Experimental economics

Experimental economics

This web site hosts a paper which described the then-unprecedented experiments which was being done to measure the affects of abstract economic concepts at work in animals. Specifically, the risk-return relationship called the utility curve was measured for bees, ants and mice. Not only did the relationship actually exist, but it behaved as economists had speculated in response to generically-secure or choppy environments.

There have since been a torrent of equivalent papers. I want to draw attention to two recent offerings which may be directly germane.

Reputation

It has been known for some time that tacit institutions - and particularly those involving the common good - are valued by people, to the extent that they will make considerable sacrifices to protect them. (e.g. Ledyard Handbook of Experimental Economics PUP 1995.)

Two new lines of evidence have been added to this. The first is concerned with reputation, where the urge to cheat has to be balanced against the affect which cheating might have in future.

Freeloading and cheating lead to the "tragedy of the commons", whereby free goods - grazing, water - are overexploited because any one actor who holds back in order to protect them loses out to others who do not. The Nash equilibrium (subject of the current hit movie, "A Beautiful Mind") takes the system into pollution, desertification and the like. Thus, theory goes, we need rules and Hobbsian rulers to impose them.

Simple experiments allow the scope of this to be investigated. Milinski et al (Nature 415 424-426 2002) run games with real money. Players contribute a variable amount to a pool, which is doubled and then returned to each, divided evenly. Thus, if each player put $5 in the pool, each would get $10 back. However, putting nothing in the pool would, if many others did in fact contribute, send the player home with a little under $15. Each player makes this calculation and, in the absence of information about the behaviour of others, contributions quickly fall to zero.

In the experiments described, individual behaviour was alternatively revealed and concealed, or (unpublished) subject to random revelation. This completely changes the outcome of the game. Contributions are high, and the overall 'value added' for the players is also high. Collaboration is by inferred models of other's conduct. We call such inferences 'reputation'. Where we can calibrate our model of others sufficiently well, then we take the risk which in involved in collaboration. Where we cannot do this, we play for the safe lowest common denominator. Interestingly, when information was cut during these game series, collaboration swiftly ceased.

Solutions to the issues raised by the Nash equilibria are less Hobbsian than Lockian. That is, we do not need enforcement so much as enforced ownership.

We are not short of cows or fir trees. By contrast, whales and some tropical forests have no owners, and it follows that there is no one body which has defensible self-interest in investment which leads to their sustainable cropping. If the UN World Maritime Organisation were to sell title to whales, for example, then the issue of conservation would reduce to one of the enforcement of ownership rights.

The cheapest and most effective form of policing is self-imposed. This works best, as we have seen, where the key penalty for defection is the loss of reputation and, as a consequence, the loss of the long-term ability to trade. It follows that a policy of making goods such as whales and forests tradable assets also requires a structure in which reputation and trust are of critical importance to long term success, and specifically important outside of national and cultural boundaries where environmental damage is tolerated or dissent is quashed.

Punishing defectors

A related major paper (Fehr and Gachter Nature 415 137-140 2002) looked at the policing of tacit institutions. A similar series of games were set up. However, individuals could now 'fine' defectors, at considerable financial penalty to themselves. The experiments showed that, as expected, collaboration fell to low levels in the absence of information and penalties for defection.

Where information was available, collaboration is stronger. However, the design of the experiment was intended to factor our the impact of reputation. Instead, players worked in novel pairs, and each had the ability to punish or not to punish their partner, at a considerable cost to themselves if they chose to exercise the option to do so. Where such penalties were put in place, collaboration and the pursuit of group norms was strong and persistent. What came as a surprise was the degree to which collaborators were prepared to harm themselves in order to enforce these norms. The conclusion that is drawn from this is that "altruistic punishment" is a major force in human affairs (and human evolution.) We are prepared to incur considerable penalties in order to deter those who go against group interests.

We will, it seems, go to considerable pains to seek out those with good reputation, and to punish those who default. We will - although this is not shown, it seems a logical consequence - go to equal pains to assure ourselves of free information flows in our societies ands organisations. After all, perhaps a third of prime time broadcasting consists of news programs and commentary, and we spend hours every day informing ourselves through gossip and newspapers, radio and television about our world.

The economics of impatience

We are all familiar with discount rates: that we regard future rewards as less valuable than rewards which are reaped today. A considerable body of work now shows that this intuition is as true for animals as it is for humans. Our planning assumptions have, however, always been based on the notion that the rate at which we discount the future is constant, both for the distance the event is to occur in the future and for the time interval between alternatives which we might trade for it. It turns out that these assumptions are wrong.

A pigeon, confronted with a crumb before it and a chunk of bread ten seconds waddle away will take the crumb. However, it will go after the larger of two chunks of bread that are distant, even though the smaller chunk is closer. In this and similar ways, we can measure how animals make choices.

It turns out that humans, faced with alternative contingencies, act in much the same manner. (e.g. Loewenstein at Carnegie Mellon.) Work by Laibson at Harvard bases an explanatory model on the notion that there is an unresolved conflict between the discount rates that determine short and long-term behaviour. This gives a far better model of actual consumer behaviour than does the constant discount rate model.

In a recent US survey, 75% said that they should be saving more for the future, but only 6% said that they were completely fulfilling these needs. A further group (Thaler at Chicago, Banartzi at UCal) worked through the logical implications of this into a practical experiment. People are reluctant to save current income, but they should be happier to save from future income. A company was persuaded to offer its employees the opportunity to commit themselves to save an increased proportion of future salary increases. In something over two years, savings rose from 3.5% to 11.8% of staff salaries.

Truth and consequences.

One wonders what the implications of this for the current rule by quarter-by-quarter earnings approach which seems to dominate in capital markets, and the importance of it for long-term partnerships with peer organisations. It seems to re-enforce one great C21st truth. We are all modular and multifaceted, whether we act as a firm, a nation or an individual. Our connections with other such modules is erratic and unpredictable. The interface - how we are interpreted, and what interpretations we make, crucially define our joint behaviour. Further, such interfaces are defined by information, expressed in ways which we call insight, trust, reputation, oversight, governance and the like. We are treated in ways which reflect how we are seen, and the more that how we are seen and what we actually do are in line with each other, the stronger our long-term collaborative relationships are likely to be.