What is Experimental Economics? Vernon L. Smith Professor of Economics and Law

Experimental economics applies laboratory methods of inquiry to the study of motivated human interactive decision behavior in social contexts governed by explicit or implicit rules. The explicit rules may be defined by experimenter-controlled move sequences and information events in extensive form n (>1)-person games with specified payoff outcomes. Or the rules may be those at an auction or other market institution in which motivated people buy or sell abstract rights (to consume or produce) information and services (e.g. transportation) within some particular technological context. Implicit rules are the norms, traditions and habits that people bring to the laboratory as part of their cultural and biological evolutionary heritage; they are not normally controlled by the experimenter.Quite generally we can think of experimental outcomes (the observed replicable order in final allocations) as the consequence of individual choice behavior, driven by the economic environment and mediated by the language and rules governing interactions supplied by the institution. The economic environment consists of agent preferences, knowledge, skill endowments, and resource constraints. Abstractly, institutions define the mapping from agent choice of messages (e.g., bids, asks, acceptances, moves in a game tree, words, actions) into outcomes. Under the operation of these rules, or of norms, people choose messages given the economic environment. A well-established finding in experimental economics is that institutions matter because the rules matter, and the rules matter because incentives matter. But the incentives to which people respond are sometimes not those one would expect based on the canons of economic/game theory. It turns out that people are often better, and sometimes worse, at achieving gains for themselves and others than is predicted by standard forms of rational analysis. These contradictions provide important clues to the implicit rules that people may follow and can motivate new theoretical hypotheses for examination in the laboratory.The design of experiments is motivated by two quite distinct concepts of a rational order. Rejecting or denying either of these concepts should not be construed as irrational. Thus, if people in certain contexts choose outcomes yielding the smaller of two rewards, we ask why, rather than conclude that this is irrational.The first concept of a rational order derives from today's standard social-economic science model (SSSM) going back to the seventeenth century. The SSSM is an example of what Hayek has called, constructivist rationalism, which, in its modern forms and power, stems from Descartes, who believed and argued that all worthwhile social institutions were and should be created by conscious deductive processes of human reason. Truth is derived and derivable from premises that are obvious and unassailable. Thus, in positive economics it has been argued influentially that you judge the validity of a model by its predictions, not by its assumptions--a methodology that provides limited guidance in experimental studies where one can control the economic environment and institutional rules. In economics the SSSM leads to rational predictive models of decision that motivate research hypotheses that experimentalists have been testing in the laboratory since mid twentieth century. The test results are decidedly mixed, and this has motivated constructivist extensions of game theory, most notably based on other-regarding, in addition to own-regarding, preferences, and on 'learning'--the idea that the predictions of the SSSM might be approached over time by trial-and-error adaptation processes.For tractability, Cartesian rationalism provisionally requires agents to possess complete information - far more than could ever be given to one mind. In economics the resulting analytical exercises, while yielding insightful theorems, are designed to aid and sharpen thinking - if-then parable. Yet, these exercises may not approximate the level of ignorance that has conditioned institutions, as abstract rules independent of particular parameterizations that have survived as part of the world of experience. The temptation, of course, is to ignore this reality, because it is poorly understood, and to proceed in the implicit belief that our parables capture what is most essential in understanding what we observe.Our theories and thought processes about social systems involve the conscious and deliberate use of reason. Therefore, it is necessary to constantly remind ourselves that human activity is diffused and dominated by unconscious, autonomic, neuropsychological systems that enable people to function effectively without always calling upon the brain's scarcest resource: attentional circuitry. This is an important economizing property of how the brain works. If it were otherwise, no one could get through the day under the burden of self-conscious monitoring and planning every trivial action in detail. Also, no one can express in thoughts, let alone words, all that he or she knows, and does not know, but might need to know for some purposive action. For example, imagine the drain on the brain's resources if at the supermarket a shopper were required to explicitly evaluate the utility from every combination of the tens of thousands of grocery items that are feasible for a given budget. Such mental processes are costly and implicitly we must avoid costs that are not worth the benefit. The challenge of any action or problem triggers first a search by the brain to bring to the conscious mind what one knows that is related to the decision context. Context triggers autobiographical experiential memory, which explains why context surfaces as a nontrivial treatment in small group experiments.We do not recall learning most of our operating knowledge - natural language is the most prominent example, but, of particular relevance for experimental economics, also virtually everything that constitutes our developmental socialization. We learn the rules of a language and of social intercourse without explicit instruction simply by exposure to family and extended family social networks.These considerations lead to the second concept of a rational order, an undesigned ecological system that emerges out of cultural and biological evolutionary processes: home grown principles of action, norms, traditions, and morality. Thus, "the rules of morality…are not the conclusions of our reason." According to Hume, who was concerned with the limits of reason and the boundedness of human understanding, rationality was a phenomena that reason discovers in emergent institutions. Adam Smith expressed the idea of emergent order in both The Wealth of Nations and The Theory of Moral Sentiments. According to this concept of rationality, truth is discovered in the form of the intelligence embodied in rules and traditions that have formed, inscrutably, out of the ancient history of human social interactions. This is the antithesis of the Cartesian and contemporary belief that if an observed social mechanism is functional, somebody in the unrecorded past must have used reason consciously to create it to serve its currently perceived intended purposes. In experimental economics this tradition is represented by the discovery of emergent order in numerous studies of existing market institutions such as the double auction. To paraphrase Adam Smith, people in these experiments are led to promote welfare enhancing social ends that are not part of their conscious intention. This principle is supported by hundreds of experiments whose environments and institutions exceed the capacity of formal game theoretic analysis. But they do not exceed the functional capacity of collectives of incompletely informed human decision makers whose mental algorithms coordinate behavior through the rules of the institution--social algorithms--to generate high levels of measured performance. Acknowledging and recognizing the workings of unseen processes are essential to the growth of our understanding of social phenomena, and we must strive not to exclude them from our inquiry, if we have any hope of understanding data inside or outside of the laboratory. In this way we at least can attempt to escape the very significant disadvantage of being a human in studying human behavior. Even those who study primates must deal with natural tendencies to anthropomorphize what they observe; so strongly do we identify with our genetic cousins.Ironically, the greatest success for non-cooperative equilibrium theory, that has emerged from experimental studies beginning over forty years ago, is its power to predict outcomes when people have incomplete (private) information on individual payoffs. This "success" has passed with little fanfare because of the standard assumption that decision-makers, like the theorist/experimentalist, must have complete information in order to construct the equilibrium.How are the two concepts of a rational order related? Constructivism takes as given the social structures generated by emergent institutions that we observe in the world, and proceeds to model it formally. An example would be the Dutch auction or a sealed bid auction. Constructivists do not ask why or how that institution arose or what were the ecological conditions that created it; or why there are so many distinct auction institutions. In some cases it is the other way around. Thus, revenue equivalence theorems show that the standard auctions generate identical expected outcomes leaving no apparent economic reason for choosing between them. Using game theory to implement constructivist rationality, one represents a socioeconomic situation with an interactive game tree. The ecological concept of rationality asks from whence came the structure captured by the tree? Why this social practice, or game, and not another? Were there others that lacked survival properties and were successfully invaded by what we observe?The two types of rational order are both expressed in the experimental methodology developed for economic systems design. This branch of experimental economics uses the lab as a test-bed to examine the performance of proposed new institutions, and modifies their rules and implementation features in the light of the test results. The proposed designs are constructivist, although most applications, such as the design of electricity markets or auctions for spectrum licenses, are far too complicated for a complete formal analysis. But when a design is modified in the light of test results, the modifications tested, modified again, retested, and so on, one is using the laboratory to effect an evolutionary adaptation as in the second concept of a rational order. If the final result is implemented in the field, it certainly undergoes further evolutionary change in the light of practice, and of operational forces not tested in the experiments because they are unknown or beyond current laboratory capability.Finally, understanding decision requires knowledge beyond the traditional bounds of economics, a challenge to which Hume and Smith were not strangers. This is manifest in recent studies of the neural correlates of strategic interaction using fMRI and other brain imaging technologies. This research explores intentions or "mind reading," and other hypotheses about information, choice, and own versus other payoffs in determining behavior.