the experimental study of behaviour in economics

7/28/2019 The Experimental Study of Behaviour in Economics

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The Experimental Study of Behaviour in Economics1

Sujoy Chakravarty2

Abstract: The study of behavior in economicsusing paid experiments has a history of about halfa century. This article tracks not just the chronological history of the field of experimental

economics but the intellectual history of the way agent behavior has been studied in economics

since the advent of the rational-actor framework in the nineteenth century. I examine themethodologies that form the bedrock of experimentation in economics, their origins, their

advantages and their antecedents. I also explore the manner in which experimental economics

has enabled theories and frameworks from fields in social sciences like psychology,

anthropology and political science to influence the way behavior is modeled in economics,leading to newer theoretical understandings that go far beyond the traditional view of the agent

as homo-economicus, i.e. - a self interested rational maximize interested in merely increasing his

material wealth.

JEL Classification: B41, B21, C9, D03

Keywords: Behaviour, Experiment, Rationality, Institution, Norms

1The author would like to thank Bhaswar Moitra, Emmanuel Dechenaux, E. Somanthan, Gerd Gigerenzer, Parikshit

Ghosh and Priyodorshi Banerjee for some particularly insightful conversations that have informed this essay. 2Associate Professor, Centre for Economic Studies and Planning, School of Social Sciences, JNU, New Delhi

110067.


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1. Introduction

this theory is not speculative in origin; it owes its invention entirely to the desire to make

physical theory fit observed fact as well as possible.

Albert Einstein on the theory of relativity, Kings College, 1921

Economics is a discipline that has repeatedly thrown up questions that are deeply anchored in

social phenomena. These questions include ones on how industries grow and organize

themselves, how consumer tastes and preferences evolve and why some societies are poor

whereas others experience untold riches. All of these questions have led economists to the study

of human behaviour, which from all accounts is fraught with contradictions. Human beings are

capable of great foresight and analysis but they are also guided by a diffuse set of motivators,

some of which are biological and others societal. Given that these nature and nurture

variables may be different over different individuals, individual behavior observed in economic

situations may differ widely depending on the actors involved and the environment in which they

operate. Examples of phenomena in which we see a distribution of behavioural realizations

include the amount of contribution made to charities, the proclivity towards acquiring resources

through corrupt means, cooperation displayed towards teammates and co-workers and the

wherewithal to take on monetary risks.

In spite of this large variance in observed behaviour, the theory used in economics to model

individual behavior has grown to be highly axiomatized and mathematized. We would not be

unjustified in saying that economic theory over the last century has concerned itself more with

rational benchmarks and less with trying to model empirically observed behavior. According

to Smith (1989) most economists feel that economics is an a-priori science rather than an

observational one. According to Milgrom and Roberts (1987, p. 185) no mere fact was a match

in economics for a consistent theory. Thus most economic theorists believe that economic

problems and agent behavior therein can be fully conceptualized by thinking about them.

Accordingly after the thinking has produced sufficient technical rigour, internal coherence and

interpersonal agreement, economists can then apply this to the world of data. (Smith, 1989, p.

152)


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The rational agent thus modeled is aself-interested maximizeralways taking a decision that

maximizes his expected wealth. However, if we look around us we see serious violations of this

behavioural norm. Human beings are prone to voluntary acts of kindness sometimes motivated

by altruism. Most people cooperate with their neighbours in the upkeep of their neighbourhoods

and most would trust another human being unconditionally often suffering negative

consequences from this trusting behavior. Are most people then irrational? If that were the case

shouldnt theory reflect this divergence from the norm especially as this divergence is often

systematic and not random? Ariely (2008) refers to these divergences as predictably irrational

ones. Basu (1983), Sugden (1986) and Coleman (1990) have attributed social norms (especially

those that inculcate values and a sense of morality) as modifiers on our desire to maximize our

material wealth.

The field of experimental economics (not to mention experimental social psychology) stands at

the centre of this debate on observed behavioural deviations from rational theoretical prediction.

The method of controlled experiments from the fifties onwards has allowed us to test game

theoretic models as well as individual choice models with human subjects in the laboratory.

Observed economic behaviors are compared to rational theoretical benchmarks, divergences

from the rational norm are noted and in certain cases theories are advanced to explain these

deviations. This article attempts to trace the evolution and success of using experimental

methods in the form of paid experiments that test economic theories and principles. In doing so

we also explore the interrelationships that experimental economics has spawned with other fields

in social science like psychology, political science, sociology and anthropology.

In the new millennium, experimental economists have ventured out beyond the laboratory to the

field, using participants who are not college students and framed environments, which bear

resemblance to natural contexts for studying specific economic behaviour. Today we stand at the

point where experimentalists studying economic problems may not necessarily be individuals

who are steeped in traditional economic theory. This democratization has enriched the set of

problems that were traditionally studied under the banner of economics to include work on the

evolution of social norms and the role of culture on economic behaviour, which is a far cry from

the modest and narrow goals of theory testing originally posited by the founders of this sub-field.

The next section discusses the evolution of the study of human behaviour in economic theory.


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2. The study of human behavior in mainstream economic theory

At the heart of the microeconomic model (and the set of axioms that drives the majority of its

results) stands the homo-economicusor the economic man - a representative agent who can

attach a well defined probability distribution over the entire set of outcomes that are available to

him from any choice problem and choose the one that would yield to him the highest expected

payoff. Legions of self-interested rational maximizers such as these, armed with private

endowments and no barriers to exchange form a market in which they can mutually trade to

increase agents welfare. Yes, purportedly the invisible hand of the market manages to

coordinate buyer and seller decisions, so that people with none other than purely selfish motives

may conduct mutually beneficial trade. The idea of the economic man has found place in the

writings of Mill (1836) whoproposed an arbitrary definition of man, as a being who inevitably

does that by which he may obtain the greatest amount of necessaries, conveniences, and

luxuries, with the smallest quantity of labour and physical self-denial with which they can be

obtained.

The idea of exchange between rational and self-serving individuals has been around for hundreds

of years. Almost a century earlier than Mill, Adam Smith refers to it in the Theory of Moral

Sentiments (1759) as well as his better known later work, The Wealth of Nations (1776). It is

however inMoral Sentiments where we see glimmers of what would ultimately be abehavioural revolution in economics two centuries later. In this treatise Smith writes about an

important psychological motivation that governs the way that economic agents conduct

exchange. The particular moral sentiment that Smith describes at length issympathy, i.e.the

feeling of compassion or concern for others. This tempers self-interest in socio-economic

transactions and leads us to sacrifice narrow profiteering in order to maintain ties of affection

with our fellow human beings. In positing this opinion Smith builds on the work of Scottish

moral philosopher David HumesA Treatise of Human Nature (Hume, [1740], 1978). In this

work Hume argues that morals and belief rather than reason governs human nature in stark

contrast to the rationalists like Descartes who preceded him.

These initial behavioural asides notwithstanding, the dominant and mathematized

microeconomic framework developed in the late nineteenth century by Leon Walras, Alfred

Marshall, William Jevons and Vilfredo Pareto didemploy the rational-actor framework in


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extending the work of Smith, Mill and David Ricardo, and came to be known as neoclassical

economics. In the first fifty years of the twentieth century Lionel Robbins, Frederick Von Hayek,

John Hicks and others further refined and extended this framework to create elegant

mathematical frameworks for consumer behavior, the IS-LM model, the business cycle, welfare

economics and various other theories that have become the bedrock of modern mainstream

economics.

Neoclassical economics went through a paradigm shift in the forties with two works of great

import. They were The Theory of Games and Economic Behaviourby John von-Neumann and

Oskar Morgenstern (vonNeumann and Morgenstern, 1944), and John Nashs doctoral

dissertation from Princeton University on non-cooperative games (Nash, 1950), which included

the powerful idea of Nash Equilibrium. Put simply, the main contribution of von-Neumann and

Morgenstern (v-NM) was to develop a framework of individual decision making under

uncertainty and that of Nash was to find an internally consistent set of strategies that decision

makers would employ in a situation of strategic interaction, from which no one had any

unilateral incentive to deviate. v-NM and Nashs theories allowed us to obtainbehavioural

predictions incorporating two very important features of economic decision making, namely, the

presence of uncertainty (embodied in probability distributions) regarding outcomes in a situation

of choice and the effect of the behavior of other economic agents (other players in a game who

may for example have conflicting interests) on an agents payoffs. These more modern theories

had more directly testable point predictions, which facilitated the formulation of testable

hypotheses that could be compared to behavioural observation. Though they came up with more

test-friendly theories of agent behaviour both von- Neumann and Nash were pure

mathematicians who had never been involved with any form of empirical or experimental work.

Morgenstern, on the other hand, felt that statistical data collected in economics had inherent

(sample selection) biases which made it difficult to isolate the true causes of observed behavior.

Of the three it was he who was more amenable to controlled experiments, as is clear from hiscomments on Chamberlins pioneering experiments on competitive markets from the forties

(Morgenstern, 1954).

According to Morgan (2003), in the middle of the twentieth century, economics was in the

process of becoming a tool-based science and distancing itself from the old, discursive moral


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science ofthe political economy framework of the late nineteenth and early twentieth centuries.

This led to theoretical models with sharp equilibrium predictions and more involvement of

computational scientists and mathematicians in theory formation and testing. By the early fifties

(fuelled no doubt by the rapid growth in computing power) computer simulations followed by

controlled experiments entered the economists toolkit. The next section discusses the

applicability and advantages of experimental methods as applied to social sciences particularly

economics.

3. The advantages of the experimental method

In this section we trace the main ways in which the experimental method has enriched economic

theory building. Economics experiments have opened intellectual directions that would have

been impossible if we were not able to observe human agents interacting in laboratory

environments that attempted to model specific theoretical contexts. As discussed below, the

observations on human behavior in the laboratory has led to a deeper understanding of economic

motivations that took researchers far beyond simple laboratory games into field contexts,

institutions and culture. This interest in variables which were not considered traditionally to be

important to the behavior of economic agents has over time brought the discipline of economics

closer to the other more non-mathematized social sciences.

3.1 The usefulness of the laboratory

Before experiments entered the analytical toolkit for economists, happenstance (naturally

occurring) data was the only way in which economic principles could be tested. However

happenstance data is not generated as per the convenience of the researcher, and it is most often

prohibitively expensive to be present at the site of data generation, like a factory (cost data) or a

marketplace (transactions data) to record it. The presence of the researcher who merely observes

and records naturally occurring processes (and hence can control for environmental variables that

could be ex-post unknown) creates a natural experiment, which if performed carefully may be

the best way to test economic theories and principles. However besides the expense involved,

there is another basic problem with natural experiments. This is the problem of bias in the

behavior of agents that is introduced because of the presence of someone recording data. A way

around this is of course to be purely anonymous which may be very difficult to do in all


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situations.3

The ideal natural experiment (and indeed the purest form in which behavior can be

recorded) is the randomized natural experiment, in which we can study the actions of agents by

selecting our experimental unit randomly over the entire set of available focus variables that

influence behavior.4

Banerjee et al. (2007) perform a randomized study in Vadodara and

Mumbai in India, where they evaluate the effect of two remedial programs on childrens

performance in school.

At the other end of the spectrum from the natural experiment is the laboratory experiment. Here

we dont attempt to observe behavioural phenomena in a naturally occurring setting. We usually

design a stylized version of the problem to be studied in a non-natural environment. Unlike in the

natural sciences where laboratory environments that are very close to the naturally occurring

phenomena can be created, in the social sciences, the environments created tend to be stylized

versions of the naturally occurring field environments. These stylizations often allow us to

collect data related to economic problems for which it is very difficult (or impossible) to obtain

happenstance data. Examples include studying the effect of insider information on traders in

asset markets, studying agent behavior in principal agent models and exploring labour market

discrimination. The usage of treatments allows us to also create the counterfactuals in theory,

which may be impossible to obtain with field data.5

3The main problem with using natural experiments on human behavior is that unlike inanimate matter, human

beings are sentient and respond to stimuli.Thus unless the experimenter/observer is completely invisible to the

agent, the behaviour we observe will be necessarily different from what is natural to them. Contrast this for example

with observationalastronomy, a branch of physics that deals with the study of movements of celestial objects. In this

scenario, natural experiments are the only empirical methodology available and they have no bias, as we are dealing

with celestial objects that are largely invariant to observation. 4In experimental design, we can broadly delineate all variables that affect subject response into focus variables and

nuisance variables. For example suppose we are trying to study the behavior of traders in a market. We may be

interested in how the trading institution and level of seller costs affect performance. These would be our focus

variables. There may be other variables such as the gender of traders, which may well influence their behavior butwe are not explicitly interested in it. We deem this to be a nuisance variable. Our purpose in designing treatments is

to minimize the impact of such a nuisance variable. For more on experimental design techniques see Box et al.

(1978).5For example we may be interested in how asset traders in a stock market aggregate diverse information regarding

the assets they buy and sell. Real world stock market data will obtain for us the behavior of agents who possess such

fragmented pieces of information. However to really comprehend how information gets aggregated we need a

counterfactual, i.e. - how do agents behave when there is no probabilistic information regarding the assets that they

possess? Real world data cannot provide this to us but laboratory procedures allow us to create this situation with

comparative ease.


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3.2 Anomalies and the emergence of behavioural economics

An important aspect of laboratory experiments in economics and psychology (the two main

social science disciplines that use experimental methodology) is the degree ofparallelism, i.e. -

how closely does the laboratory problem correspond to the problem in the field? Often this

parallelism is low in laboratory environments where closeness to the field is sacrificed in order to

gain a high degree of experimental control. Observing subjects in a specially set up environment

necessarily increases the level of bias but allows us to fine tune focus variables in a way that

would be impossible in the field. As economic theory (rather than psychological theory) is

concerned with more abstract behavioural consequences that depend less on the environment and

the institutions (for example Nash equilibrium in games or the Walrasian equilibrium), a stylized

interface that distils the essence of these models without too much operational detail may be

enough to test theory somewhat satisfactorily albeit in a narrow fashion.

However, can we make the claim that experimental methods allow us to test theory in a

foolproof manner? If indeed subjects display behavior concordant with theory can we say that

the theory is correct? What about if behavioural violations of theory are observed? Will it then

inform us that the theory is incorrect? Unfortunately an economics experiment does not give us

the wherewithal to accept the theory in the first case and reject it in the second. According to

Friedman and Sunder (1994), experiments can never exactly replicate the conditions laid out in

formal economic theory. All theories leave out significant operational detail and so any attempt

in the experimental design to try to fill these in necessarily alters the theoretical model, i.e. - the

laboratory version of the theory is necessarily different from the written version of theory. What

then do laboratory experiments contribute? They provide another understanding of economic

phenomena separate from economic theory and empirical analysis of happenstance data. It would

be fair to say that theory, empirical data analysis and laboratory experiments move on parallel

tracks, reinforcing our understanding of the behavior being modeled in a subtly different but

ultimately unified manner.

For the first half-century of the application of experimental methodology to economics,

laboratory studies were the mainstay of the sub-discipline. The laboratory allowed us to

comprehend the power of the market in aggregating trader bids and asks in a decentralized

manner to clear markets. It also blew the door open on many anomalies, orpersistent violations


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of theoretical equilibria. In game theory experiments, these anomalies often take the form of

paradoxes of rationality, where the rational outcome predicted by theory is consistently

violated by behavior observed amongst human subjects. The Prisoners Dilemma (Axelrod,

1970, 1984; Andreoni and Miller, 1993), the classic Bertrand duopoly game (Dufwenberg and

Gneezy, 2000), the Ultimatum Bargaining Game (Guth, et al., 1982) and the Travellers

Dilemma (Holt, 1999) provide such examples. These anomalies led to the adoption of

approaches from cognitive psychology such as boundedrationality. As the problems involved

more and more complex computation to reach the equilibrium, the limits on human

computational ability necessitated the use of thumb rules or heuristics in order to be able to

optimize over a small set of variables, (a subset of the larger set of variables that govern the

problem) which were considered central to solving the problem. Over time to cite an

evolutionary argument, the heuristics that got adopted were ones that optimized over a smaller

set of variables and obtained desirable outcomes for agents. The other rules which got less than

desirable outcomes got discarded. The origin of this boundedly rational approach is from

Simons (1955) idea of procedural rationality whereby agents follow reasonable heuristics and

on average achieve close to optimal outcomes. This is distinct from substantive rationality,

where the agent considers the entire set of variables to make her decision.6

The integration of

psychological motivations/limitations into economic decisions led to theory building and

experimental studies that went well beyond testing simple economic models and over time led to

the more cross-disciplinary sub-field ofbehavioural economics that combines analytical tools

from primarily the fields of psychology and economics. See section 4 for more discussion on

behavioural economics.

3.4 Institutions matter as do culture and norms

Institutions provide the rules by which agents transact in an economy. Traditional economic

theory is free of institution specific cues on behaviour. For example, market clearing is not

influenced by the trading rules specified for the agents in the Arrow-Debreu (Arrow and Debreu,

1954) model. Another example would be the four major auction formats, the English ascending

6The idea of heuristics as a second best approach, originating because of mental limitations has been recently

questioned. Studies such as Gigerenzer and Brighton (2009) have shown us that very often, fast and frugal

computations give us much more predictive accuracy (not in terms of mean prediction but with respect to individual

prediction) than models that compute over the entire set of variables.


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price auction, the Dutch descending price auction, the first price sealed bid auction and the

second price sealed bid auction, all of which are revenue equivalent for risk neutral agents.

Experimental data from auction experiments do not bear out the equivalence of these four

formats.

Smith (1989) presents a schematic diagram of the way behavior has been conceptualized and

studied in economics over the twentieth century. I update it below in figure 1 to include newer

developments some of which are from literatures other than economics such as psychology,

political science and anthropology. Before 1960, economic theory was largely not concerned

with institutional differences, asserting that as long agent preferences and firm costs were the

same, it did not matter what the specific rules of interaction were for the agents.7

The outcome in

such theory is determined directly from environment (given by cost and preference parameters),

whereas in an institution-specific theory the outcome is determined both by the institution as well

as the environment. The two most important market institutions explored in experimental

economics are the double auction and the posted offers markets. From laboratory studies it was

evident that human agents did not behave the same way in these different institutions (Ketcham

et al. (1984)). Kagel and Levins (1986) study of common value auctions, Friedmans model

(1991) of the double auction market are two institution specific theoretical studies. For a detailed

discussion on the role of institutions in economic theory see Aoki (2001).

A very important intellectual direction that emerged out of the paradoxes of rationality observed

in laboratory games was the study of the effect of culture and demographics on economic

behaviour through the formation and enactment of social norms. Sen (1973) alludes to social

norms when he discusses the prevalence of cooperative action in the Prisoners Dilemma game.

Arrow (1982) clearly states that The model oflaissez-faire world of total self-interest would not

survive for ten minutes; its actual working depends on an intricate network of reciprocal

obligations, even among competing firms and individuals. The interest in social norms andculture in turn has fed back to the design of experiments with the emergence of theArtefactual

7According to North (1991, p. 97) institutions are the humanly devised constraints that structure political,

economic and social interaction. Throughout history, they have been created by human beings to promote order and

reduce uncertainty in markets. Together with the standard constraints in economics (i.e. - those imposed by

preferences and costs) they define the choice set and therefore determine transaction and production costs and hence

the profitability and feasibility of different economic activity.


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Field Experiment(AFE). An AFE lies between a laboratory and a natural experiment in that

laboratory tasks are now performed not by college students (the usual subject group used in

Economics and Psychology experiments) but by more unsophisticated subjects from the field.8

Some early work in field experiments includes Lichtenstein and Slovic (1973), Kagel et al.

(1979), Binswanger (1980, 1981) and DeJong et al. (1988) who study decision and game

theoretic problems in the field.

North (1991) in his essay on institutions recognizes the power of norms as informal constraints

on behavior which include sanctions, taboos, customs, traditions and codes of conduct. These

non-legally binding but morally enforceable informal institutions have become very important in

the study of economic outcomes today. Hume ([1740], 1978) was the first to discuss the central

role that norms play in the construction of social order. Since the evolution of norms is

necessarily culture specific, the study of these norms and their effect on economic equilibria has

meant that cultural and demographic variables which were hitherto unstudied have found their

way into the economics literature. Norms influence the choice of equilibria and sometimes cause

outcomes to be adopted which may not necessarily be equilibria in a game theoretic sense.

Accordingly, fairness norms may influence the playing of the cooperation (dominated) strategy

in an N-player Prisoners Dilemma (NPD) game such as the public goods game. Furthermore,

informal social sanction such as threat of ostracism in communities may cue agent behavior

towards more equitable outcomes in spite of the presence of short term economic incentives for

self aggrandizement. Coleman (1990), Henrich et al. (2004), Bowles (2004) and Ostrom (1995,

1998) provide empirical evidence as well theoretical frameworks that analyse the role of culture,

demographics and social norms on economic outcomes.

As indicated in figure 1, social norms influence behaviour both directly and indirectly. Norms

related to social incentives and sanctions influence agent behavior directly by identifying focal

points (some of which may not even be equilibrium in the game theoretic sense).Furthermore,norms indirectly affect agent behavior either by altering the evolution of institutions and the rules

of interaction therein or affecting the evolution of preferences and costs over time.

8In a related class of field experiments, Framed Field Experiments, the experimental tasks given to the subjects in

the field are framed in a context that is relevant to the field. See Harrison and List (2004) for a more detailed

discussion.


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Figure 1: Institutions, culture, environment and behaviour in economics (extended from Smith, 1989)

4. Experimental economics contrasted with experimental psychology

The methodologies used to study bounded rationality and divergences from normative

behavioural paradigms are different in Social Psychology from Experimental Economics, which

had initially led to very little joint experimental work between the two disciplines. Over time a

significant number of economists have actually started to appreciate the problems investigated

and methodologies used by psychologists, which has led to some convergence between the fields

though serious divergences regarding procedure and implications remain.

The main methodological conflict between economists and psychologists arises on the issue of

subject payments. A significant number of psychology experiments do not actually pay subjects

OUTCOMES

Prices, allocations

CHOICE

BEHAVIOUR

ENVIRONMENT

Agent values, costs,

endowment,

technology

INSTITUTIONS

Language of the market

Rules of communication and

contract

Extensive form structure

CULTURE and

DEMOGRAPHICS

Social Norms

Pre-1960 institution free

theory

Post 1960institutionsmatter

Post 1980culture and

demographics matter.


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for their responses. This includes the classic Kahneman and Tversky (1979) study on Prospect

Theory. Even when experimental psychologists pay their subjects, often these are flat payments

and not contingent on the decision they make.910 Psychologists have defended the no/low

payment paradigm in psychology studies variously, as a large number of individual choice

experiments in psychology deal with non-monetizable utilities or even payoffs that are difficult

to measure.11

A second point of contention deals with deception, i.e.misleading subjects regarding the actual

objectives of the experiment. Again, according to many psychologists who study boredom,

cheating, excitement, pain and anger, the treatments critically hinge on the subjects not being

aware of the stimuli they are going to be subjected to, or the purpose behind the experiment, as

this would lead to biased actions.

Another important point of divergence between experimental psychology and experimental

economics is related to the theoretical underpinnings behind various results that may be obtained

from an experiment. Most economists dont really need a precise and accurate theory at the

individual level, just as long as it is general enough to explainsome of the observed behaviour

accurately and generate an aggregate prediction that is more or less accurate. So elegance and

generality are generally desirable in economic theory, whereas psychologists and cognitive

scientists are interested in modeling the precise nuances of behavior displayed by individuals.

An example should make this clear. A typical economics experiment on attitudes towards risk

would have the researcher make an assumption about the form of the utility function (say

constant relative risk aversion or CRRA) that the agents purportedly follow. Using this function

and the choice response in the experiment, one can calculate some measure (maybe Arrow-Pratt)

of risk aversion and then compare this across agents, over time, cross-culturally etc. If anyone

questions the validity of using this functional form over another one, most of the time the answer

9See Harrison (1989, 1992 and 1994) for a payoff dominance critique of experiments in economics.

10The three main principles that should govern payments in an economic experiment are salience, dominance and

monotonocity. Salience requires that the payment given to a subject must be different for different outcomes in the

game/decision theoretic situation. Dominance requires that the reward medium dominate decision costs for the

subjects and monotonicity implies more of the reward medium is preferred to less of the reward medium. See

Friedman and Sunder (1994), Harrison (1989, 1992 and 1994), Plott (1991) and Smith (1989) for more detailed

exposition on monetary incentives in economic experiments.11For studies where the payoffs are non-monetizable see Ariely and Loewenstein (2005), Ariely, Loewenstein and

Prelec (2003) and Berns et al. (2007)


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that a theorist or an experimental economist would give you would be that it doesnt matter as

long as everyones attitude to risk is measured using the same CRRA specification. Most

psychologists and cognitive scientists would be quite unhappy with this as if way of

evaluation. They would be more interested in the cognitive processes that govern the choice

made by the decision maker, rather than obtaining some measure which has good internal

validity but potentially scanty external support.12

According to Camerer (1995), most economists have a one-size-fits-all approach to studying

economic problems vis--vis psychologists. So if a task involves elicitation of a probability, most

psychology experiments would frame the problem in a natural setting using a vignette. This

would anchor the tasks to certain specific stimuli. Most economists would go ahead and attempt

to elicit the same probability using a more decontextualised device such as a pair of dice or a

bingo cage. This is in keeping with the institution free pedagogy of neoclassical economics

where elicitation of a probability is coming up with a specific statistical measure rather than an

assessment of a contextualized measure of uncertainty. Economists are also interested in static

repetition of tasks with a view to studying convergence to equilibria or some non-equilibrium

outcome. On the contrary psychologists would be the most interested in the behaviour of a

subject the first time they experience the stimulus as they feel that quick static repetition

overstates the speed and clarity of feedback that would be provided in a natural setting.

The development of the hybrid field ofbehavioural economics in the 1970s represented a

convergence between the fields of economics and experimental psychology. However, given that

psychology as a discipline has a significant interface with other social sciences such as

anthropology and the biological sciences, especially evolutionary biology, these too have found

their way into behavioural economics. This subfield draws from a lot more than economic theory

and attempts to actually provide a handle on the more primitive elements that make up behavior

by studying context specific biases and documenting deviations for norms in a precise and

detailed manner. Some behavioural economists are also interested in finding how behaviour

correlates with neural substrates or pathology, which may sometime in the future give us a more

12In fact the evolutionary biologist Dawkins (1989) too expresses some reluctance at accepting this as if approach

to decision making when he states that in problems that involve spatial computation like a baseball player running to

catch a ball he behaves as ifhe had solved a set of equations in predicting the trajectory of the ballat some

subconscious level, somethingfunctionally equivalentto the mathematical calculations is going on.


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precise medical answer to questions like why some people are risk loving (which is manifested

in the theory as a convex utility function) and others risk averse (concave utility function).

Indeed, behavioural economics studies behaviour such as procrastination or explores physical or

emotional states such as boredom, pain and sexual arousal, which may not have received much

(or any) importance in economic theory, but which have huge implications for economic

behaviour.13 For more detailed analyses regarding the methodological differences between

experimental psychology and experimental economics see Camerer (1995), Sonnemans (2007),

Ariely and Norton (2007) and Zwick et al. (1999).

At the crux of this methodology debate is the fact that the raison-d etre of experimental

economics for many decades was to test highly axiomatized economic theories. Not much was

asked by way of speculation regarding deviations from normative behaviour. According to Erev

and Roth (1998, p. 848) Economists have traditionally avoided explaining behavior as less than

rational for fear of developing many fragmented theories of mistakes . Thus the appeal of utility

maximization and Nash equilibrium is that they provide useful approximations of great

generality, even if they do not precisely model human behavior (Roth, 1996).

5. Historical progression of experiments in economics

The earliest experiments were run in the forties by Edward Chamberlin at Harvard to show his

graduate students the falsity of the theory of competitive markets. Although the results of such

experiments were published in Chamberlin (1948), nobody at the time, including Chamberlin

himself, attributed much scientific value to them.

Merrill Flood and others were also performing experiments at the RAND Corporation in the

early fifties. In 1952, the Ford Foundation and the University of Michigan organized a two-

month seminar in Santa Monica on the design of experiments in the study of decision processes

in which Flood and his group participated. This seminar did not yield significant research work

in experimental economics but sensitized many researchers who participated in it to the

possibilities of using controlled experiments to study behaviour. As an interesting aside, a game

13The idea that motivations beyond the simple calculus of self-aggrandizement could drive human behaviour was

noted more abstractly by Hume (1739) and extended by Smith (1759) in his Theory of Moral Sentiments. Smith may

have been the first economist (or as they were then known, moral philosopher) to attribute psychological

motivations towards economic activity such as other-regarding preferences and bounded rationality.


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entitled the Prisoners Dilemma, originated by Melvin Dresher and Flood a few years before and

discussed at the Santa Monica seminar, proved to be an important game in experimental

economics as it provided a stark example of a broad class of game theoretic problems in which

the rational maximizing strategy when played by all would lead to an equilibrium outcome in

which everyone is worse off.14

This paradox of rationality would capture the imagination of

experimental researchers in later decades and many other dilemma games such as the Trust

game (Berg et al., 1986), the Voluntary Contributions Mechanism (Isaac at al., 1988a, 1988b)

and the Travellers Dilemma (Basu, 1984, Capra et al., 1999) would be studied to actually see if

players played like rational fools (Sen, 1977) and displayed behaviour according to the

normative theoretical paradigm. In all such games, human subjects in paid experiments deviated

significantly from theoretical predictions, i.e. - they were less rationally foolish than predicted

by theory.

At the same time as the Santa Monica seminar, Sidney Siegel and Lawrence Fouraker studied

bargaining behaviour at Pennsylvania State University. They combined aspects of methodology

from both Economics and Psychology and provided one of the first examples of the study of how

behaviour alters with monetary incentives and amount of information provided to experimental

subjects (Siegel and Fouraker, 1960). In this way, Siegel and Fourakers experiments profoundly

influenced younger researchers like Vernon Smith who would incorporate this idea of salient

monetary incentives and double blind experimental procedures in important publications in the

seventies and the eighties. Smith would later formalize these methods in the precepts or rules

related to his proposed induced value theory, (the use ofmonetary incentives to control

subjects preferences) which would be the methodological touchstone of laboratory

experimentation in economics (Smith, 1976, 1982). This practice of using salient payments

(subjects obtain payments that are monotonically linked to the outcomes in an experiment as

opposed to flat payments that were common in psychology experiments) also allowed Smith,

Charles Plott and other newly christened experimental economists to differentiate themselves onthe academic spectrum from researchers in experimental psychology and contributed greatly to

establishing a distinct methodology in this new sub-field of economics.

14See Flood (1952) for accounts of early experimental examination of zero and constant sum games.


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Though not an economist himself, Herbert Simon of Carnegie Mellon University was a cognitive

scientist who studied individual decision making in the fifties and his experiments largely in a

managerial environment indicated that individuals made decisions in a boundedly rational

manner, i.e. - with an intent to do as well as possible for themselves, but unable or unwilling to

take into account all possible contingencies and/or outcomes. Thus Simon posited that agents

satisficed rather than optimized, i.e. - they played in a boundedly (or procedurally) rational

manner and obtained a sufficiently high payoff with which they were satisfied (Simon, 1955,

1956). In this way Simon can be said to be the first behavioural economist and laid the

foundations for the study of systematic bias, the use of heuristics and other psychological

underpinnings of economic behaviour that were studied by both psychologists and economists

through the next four decades.

The two most well known behavioural economists of the next two decades were Daniel

Kahneman and Amos Tversky of the Hebrew University whose most important contribution was

the formulation of Prospect Theory (Kahneman and Tversky, 1979), a behavioural alternative to

von-Neumann and Morgensterns Expected Utility Theory (vonNeumann and Morgenstern,

1944) that they established in the seventies. Used to explain deviations from Expected Utility

Theory (notably the Allais Paradox, see Allais (1953)), Kahneman and Tversky made several

behavioural assumptions (that were psychological in nature) regarding agents state dependant

attitude to risk, their underestimation or overestimation of probabilities that they confront and

their inability to process compound lotteries. In doing so, they made one of the first and maybe

the most celebrated theories that were created in order to explain deviations from mainstream

theoretical predictions among laboratory subjects. Over the last two decades Gigerenzer (2008)

and Guth (1995, 2008) have criticized Kahnemann and Tversky for their methodology,

describing it as repair program for neoclassical economics. According to them Prospect

Theory models decision making under risk in an as-if manner by adding transformations and

free parameters to the standard expected utility framework, instead of attempting to actually mappsychological processes that may lead to the observed behavior of agents.

In the sixties and seventies experiments in economics went through a period of slow growth and

certain experimenters distinguished themselves by both their prolific output and their desire to

posit economics as an experimental science. Vernon Smiths study of competitive market


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behavior (Smith, 1962) showed that the institution of the Double Auction market with financially

motivated agents worked well in reaching equilibrium. In doing so Smith replicated

Chamberlins earlier classroom experiments on competitive markets using students of Purdue

University, where he was employed as Assistant Professor. To his surprise he got the opposite

results from Chamberlins experiments using careful laboratory procedures and financially

motivating subjects. Over the next two decades Smith studied market behaviour, different

auction formats, public goods and models of altruism and reciprocity until the eighties when his

prolific research output in both experimental game theory and competitive markets brought him

to the forefront of the newly consolidating field. Smith ultimately received a Nobel Prize in 2002

for being a leading light in establishing laboratory experiments as a credible tool for economic

analysis, especially in the study of different market mechanisms. He shared the 2002 Nobel with

Daniel Kahneman whose cited contribution was in incorporating insights from psychological

research into economics, especially with respect to individual decision making under uncertainty.

The eighties and nineties were good decades for experimental economics and by the turn of the

millennium major universities in both the US and Europe had groups of experimental researchers

who worked on problems in game theory, decision theory and market behaviour. An influential

researcher who made significant contributions to experimental economics in this era was Charles

Plott, an ex-colleague of Vernon Smiths from Purdue who was now a professor at the California

Institute of Technology. Like Smith, Plott too was interested in market behaviour especially

experimental asset markets. His studies with Thomas Palfrey and Shyam Sunder on securities

markets (Plott and Sunder, 1982, 1988) were very influential in sparking off interest in the then

nascent sub-field of behavioural finance. An important reason why experimental economics

flourished in the eighties and nineties was keen interest taken in it by theorists. The reason that a

lot of theorists felt attracted to experiment was that especially in game and decision theory, many

anomalies (unanticipated divergences from the normative prediction) had emerged from

experimental studies. Important theoretical results had been seen to not hold when humansubjects were asked to make decisions in the laboratory. Thus there was a need felt to perform

stress tests in the laboratory in order to help formulate theories with better empirical support.

The most notable of the early theorists who took an interest in experimenting was Reinhardt

Selten, who shared a Nobel Prize in 1994 with John Harsanyi and John Nash, for his work on the

theory of dynamic games. From the early seventies Selten had a keen interest in the experimental


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verification of theory. His experimental publications largely dealing with learning and evolution

of behavior in laboratory games in the seventies and eighties had an empirical flavor that would

be in vogue in the field in the new millennium (see Selten and Stoecker, 1986; Selten et al., 2005

and Ockenfels and Selten, 2005).Many other theorists such as James Andreoni, Alvin Roth,

Daniel Friedman and Thomas Palfrey published thought provoking experimental studies on

altruistic motivation and charitable giving (Andreoni, 1990, Andreoni and Miller, 2002),

reinforcement learning in games (Erev and Roth, 1998), equilibrium in evolutionary games

(Friedman, 1997), belief learning (Cheung and Friedman, 1996) and quantal response

equilibrium (McKelvey and Palfrey, 1995).

In this era, experiments in economics were posited primarily as being of the theory testing

variety, often involving stylized laboratory games, markets and decision problems with

negligible parallelism to the corresponding field institutions. External validity of laboratory

environments used was not considered important (as long as the laboratory economy was

internally consistent) and subject pools were often limited to undergraduate students of US and

European institutions. It is true that some studies explored scaled down laboratory versions of

various real world mechanisms such as airport time slot allocation (Rassenti et al. (1982),

telecommunication spectrum auctions (Plott, 1997) and pollution permits (Cason (1995), Cason

and Plott (1996), Cason and Gangadharan (2003)), but these were relatively rare.15

6. New millennium, new directions

Today half a century after the first economics experiments were performed we stand at an

interesting juncture in the field where the desire to test theory has given way to actually

attempting to understand behavior and its underpinnings. This has led to economists

collaborating with researchers from other fields in basic and social sciences such as cognitive

psychology, evolutionary biology and sociology/anthropology. Henrich et al. (2001) was the first

major study that investigated the impact of demographics on human cooperation using theultimatum game.16 They obtained the results that far from the rational-actor framework of the

15 Experiments that study mechanisms from the real world using scaled down environments in the laboratory are

referred to as testbed experiments. The results from testbed experiments can be then used to refine institutional

rules or design new rules of interaction.16An ultimatum game, first studied experimentally by Gthet al. (1982)is one where a proposer sends an offer to a

responder splitting a rupee in the proportion that is acceptable to him. If the responder agrees to the split (say


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canonical microeconomic model, peoples cooperative behavior is not exogeneous, and critically

depends on the economic and social realities of everyday life. The fact that culture and

demographics matter in determining choice in humans is here to stay in economics and several

studies after Henrich et al. (2001) such as Kurzban and Houser (2001), Harrison et al. (2002),

Sosis and Ruffle (2003), Cardenas and Ostrom (2004) and Andersen et al. (2008) investigate the

effect of culture and individual (non-economic) characteristics on economic choice behavior. An

important consequence of the diversification of the subject pool brought about by these field

experiments is the comparisons that are starting to be made between results obtained from

decades of laboratory experiments in the behavioural sciences that involve primarily

undergraduate students from industrial nations and the newer results from societies in developing

nations. Henrich et al. (2010) show that the behaviours in a variety of decision-making situations

differ significantly in this larger slice of humanity from that displayed by subjects from what

they refer to as the WEIRD societies.17They conclude that members of WEIRD societies are

among the least representative populations one could find for generalizing about human

behaviour.

The prevailing atmosphere of interdisciplinarity has also led to collaborations between

economists and clinical neurologists leading to the sub-field ofNeuroeconomics, which attempts

to find the roots of behavior as reflected in the working of neural substrates. Both game and

decision theory problems have been investigated by projects in Neuroeconomics that have both

social scientists as well clinicians who are familiar with the working of fMRI(Functional

Magnetic Resonance Imaging) machines. The idea is simple: put subjects in MRI machines with

the electrodes connected. Then give them tasks to do and observe which sets of neurons fire up.

McCabe at al. (2001) was the first major research study in Neuroeconomics, which posited that

mentalizing was important in games involving trust and cooperation.18 They found that players

who were more trusting and cooperative showed more brain activity in Brodmann area 10

60p./40p.) then these are the final allocations. If the responder does not agree to the split, both get zero. The SPNE

of this game is for the proposer to keep the full rupee and offer the responder nothing. The responder in equilibrium

should accept this offer. Empirically however, this SPNE is rarely played: proposers are mostly equity preserving in

their offers and responders often reject moderately non-egalitarian offers. 17WEIRD stands forWestern, Educated, Industrialized, Rich, and Democratic.

18Many neuroscientists believe there is a specialized mentalizing (or theory of mind) module, that controls a

persons inferences about what other people believe, feel, or might do. This is of particular interest to game theorists

who create theories regarding how agents behave in strategic environments.


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(thought to be the locus of mentalizing) and more activity in the limbic system which processes

emotions. In the Smith et al. (2002) experiment, payoffs and outcomes were manipulated

independently during choice tasks in the form of gambles (involving risk or ambiguity) as brain

activity was measured with positron emission tomography (PET) scans. Their analyses indicate

that the interaction between belief structure (whether the prospect is ambiguous / risky) and

payoff structure (whether it is a gain frame / loss frame) shapes the distribution of brain activity

during choice. Accordingly, there are two disparate, but functionally integrated, choice systems

with sensitivity to loss. A neocortical dorsomedial system is related to loss processing when

evaluating risky gambles, while a more primitive ventromedial system is related to the

processing of other stimuli. See Camerer et al. (2005) for a detailed survey of Neuroeconomics

studies and their impact on mainstream economics. Though Neuroeconomics claims that many

fundamental insights in economics can be generated from these imaging studies, Harrison (2008)

and Rubinstein (2008) have criticized this sub-field for adding no fundamental insight in our

understanding of how economic decisions are made, and have variously referred to it as a faddist

technological gimmick, attempting to provide hard evidence for violations from normative

behavior. According to them, results from Neuroeconomics studies are inconclusive and the

insights if any are far from re-shaping the way we think about economics. The crux of the

problematic nature of Neuroeconomics presented in Rubinstein (2008) is as follows- even if we

know the exact centre of the brain that engages (and the extent to which it engages) when we

perform certain activities, it is unclear how that would help us design mechanisms or devise

strategies (short of surgical intervention) that would help humans make better decisions.

Furthermore, unless imaging techniques available allowed us to monitor brain activity in real

time for all humans (a proposition that harkens to a dystopic world portrayed in science fiction

novels), it would be really difficult to use this information for anything meaningful.

In conclusion, the recognition of the fact that behavior as modeled in economics cannot be

treated independently of human behavior observed in studies in psychology or anthropology or

even medical science has greatly augmented the breadth and depth of experimental work in

economics. This has also spurred numerous interdisciplinary collaborations some of which have

been more fruitful than others, but the writing on the wall is clearits no longer possible to

think of economic choice problems to be mutually exclusive to similar problems studied in other


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disciplines in social and biological sciences. A healthy concomitant of this is the relatively

smaller weight put on narrow results arising from specific formulations of problems that are

studied in research programs. Behavioural researchers today seem more interested in the

direction of their results than the magnitude of their divergence from some field-specific

theoretical norm. This is inevitable because we do ultimately need to correlate our results with

those from other disciplines that have different parameterizations of the same problem. Today it

is increasingly becoming clearer that just numerical averages on outcomes help us very little in

terms of generating insights pertaining to populations. As researchers, we often have to actually

spend some time connecting the dots and synthesising observation from across two to three fields

in an attempt to actually gain an insight into the behavior being explored.

the experimental study of behaviour in economics

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