davis and holt-experimental economics

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Book reviews

411

market to lighten the tone. All these factors make this a book for a hard chair, not an easy

chair.

With these caveats, the book repays a careful reading, especially of the first five

chapters plus a few additional chapters in areas of your interest. The stylized facts

themselves are worth the effort. In addition, the author has organized our thinking about

dynamics, both in his classification system and in his methodology. No one can read this

book without feeling challenged to explain in a paper of his own at least one of his

observations.

Steven C. Michael

George Mason University, Fai x, VA, USA

PII SOl67-2681(96)00813-X

Douglas D. Davis and Charles A. Holt, Experimental Economics (Princeton University

Press, Princeton, 1993), pp xi+57 1.

The use of laboratory experiments in economics is a rapidly growing phenomenon. It

was only ten years ago that the Econometric Society devoted its first symposium on

significant recent advances in Economics to experimentation, (Roth 1985, 1987). The

publication of Experimental Economics marks an important step in the transition of

laboratory experimentation from an exploratory technique, used by relatively few

economists, to incorporation into the standard toolbox of the profession.

In this ambitious work, Douglas Davis and Charles Holt set out to bring an

appreciation for both the methods of experimentation and the results of a large body of

experimental work from the academic journals down to the level of the advanced

undergraduate. The book is organized in part as a primer and in part as a review of many

contributions of experimental research to economics. As such, it is well-suited as a

principal text for use in an advanced undergraduate seminar on experimentation in

economics. Various chapters in the text may also be profitably used in such standard

economics courses as industrial organization and public finance to introduce students to

relevant experimental literature. The professional economist who is looking for an

introduction to experimental methods will find one here.

In chapter one Davis and Holt discuss the basic rationale for the use of laboratory

experiments by economists. They describe the kinds of experiments that economists have

conducted. They articulate a set of procedural and design questions that every

experimenter must address and to which every reader of a report of an experiment

should be attentive. The rationale for experimentation is straightforward. Historically,

economics has paid little attention to the detailed structure of the institutions through

which economic agents interact, focusing instead on the effects of such basic structural

characteristics of an economic environment as the number of agents, preferences,

endowments and technology on the pattern of economic activity. However, observations

in natural markets do not lend themselves to direct measurements of these structural

characteristics. As Davis and Holt observe,

“As a consequence of these data problems,



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economists have often been forced to evaluate theories on the basis of plausibility, or on

intrinsic factors such as elegance and internal consistency.” By contrast, in designing a

market experiment the experimenter attempts to establish complete control over these

variables. In this way laboratory experimentation allows a dramatic reduction in the

number of auxiliary hypotheses that must be maintained in order to test a hypothesis of

primary interest.

A second feature of laboratory experimentation, emphasized earlier by Smith (1982), is

that it is not possible to design a laboratory experiment without designing an institution in

all of its detail. This naturally turns the attention of the experimenter to the influence of

not only the structural characteristics of the environment that econometricians try so

valiantly to measure in field data, but also to the influence of specific features of the

institutions themselves. Since one of the principal insights of-game theory is that the

detailed structure of the rules of a game can have a profound influence on its outcome, it

is not surprising that the growing application of game theoretic modelling should be

accompanied with increased use of controlled experimentation. Of course, as Smith’s

own work has amply demonstrated, much can be learned from the experimental

manipulation of institutional and structural design even without waiting for a complete

theoretical analysis of the effects to be expected from such changes.

Chapter two contains a brief review of a variety of topics in decision theory and game

theory. This is meant to provide a sufficient introduction to the reader to the terminology

and basic ideas of these subjects so that they can begin to follow the reviews of

experimental literature that form the body of the text. As the authors caution, the material

in the chapter is “ . .no substitute for a systematic treatment of these topics, and anyone

with a serious interest in experimental economics should sooner or later master the

material in an up to date course with an appropriate emphasis on decision and game

theories.” With this caveat, the chapter is a lucid exposition that serves its purpose well.

The literature reviews that comprise chapters three through eight of the text are

grouped into three general categories: Market Experiments, Game Experiments,

Individual Decision Experiments. Davis and Holt describe Market Experiments as

experiments in which a market institution is created that has features that parallel trading

rules in naturally occurring markets. The resource allocation mechanisms created in these

experiments are ones for which there is not currently any satisfactory game theoretic

analysis to guide hypothesis testing. Instead, the focus of these experiments has been on

assessing the performance of these institutions relative to a standard of 100 extraction

of the gains from trade under a variety of parametric configurations. Game Experiments,

by contrast, are experiments that implement the rules of a particular game whose

theoretical equilibria are known. These experiments are designed to test whether or not

game theoretic equilibrium predictions are informative of how such games are actually

played. The Individual Decision Experiments reviewed in chapter eight consider

evaluations of expected utility theory of individual decision making in the face of risk and

probe for biases in probability judgements.

Chapters three and four are devoted to Market Experiments. Chapter three provides an

extended discussion of the procedures, performance properties and applications of the

laboratory double auction market mechanism introduced by Smith (1962). Because the

results found by Smith have been so widely replicated, and because convergence to



Book reviews

413

competitive equilibrium appears to be robust to a large number of parametric changes, the

literature on double auction experiments deserves the detailed account Davis and Holt

give it. An important feature of Smith’s original design that has been incorporated into

most subsequent experiments with the double auction mechanism is that once an auction

is closed, a new auction with the same initial distribution of reservation price schedules is

opened again. An experimental session therefore consists of a sequence of auctions,

typically operated under very stationary conditions. Much of this remarkable robustness

in the pattern of convergence to the competitive equilibrium may be attributable to the

extreme stationarity of the designs. Typically, when aggregate demand or supply shifts

occurred in an experiment the same shift occurred for all subjects in a given role. An

exception is an experiment conducted by Aliprantis and Plott (1992). In their setup, a

trader participated in two consecutive auctions in which the endowments of a trader in the

second auction depended upon the trades made in the first auction. They observed much

more volatility and less of a tendency to convergence to competitive equilibria than in the

typical double auction experiment. Since trades affect endowments in naturally occurring

double auction markets it may be unwise to infer from the large body of laboratory

experiments that such markets will perform with extremely high efficiencies.

The posted offer market is another institution that has been widely used in market

experiments. The first oligopoly experiments used posted offer market institutions in

which the behavior of buyers was typically simulated via a payoff table that determined

how any one seller’s payoff depended upon the posted price (or quantity) of that subject

and of the posted prices (or quantities) of all the other subjects who played the role of

sellers. Subsequent experiments with posted offer markets, influenced by the

performance of double auction experiments in which buyer redemption values and seller

costs are private information, incorporated this privacy of information feature into the

design of posted offer institutions and the institution came to be known as a posted offer

auction. A discussion of experiments using the posted offer auction mechanism comprises

Chapter five. The predominant lesson to be drawn from the experiments reviewed in this

chapter is that trading institutions really do matter. Trading patterns in the posted offer

institution are markedly different than in the double auction institution, with different

dynamics, different distributions of the gains from trade from the same underlying

reservation price schedules, and different degrees to which market power can be exerted.

Chapters five, six and seven are devoted to reviews of a variety of Game Experiments.

Because there have been a wide variety of experiments testing various propositions of

game theory and game theoretic models it is inevitable that not all topics of active

interest, such as coordination games, are reviewed. Furthermore, the reviews of the topics

covered in this section of the book are less extensive that in the review of Market Games.

The reader who is looking for more comprehensive surveys of the experimental literature

will find them in Kagel and Roth (1995).

Chapter five is devoted to bargaining experiments and auction experiments. Davis and

Holt provide an exposition of the axiomatic theory proposed by Nash and briefly describe

a sequence of experiments designed to test that theory. Their discussion nicely illustrates

how the results of one experiment often prompts the design of another as experimenters

try to sharpen tests and account for anomalies. They also discuss experiments in

structured bargaining games. Such games are amenable to strategic analysis so that Nash



4 4 Book reviews

equilibrium and equilibrium refinement concepts are applicable. This section is also

relatively brief, but nicely organized. Two important regularities have been discovered in

these experiments: (1) games end in disagreement a significant fraction of the time, and

(2) individuals often fail to extract all of the monetary gains apparently available to them,

given the strategic advantages conferred upon them by the structure of the game. Davis

and Holt interpret this as a failure of the theory since ‘seemingly nonstrategic

considerations are relevant’ (in accounting for observed behavior). An alternative

interpretation is that such experiments illustrate the difficulty of achieving full

experimental control over subject utility functions in bargaining games. (See, e.g. Ochs

and Roth, 1989.)

In the auction section, Davis and Holt provide good discussions of the revenue

equivalence theorems applicable to private value actions and of the nature of the

‘Winner’s Curse’ in common value auctions. The experiments with common value

auctions have shown that the Winner’s Curse phenomenon is commonly observed and

remarkably resilient to experience. These experiments demonstrate that the strong

assumptions about the information processing and optimizing capacities of agents that are

embedded in extant game theoretic models sometimes do a very poor job of predicting

the behavioral rules that people follow. This is a result that is also found in many other

game experiments. This section also considers the use of laboratory experimentation to

test the properties of new auction mechanisms that may be designed for newly created

markets, such as the marketing of space on the space shuttle, or pollution rights, or the

introduction of new rules in existing markets to accommodate advances in communica-

tions and computerization.

Chapter six is devoted to reviews of some experiments that are related to the public

economics literature. Laboratory experiments with voluntary contribution games for

which the dominant stage game strategy is to free-ride, i.e. not contribute, are typically

conducted with several repetitions of play. The common feature of these experiments is

that a significant percentage of subjects do make a contribution in the early stages of

these experiments. However, in some, but not all of these experiments there is a marked

tendency for the contribution rates to fall as more stages are played. One factor which

seems to account for this variation in the persistence of contribution rates is the minimum

sum of contributions that must be made to the public good before any contributor realizes

a positive net payoff from his own contribution. Since zero contribution is a dominant

strategy, subjects who continue to contribute because they are getting a positive net

payoff from their contributions are not maximizing their own payoffs. This is inconsistent

with basic assumptions of ‘rationality’ but may be well-accounted for by re-enforcement

learning models. A nice discussion of how a model that uses an adaptive learning

algorithm can account for such observed regularities in these games can be found in

Miller and Andreoni (1991). Interest in modelling learning and incorporating such

models into accounts of the dynamics of various game experiments is growing rapidly.

Erev and Roth (1995) and Roth and Erev (1995) provide many examples of the

remarkable ability of simple models of reinforcement learning to track the dynamics of

play actually observed in a variety of game experiments.

Chapter six also briefly discusses the concept of incentive compatible mechanisms for

determining the quantity of a public good to produce and allocation of its costs, together



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415

with quite cursory discussion of a few experiments that were designed to test the efficacy

of such mechanisms, experiments involving externalities and experiments to study the

influence of agenda setting on voting outcomes.

The adage, ‘Knowledge is Power,’ is reflected in the economist’s concern for the

influence of asymmetric information in shaping economic phenomena. Chapter seven

provides a discussion of a variety of experiments in which information asymmetries can

result in resource mis-allocations. Experiments that are designed to first establish a

baseline treatment where the ‘bad’ and/or the fear of the ‘bad’ drives out the ‘good’ in the

marketplace are discussed, as are experiments that study how various alterations in

institutional rules (e.g. advertising, enforceable warranties, costly auditing, and

differentially costly signals) affect market performance. The chapter also contains a

nice discussion of signalling games that may have multiple equilibria. As they show,

experiments with such games indicate that, contrary to the equilibrium refinement

literature, actual out-of-equilibrium play is the principal determinant of which

equilibrium emerges.

Laboratory experiments are well-suited to test the power of market prices to reflect the

best available information since, unlike field situations, the experimenter actually knows

what information is available. In Chapter seven Holt and Davis review several laboratory

asset market studies that establish, at least, baseline cases for when market prices will,

and will not, fully reflect the best available information in the market. The last section of

this interesting chapter discusses the Iowa Presidential Stock Market, a betting

mechanism that has generally outperformed national polls in predicting the outcome of

elections.

The theory of expected utility maximization is the basic model of individual decision

making upon which all of game theory rests. In chapter eight Davis and Holt discuss

various experiments that have been conducted to test the basic propositions of this model.

They also discuss how the theory has been used by experimenters to devise methods for

eliciting preference/probability assessments of subjects and/or to induce a particular risk

preference profile as part of an experimental design. They review the results from a

number of lottery choice experiments in which many subjects exhibit violations of the

predictions of expected utility theory. Their own preferred (but tentative) explanations for

the disconfirming observations is that either subjects were not sufficiently motivated (in

many experiments the choices made were hypothetical in that subject payments were

unrelated to the actual lotteries they chose) or were contaminated by wealth effects since

one’s attitude toward risk depends upon one’s current wealth and subjects were often

asked to make a sequence of choices, having choices made at one point in the sequence

occurs after payment for play of earlier lottery choices.

Davis and Holt suggest that a serious experimental effort to document wealth effects

would be useful. To this reader, any finding of significant wealth effects in laboratory

experiments, under a hypothesis of expected utility maximization, would be as damaging

to the theory of expected utility maximization as is the interpretation of the existing

experimental results under the maintained hypothesis that wealth effects are not the cause

of the disconfirming observations. Expected utility theory says that an individual’s

assessment of risk at a given level of wealth is a reflection of the higher order derivatives

of his utility of wealth function evaluated at his current wealth. Since the magnitude by



416

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which an individual’s wealth can possibly change in most experiments is exceedingly

small, it is incredible to believe that one could estimate the values of these higher order

derivatives on the basis of behavior observed in such experiments. A finding of wealth

effects would therefore lead to the conclusion that the choice behavior of subjects in the

experiment is based upon some utility function that is distinct from the utility function

guiding their behavior outside the lab. That is, a finding of wealth effects would give

credence to the hypothesis preferred by some psychologists that an individual does not

have a single utility function but rather that the context or frame within which an

individual finds himself in a given situation determines his valuation function in that

situation.

In the last chapter, Davis and Holt provide a summary of the major results of

experimentation and a discussion of major issues of research design and statistical

methods appropriate for the analysis of experimental data. This material should be

especially helpful for anyone contemplating the execution of an experiment.

This book represents an ambitious and largely successful effort to bring to the reader a

sense of the scope, promise and limitations of laboratory experimentation in economics.

Its blend of clear expositions of the theoretical underpinnings of experimental work,

descriptions of a wide variety of experimental studies and discussion of practical

problems of experimental design and interpretation of experimental results is sure to

further widen the audience for experimental work in economics.

References

Aliprantis, C. and Plott, C., 1992, Competitive equilibria in overlapping generations experiments, Economic

Theory 2, 389-426.

Erev, I. and Roth, A., 1995, On the need for low game theory: Reinforcement learning in experimental games

with unique mixed strategy equilibria (Mimeo, University of Pittsburgh).

Kagel, J. and Roth, A., eds., 1995, The handbook of experimental economics (Princeton University Press,

Princeton, xvii+721).

Ochs, J. and Roth, A., 1989, An experimental study of sequential bargaining, American Economic Review 79,

355-384.

Miller, J. and Andreoni, J., 1991, Can evolutionary dynamics explain free riding in experiments, Economic

Letters 36, 9-15.

Roth, A., 1985, Laboratory experimentation in economics, Economics and Philosophy 2, 245-273. Also in:

Truman Bewley, ed., Advances in economic theory (Fifth World Congress, Cambridge University Press,

1987) 269-299.

Roth, A. and Erev, I., 1995, Learning in extensive form games: Experimental data and simple dynamic models in

the intermediate term, Games and Economic Behavior 8, 163-212.

Smith, V., 1962, An experimental study of competitive market behavior, Journal of Political Economy 70,

111-137.

Smith, V., 1982, Microeconomic systems as an experimental science, American Economic Review 2,

923-955.

Jack Ochs

niversity of

P i t t s bu r g h P i t t s bu r g h PA l JSA

PII SOl67-2681(96)00814-l

davis and holt-experimental economics

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