V. Smith, (1994). "Economics in the Laboratory," Journal of Economic Perspectives 8(1), 113-131.

By Vernon Smith

Why do economists conduct experiments? To answer that question, it is first necessary briefly to specify the ingredients of an experiment. Every laboratory experiment is defined by an environment, specifying the initial endowments, preferences and costs that motivate exchange. This environment is controlled using monetary rewards to induce the desired specific value/cost configuration (Smith, 1991, 6).1 An experiment also uses an institution defining the language (messages) of market communication (bids, offers, acceptances), the rules that govern the exchange of information, and the rules under which messages become binding contracts. This institution is defined by the experimental instructions which describe the messages and procedures of the market, which are most often computer controlled. Finally, there is the observed behavior of the participants in the experiments as a function of the environment and institution that constitute the controlled variables.

 

 

V. Smith, (1987) V. Smith, (1982). "Microeconomic Systems as an Experimental Science," American Economic Review 72(5), 923-955.atwell, Murray Milgate, and Peter Newman, reproduced with permission of Palgrave.

By Vernon Smith

Historically, the method and subject matter of economics have presupposed that it was a non-experimental (or 'field observational') science more like astronomy or meteorology than physics or chemistry. Based on general, introspectively 'plausible', assumptions about human preferences, and about the cost and technology based supply response of producers, economists have sought to understand the functioning of economies, using observations generated by economic outcomes realized over time. The data of the astronomer is of this same type, but it would be wrong to conclude that astronomy and economics are methodologically equivalent. There are two important differences between astronomy and economics which help to illuminate some of the methodological problems of economics. First, based upon parallelism (maintained hypotheisis that the same physical laws hold everywhere), astronomy draws on all the relevant theory from classical mechanics and particle physics -- theory which has evolved under rigorous laboratory tests. Traditionally, economists have not had an analogous body of tested behavioural principles that have survived controlled experimental tests, and which can be assumed to apply with insignificant error to the microeconomic behaviour that underpins the observable operations of the economy. Analogously, one might have supposed that there would have arisen an important area of common interest between economics and, say, experimental psychology, similar to that between astronomy and physics, but this has only started to develop in recent years.

 

V. Smith, (1982). "Microeconomic Systems as an Experimental Science," American Economic Review 72(5), 923-955.

By Vernon Smith

The experimental literature contains only a few attempts to articulate a "theory" of laboratory experiments in economics (Charles Plott, 1979; Louis Wilde, 1980; my articles, 1976a, pp. 43-44, 46-47; 1976b; 1980). It is appropriate for this effort to have been modest, since it has been more important for experimentalists to present a rich variety of examples of their work than abstract explanations of why one might perform experiments. Wilde's contribution provides an integration and extension of earlier papers, and brings a fresh perspective and coherence that invites further examination. This seems to be the time and place to attempt a more complete description of the methodology and function of experiments in microeconomics.

 

 

Daniel Kahneman and Amos Tversky(1979). "Prospect Theory: An Analysis of Decision under Risk", Econometrica, Vol. 47, No. 2, (Mar., 1979), pp. 263-291

By Daniel Kahneman

This paper presents a critique of expected utility theory as a descriptive model of decision making under risk, and develops an alternative model, called prospect theory. Choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory. In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This tendency, called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses. In addition, people generally discard components that are shared by all prospects under consideration. This tendency, called the isolation effect, leads to inconsistent preferences when the same choice is presented in different forms. An alternative theory of choice is developed, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights. The value function is normally concave for gains, commonly convex for losses, and is generally steeper for losses than for gains. Decision weights are generally lower than the corresponding probabilities, except in the range of low prob-abilities. Overweighting of low probabilities may contribute to the attractiveness of both insurance and gambling.

 

 

Amos Tversky, Paul Slovic, Daniel Kahneman(1990). “The Causes of Preference Reversal”, The American Economic Review, Vol. 80, No. 1, (Mar., 1990), pp. 204-217

By Daniel Kahneman

Observed preference reversal (PR) cannot be adequately explained by violations of independence, the reduction axiom, or transitivity. The primary cause of PR is the failure of procedure invariance, especially the overpricing of low-probability high-payoff bets. This result violates regret theory and generalized (nonindepen-dent) utility models. PR and a new reversal involving time preferences are explained by scale compatibility, which implies that payoffs are weighted more heavily in pricing than in choice.