Experimental and Behavioral Economics

Ernst Fehr (Univ. of Zürich & MIT)

• Lecture takes place every Wednesday 4 – 7 pm, from September

8th 2003 – October 15th 2003

• Mini-course on z-Tree, one of the leading software packages in

experimental economics by Dr. Urs Fischbacher

• Mini-course takes place on Thursday September 18 – Friday

September 19 in 4 blocks of 3 hours each (exact details follow).

Ernst Fehr – Experimental & Behavioral Economics 1

 Experimental and Behavioral Economics -
Course Outline

• Lecture 1&2: Advantages and Limitations of Laboratory Experiments

• Lecture 3: Competitive Experimental Markets
• Lecture 4: Bargaining Behavior
• Lecture 5: Fairness and Competition
• Lecture 6: Voluntary Cooperation and Public Goods Provision
• Lecture 7: Theories of Fairness and Reciprocity
• Lecture 8: Enforcement of Social Norms
• Lecture 9: Behavioral Economics of Incentives and Contracts I
• Lecture 10: Behavioral Economics of Incentives and Contracts II
• Lecture 11: Loss Aversion and Labor Supply
• Lecture 12: The Economics of Money Illusion

Ernst Fehr – Experimental & Behavioral Economics 2

 Expected Performance

• Design an experiment including the writing of instructions and develop

behavioral predictions.
• This involves, among other things, answering the following questions:
o Which economic question do you want to answer with your
experiment?
o What are the potential answers to your question?
o What are the advantages and disadvantages of an experiment for
answering your question?
o What are the chances that the result of your experiment will
surprise others? Will anybody change his/her opionion?
o How do you conduct the experiment? (Describe the design and
write down the instructions)
o Is you design the simplest possible design to answer your
question?

Ernst Fehr – Experimental & Behavioral Economics 3

 Lecture 1&2: Advantages & Limitation of
Lab Experiments

• Experimental and behavioral economics

• An example – buying & selling in a market

• Advantages of lab experiments
• Objections to lab experiments
• Controlling Preferences: Induced-Value-Theory
• Objectives of lab experiments

Ernst Fehr – Experimental & Behavioral Economics 4

“One possible way of figuring out economic laws ... is by controlled
experiments. ... Economists (unfortunately )... cannot perform the
controlled experiments of chemists or biologists because they cannot
easily control other important factors. Like astronomers or meteorologists,
they generally must be content largely to observe.” (Samuelson and
Nordhaus, 1985, p. 8)

“Economic Theory, through a formal deductive system, provides the

basis for experimental abstraction and the experimental design, but
society in most cases carries out the experiment, .... Therefore, the
economic researcher observes the outcome of society’s experiment or
performance but has little or no impact on the experimental design and
the observations generated. Thus, by the passive nature of the data,
economic researchers are, to a large extent, restricted in their knowledge
search to the process of nonexperimental model building. ... the experiment
is outside the researcher’s control.”( “The Nonexperimental Model-
Building Restriction” in Judge et al. (1988))

Ernst Fehr – Experimental & Behavioral Economics 5

 2002: Vernon Smith and Daniel Kahneman
receive the Nobel Prize

• Vernon Smith: „for the use of laboratory experiments as a tool in

empirical economic analysis, in particular, for the study of different
market mechanisms“. Founder of experimental economics.
• Daniel Kahneman: „for the introduction of insights from
psychological research into economics, in particular with regard to
judgements and decisions under uncertainty“. Kahneman’s research is
based on psychological experiments and questionnaires. Founder of
behavioral economics.
• An Irony: In 1991 (JPE) Smith attacked Kahneman. His claim:
Anomalies at the individual level play no role at the aggregate level, in
particular, in competitive markets.

Ernst Fehr – Experimental & Behavioral Economics 6

 Experimental Economics (EE)

Happenstance Data Experimental Data

Field GDP Income Maintenance

Data Inflation Experiments
Incentive Experiments in
Firms
Lab Data Discovery of Penicillin Experimental Markets
Reciprocity & Contract Bargaining Experiments
Enforcement ...
Money Illusion, ...

Ernst Fehr – Experimental & Behavioral Economics 7

 Behavioral Economics (BE)

• PUP Series in behavioral economics

• Behavioral economics uses facts, models, and methods from

neighboring sciences to establish descriptively accurate findings about
human cognitive ability and social interaction and to explore the
implications of these findings for economic behavior. The most fertile
neighboring science in recent decades has been psychology, but
sociology, anthropology, biology, and other fields can usefully
influence economics as well. Behavioral economics is deeply rooted in
empirical findings or methods, and advances economics on its own
terms – generating theoretical insights, making more accurate
predictions of field phenomena, and suggesting better policy.

Ernst Fehr – Experimental & Behavioral Economics 8

 My Speculation

• Experimental economics is essentially a method of empirical

investigation. If successful the method will become a standard
instrument in economist‘s toolbox.
• Behavioral economics is concerned with importing relevant insights
from other disciplines to economics. Since, by definition, these
insights have so far been neglected, it is in opposition to mainstream
econ.
• There is only a limited number of insights from other disciplines that
are of first-order importance for economics. If these insights are
incorporated into mainstream economics BE ceases as a separate sub-
field in economics.

Ernst Fehr – Experimental & Behavioral Economics 9

 My Approach

• Use EE tools to study neurological, psychological and

sociological forces in important economic contexts.
Combination of EE and BE.

• In general, economists are mainly interested in the aggregate

outcomes of interactive games.

• Experiments are an excellent tool for studying how „neglected“

forces play out at the aggregate level.

Ernst Fehr – Experimental & Behavioral Economics 10

An Example: Buying and Selling on a Market
(Instructions)
• In the following experiment you are either a buyer or a seller. The
experiment is partitioned into periods. In total, there are 5-8 periods
and one period lasts 3 minutes. During the period each buyer can buy
at most one unit of the good and each seller can sell at most one unit of
the good. By buying and selling you can earn money.
• Each seller receives a sheet of paper with information about the unit
costs c of the good. If a seller sells at price p he earns p – c. If he sells
nothing his profit is zero.
• Each buyer receives a sheet of paper with information about the resale
value v of the good. If the buyer buys at price p he earns v - p. If he
buys nothing his profit is zero.
• p – c and v – p are the profits per period. In each period the same unit
costs and resale values prevail. Total profits are given by the sum of
profits over all periods.

Ernst Fehr – Experimental & Behavioral Economics 11

 Trading Rules (Double Auction)

• If a buyer wants to bid he raises his hand and announces: buyer xx

bids yy. As long as a buyer has not yet traded he can make as many
bids as he likes. The bids have to obey the improvement rule for
buyers – each bid must be higher than the highest prevailing bid.
• A seller who wants to make an ask raises her hand and announces:
seller xx demands yy. As long as a seller has not yet traded she can
make as many asks as she likes. The asks have to obey the
improvement rule for sellers - each ask must be lower than the lowest
prevailing ask.
• Each buyer can accept a seller‘s aks and each seller can accept a
buyer‘s bid. Acceptance leads to a binding contract. The other bids and
asks of accepting traders are no longer valid. Each subject who traded
once in a period cannot conclude any further contract in that period.

Ernst Fehr – Experimental & Behavioral Economics 12

 Competitive Predictions

Price

120 Supply
108
110
106 Prediction
100 97
92
- Price between 83 - 88
90 88 88 91
- # Trades: 6
83 83
78 80 - 91 and 80 do not trade
80
75
70 72
64 Maximal gains from trade:
60 124
50

40

30
Demand
20

10

Quantity
1 2 3 4 5 6 7 8

Ernst Fehr – Experimental & Behavioral Economics 13

 These predictions are not obvious!

Price
120
108
In principle, all potential
110
Demand 106 units could be traded so
100
92
97 that all subjects actually
88 88 91
90 83 83 trade.
80 80 78
75 Supply Prices could be very
72
70
64 different.
60
There is no full game
5
theoretic solution yet
40 available (though see
30 Sadrieh 2000).
20

10

Quantity
1 2 3 4 5 6 7

Ernst Fehr – Experimental & Behavioral Economics 14

 What did we learn?

• Competitive equilibrium prediction organizes the data well although

every trader is a price taker as well as a price maker and although there
is no auctioneer who limits trading to equilibrium trades.

• In general, prices are in the predicted interval.

• Efficiency is high.

• In general, only those who are predicted to trade do actually trade.

Ernst Fehr – Experimental & Behavioral Economics 16

 Components of an Experiment

• Environment:
o Preferences, technologies, initial endowment
o ...implemented by appropriate monetary incentives.
• Institution (Rules of the game)
o Feasible actions
o Sequence of actions
o Information conditions

o Lab experiments often (implicitly or explicitly) define a game. =>

Game theory and experimental economics are strongly related and
affect each other.
• Framing of instructions.

Ernst Fehr – Experimental & Behavioral Economics 17

 Advantages of (Lab) Experiments –
Enhanced Control
• Subjects are randomly assigned to the treatment conditions – rules out
selection bias.

• It is known which variables are exogenous and which are endogenous –

allows to make causal inferences.
o Does money cause output or does output cause money?

• Experimenter can make ceteris paribus changes in the exogenous variables –

allows for the isolation of true causes.

• Many variables that cannot be directly observed in the field can be observed
in the lab.
o Reservation wages, anticipated versus non-anticipated money supply
shocks.

Ernst Fehr – Experimental & Behavioral Economics 18

 Advantages - continued

• Informations conditions and exogenous stochastic processes can be

controlled.
o Important for the testing of models with asymmetric information.
o Are financial markets informationally efficient?
• Enhanced control opportunities often imply that the experimenter
knows the predicted equilibrium exactly.
o Equilibrium and disequilibrium actions can be explicitely
observed.
o Quick or sticky adjustment can be explicitly observed
o Example: What are the supply and demand schedules that underlie
observable price & quantity data? Is the observed price-quantity
combination a competitive equilibrium?

Ernst Fehr – Experimental & Behavioral Economics 19

 Advantages - continued

• Better direct controls are often a substitute for complicated

econometric methods.

• Replicability – provides the basis for statistical tests. Critics can run
their own experiments.

Ernst Fehr – Experimental & Behavioral Economics 20

 Lack of Control – an Illustration

• Question: Do employment and training programs increase mean annual

earnings of participants?

• Basic econometric problem: selection bias.

o More ambitious people participate (upwards bias).
o More optimistic people participate.
o Subjects with low earnings prospects participate (downwards bias).

• Solution: apply econometric techniques to control for selection bias.

Ernst Fehr – Experimental & Behavioral Economics 21

 Lack of Control – Lalonde AER 1986

• Take data from a controlled field experiment in which individuals are

randomly assigned to the treatment condition (“training”) and the control
condition (“no training”). Rules out selection bias.
• Exercise 1: Conduct a simple non-parametric test that compares the
average incomes in the two conditions.
• Exercise 2: Assume that you do not know that subjects are randomly
assigned. Apply econometric techniques to control for selection bias.
• Striking result:
“Even when the econometric estimates pass conventional
specification tests (designed to control for sample selection bias,
E.F.), they still fail to replicate the experimentally determined
results.” (p. 617)

Ernst Fehr – Experimental & Behavioral Economics 22

 Objections to Lab Experiments: Lack of
external validity
• Internal validity: Do the data permit causal inferences?
o Internal validity is a question of proper experimental controls and
correct data analysis.

• External validity: Can we generalize our inferences from the lab to the
field?
o Problem of induction: Behavioral regularities persist in new
situations as long as the relevant underlying conditions remain
essentially unchanged.
o Problem of representativity: Are experimental subjects
representative for out of sample applications?

Ernst Fehr – Experimental & Behavioral Economics 23

 Objections - Remarks on Induction

• For millenia the sun rises every morning. Yet, this does not allow you
to make the inference that tomorrow morning the sun will rise again.
Nevertheless, almost all people believe this. This confidence is the
essence of induction.
• No experiment and no other empirical result whatsoever can prove that
under the same circumstances the same regularities will prevail.
• Yet, if many experiments have shown that – given a certain set of
conditions – robust and replicable regularities emerge, we can have
faith that the same regularities will occur in reality given that the
conditions are met.
• Therefore, an honest sceptic who doubts the external validity of an
experiment, has to argue that the experiment does not capture
important conditions that prevail in reality.
• Response: Try to implement the neglected conditions.

Ernst Fehr – Experimental & Behavioral Economics 24

 Objections – Lack of Realism

• Lab experiments are unrealistic and artificial

• Most economic models are unrealistic in the sense that they leave out
many aspects of reality. However, the simplicity of a model or an
experiment is often a virtue because it enhances our understanding of
the interaction of relevant variables. This is particularly true at the
beginning of a research process.

• Whether realism is important depends on the purpose of the

experiment. Often the purpose is to test a theory or understanding the
failure of a theory. Then the evidence is important for theory building
but not for a direct understanding of reality.

Ernst Fehr – Experimental & Behavioral Economics 25

 Objections - continued

• Ch. Plott (1982, p. 1509): “The art of posing questions rests on an

ability to make the study of simple special cases relevant to an
understanding of the complex. General theories and models by
definition apply to all special cases. Therefore, general theories and
models should be expected to work in the special cases of laboratory
markets. As models fail to capture what is observed in the special
cases, they can be modified or rejected in light of experience. The
relevance of experimental methods is thereby established.”
• Ch. Plott (1982, p. 1482): “While laboratory processes are simple in
comparison to naturally occurring processes, they are real processes in
the sense that real people participate for real and substantial profits and
follow real rules in doing so. It is precisely because they are real that
they are interesting.”

Ernst Fehr – Experimental & Behavioral Economics 26

 Other Objections

• Participants are just students – lack of representativity

• The stakes are small
• The number of participants is small
• Participants are inexperienced

• Response
o Take other subject pools (workers, soldiers, CEOs)
o Conduct representative experiments (Fehr et al. 2003)
o Increase the stakes (Cameron EI 1999, Slonim & Roth Ectra 1997,
Fehr et al. 2002).
o Increase the number of participants (Isaac and Walker, J.Pub.E
1994)
o Invite experienced participants (Kagel&Levin, AER 1986)

Ernst Fehr – Experimental & Behavioral Economics 27

 Objections – General Remarks

• Whether the conditions implemented in the laboratory are also

present in reality will probably always be subject to some
uncertainty. Therefore, laboratory experiments are no substitute for
the analysis of field happenstance data, for the conduct and the
analysis of field experiments and survey data. This calls for a
combination of all these empirical methods.
• My strategy: Choose important unresolved debates in theoretical or
empirical economics and highlight the contested issues by rigorous
experiments (Examples: Gift Exchange Markets, Cooperation and
Punishment, Nominal Inertia, Relational Contracts)
• To be a good experimental economist you have to be a good
economist.

Ernst Fehr – Experimental & Behavioral Economics 28

 Controlling Preferences
(Induced Value Theory, Smith AER 1976)

• In many experiments the experimenter wants to control subjects

preferences. How can this be achieved?
• Subjects’ homegrown preferences must be “neutralized” and the
experimenter “induces” new preferences. Subjects’ actions should be
driven by the induced preferences.
• Use of money as a reward medium: ∆m denotes the subject’s money
earnings resulting from her actions in the experiment. m0 represents a
subject’s “outside” money. Total money holdings are m = (m0 + ∆m).
• Subject has unobservable preference
V(m0 + ∆m,z)
• z represents all other motives.

Ernst Fehr – Experimental & Behavioral Economics 29

 Controlling Preferences - Assumptions

1. Monotonicity: Vm exists and is strictly positive for any (m,z)-

combination.

2. Dominance: Changes in a subject’s utility from the experiment come

predominantly from ∆m. The influence of z is negligible.

• If monotonicity and dominance are met the experimenter has control

over the subjects’ preferences, i.e., subjects face economic incentives for
those actions that are paid and other motivators are negligible.

• A flat payment for participation in the experiment does not establish

control over preferences. This also holds for questionnaires.

Ernst Fehr – Experimental & Behavioral Economics 30

 Interpretation of z

• Boredom – experiments with hundreds of periods are problematic.

• public information about individual payoffs may render relative

comparison motives important (envy, fairness).

• Experimenter demand effects – Subjects want to help or hinder the

experimenter; they receive subtle hints what they should or are
expected to do.

• Solutions
o Make ∆m sufficiently large.
o Avoid public information about payoffs.
o Avoid any hints regarding the purpose of the experiments.
o Use neutral language in the instructions.

Ernst Fehr – Experimental & Behavioral Economics 31

 Illustration
• Experimenter wants to induce the utility function U(x,y) .
x: number of slips of red paper
y: number of slips of blue paper
• The experimenter pays subjects according to the final holdings of red and
blue paper slips. The monetary payoff function R(x,y) is identical to the
utility function U(x,y).
• Subjects have the following preference:
V(m0+U(x,y), z)
• Since the MRS between x and y under the utility function V is identical to
the MRS under the function U or R, respectively, V and U represent the
same preferences with regard to x and y.
MRSV = V1Ux/V1Uy = Ux/Uy = MRSU = Rx/Ry = MRSR

• Remark: Dominance ensures that z does not depend on x and y, i.e.,

homegrown preferences do not disturb induced preferences.

Ernst Fehr – Experimental & Behavioral Economics 32

 Purposes of Lab Experiments

1. Testing theories
2. Elicitation of preferences
Goods, risk, fairness, time
3. Exploring boundedly rational behavior
4. Establish empirical regularities as a basis for new theories
5. Theory free comparison of institutions
6. Wind tunnel experiments
7. Teaching experiments

Ernst Fehr – Experimental & Behavioral Economics 33

 1. Testing Theories

• Economic theory provides the basis for experimental abstraction

and experimental design .
• Implement those conditions of the theory (e.g. preference
assumptions, technology assumptions, institutional assumptions) that
you do not want to check. Comparison of the predictions with the
experimental outcome provides a test of those components of the
theory that are established through the subjects’ behavior.
• Attention: often this comparison is a joint test of several assumptions.
• When does the theory fail, when does it succeed?
• Design proper control treatments that allow causal inferences about
why the theory fails (example: bargaining experiments)

Ernst Fehr – Experimental & Behavioral Economics 34

 2. Elicitation of preferences

• How much money should be spent to avoid traffic accidents?

(involves risk preferences)
• How much money should be spent on protecting the natural
environment? (involves preferences for public goods)
• Should the government subsidize savings? (involves time
preferences)
• A nonarbitrary and nonpaternalistic answer to these questions
depends crucially on one’s view about how much people value the
above goods.
• Measuring people’s values requires a theory of individual
preferences and knowledge about the strength of particular
“motives” (preferences).
• This requires the testing of individual choice theories and
instruments for the elicitation of preferences.
Ernst Fehr – Experimental & Behavioral Economics 35
 3. Exploring Bounded Rationality

• Do people make systematic mistakes in risky decisions or

intertemporal choice?
• To what extent do people apply backwards inductions?
• How do people form beliefs about the behavior of others‘?
• Are people prone to money illusion?
• Above all: How does bounded rationality play out in strategic
games, i. e. to what extent does it affect aggregate outcomes?
• How and what do people learn?

Ernst Fehr – Experimental & Behavioral Economics 36

 4. Establish Empirical Regularities as a
Basis for New Theories

• Well established empirical regularities direct the theorists’ effort

and can help develop empirically relevant theories.

• Experimenter can implement important games for which no

game theoretic predictions exist because the analysis is too
complicated (example: double auction)

Ernst Fehr – Experimental & Behavioral Economics 37

 5. Theory Free Comparison of Institutions

• To learn something about the efficiency properties of institutions it is

not necessary to have a full theory that explains and predicts behavior
o Welfare measure: total money earnings of all subjects in the
experiment divided by the total earnings.

• Example: double auction versus one-sided continuous auction

• Check the robustness of institutions in different environments.

Ernst Fehr – Experimental & Behavioral Economics 38

 6. Wind Tunnel Experiments

• The great thing about economic theory is that one can examine
what would happen if one changed policies or implemented new
institutions.
• Does the reduction of entry barriers increase aggregate welfare?
• Which auctions generate the higher revenue for government securities?
• Do tradable emission permits allow efficient pollution control?
• How should airport slots be allocated?
• How can the market for hospital doctors be organized efficiently?
• Which institutions ensure an efficient provision of public goods?
• The great thing about economic experiments is that they allow us
to examine these questions empirically.

Ernst Fehr – Experimental & Behavioral Economics 39

 Clarification of Terms

• Experiment
9. May 2001 High cost Low cost
• Session = Experiment date 13:00
with a group of subjects.
9. May 2001 High cost Low cost
• Treatment = Experimental 16:00
condition (HC or LC)
9. June 2001 Low cost High cost
• (Cell)
14:00
• Subject = Participant
11. July 2001 Low cost High cost
13:00
12. July 2001 High cost
13:00
12. July 2001 Low cost
16:00

Ernst Fehr – Experimental & Behavioral Economics 40