess Roth and kidney exchangeRoth and kidney exchange Test bed, wind channel, Grether and Plott: Test bed, wind channel, Grether and Plott:

testing existing market instututionstesting existing market instututions Which hypothesis do you want to test?Which hypothesis do you want to test?

Design of a sessionDesign of a session

Simplicity, transparency and control vs Simplicity, transparency and control vs realismrealism Internal vs external validityInternal vs external validity

Game character Game character Time limitTime limit ““independent observations”independent observations” Learning vs one-shot games, repetitions, Learning vs one-shot games, repetitions,

which do count?which do count? HonestyHonesty PaymentPayment No need to use computers!No need to use computers!

Design of an experimentDesign of an experiment

HOW MANY SESSIONS?HOW MANY SESSIONS? BUDGET CONSTRAINT!BUDGET CONSTRAINT! Focus vs nuisance variablesFocus vs nuisance variables Treatment variablesTreatment variables Keeping nuisance variables constant Keeping nuisance variables constant Randomization designRandomization design Block designBlock design Fractional factorial designFractional factorial design Double blind experimentsDouble blind experiments Within subject designWithin subject design Ensure that enough subjects show up on time!Ensure that enough subjects show up on time!

Subjects and roomSubjects and room

Typically: studentsTypically: students ““Practitioners” will bring their Practitioners” will bring their

experience to the labexperience to the lab Don’t pay executives!Don’t pay executives! ““field” experimentsfield” experiments Prevent uncontrolled communication Prevent uncontrolled communication

and exchange of information (video and exchange of information (video experiments)experiments)

Instructions, test roundsInstructions, test rounds

The biggest bore, necessary like in a new The biggest bore, necessary like in a new parlour game parlour game

Clarity of instructions is crucial Clarity of instructions is crucial Avoid jargon, misinterpretations, allusions to Avoid jargon, misinterpretations, allusions to

the real worldthe real world Foreign languagesForeign languages Don’t bias subjects by giving away the Don’t bias subjects by giving away the

purpose of the experiment! purpose of the experiment! Test questionsTest questions Test roundsTest rounds

Pilot sessionsPilot sessions

Necessary to check for bugs, both in Necessary to check for bugs, both in software, design and instructionssoftware, design and instructions TyposTypos Incorrect implementationIncorrect implementation How expensive will it get?How expensive will it get? Time length.Time length.

RecruitmentRecruitment

Now all computerized, we get our Now all computerized, we get our experiments filled within hoursexperiments filled within hours

Possibility to restrict access to Possibility to restrict access to certain groupscertain groups

PaymentsPayments

Payment = money Payment = money Payoff = utilityPayoff = utility Controlling for risk aversion (Roth, Controlling for risk aversion (Roth,

Malouf), “irrational” risk avoidanceMalouf), “irrational” risk avoidance Controlling for fairness and spite Controlling for fairness and spite Not every round has to be paidNot every round has to be paid Keep it secret!Keep it secret!

Statistical evaluationStatistical evaluation

Descriptive statisticsDescriptive statistics Often there are no established theories or Often there are no established theories or

these are themselves in questionthese are themselves in question Keep it simple, use non-parametric statistics: Keep it simple, use non-parametric statistics:

Binomial test, sign test, Wilcoxen test, Fisher Binomial test, sign test, Wilcoxen test, Fisher test, Spearman’s rank correlation testtest, Spearman’s rank correlation test

All parametric and econometric tests have All parametric and econometric tests have many more auxiliary assumptions, also many more auxiliary assumptions, also probit and logit approachesprobit and logit approaches

Testing initial hypotheses vs generating new Testing initial hypotheses vs generating new knowledge.knowledge.

Suggestions for Suggestions for ExperimentsExperiments

1.1. Network Externalities. Network Externalities. 2.2. Insurance.Insurance.3.3. Bubble experiment.Bubble experiment.4.4. 2x2 games2x2 games5.5. Hold up problemHold up problem6.6. Sports DraftSports Draft7.7. (Mini) ultimatum games / Dictator games / (Mini) ultimatum games / Dictator games /

reciprocityreciprocity8.8. Bank Runs. Bank Runs. 9.9. Signalling. Signalling. 10.10. Bertrand Complements.Bertrand Complements.11.11. Cournot MarketCournot Market12.12. Behavioural Biases / AnomaliesBehavioural Biases / Anomalies13.13. Cascade experimentCascade experiment14.14. Public Good/PD. Public Good/PD.