Ernst Fehr – Experimental & Behavioral Economics1Experimental and Behavioral EconomicsErnst 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 Economics2Experimental 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 IllusionErnst Fehr – Experimental & Behavioral Economics3Expected 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 Economics4Lecture 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 experimentsErnst Fehr – Experimental & Behavioral Economics5“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 andNordhaus, 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 Economics62002: Vernon Smith and Daniel Kahnemanreceive 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 Economics7Experimental Economics (EE)Experimental MarketsBargaining Experiments...Discovery of PenicillinReciprocity & Contract EnforcementMoney Illusion, ...Lab DataIncome Maintenance ExperimentsIncentive Experiments in FirmsGDPInflationFieldDataExperimental DataHappenstance DataErnst Fehr – Experimental & Behavioral Economics8Behavioral 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 ownterms – generating theoretical insights, making more accurate predictions of field phenomena, and suggesting better policy.Ernst Fehr – Experimental & Behavioral Economics9My 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 thatare 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 Economics10My 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 Economics11An Example: Buying and Selling on a Market (Instructions)• In the following experiment you are either a buyer or a seller. Theexperiment is partitioned into periods. In total, there are 5-8