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This year's
economics laureates — economist Vernon Smith of George Mason University
and psychologist Daniel Kahneman of Princeton University — have both
been pioneers in the field of experimental economics. But the similarity
between their contributions ends there. Vernon Smith has used experiments
to test and essentially validate existing theories of market. Daniel
Kahneman, on the other hand, has applied experimental data to question the
assumption of rationality in the traditional theory of decision-making
under uncertainty and constructed an alternative theory. To be
sure, several economists including his teacher at Harvard, late Edward
Chamberlin, preceded Smith in applying the experimental approach to
testing theories. But having made the most important early contributions
and trained a large number of young researchers, Smith remains the
undisputed central figure in the field. Smith's
most celebrated contribution, made in 1962, tested the validity of the
standard perfect competition model. In the simplest form, this model says
that in a competitive market, exchanges take place at a price that equates
demand and supply. Smith randomly assigned the roles of buyer and seller
to his subjects in a so-called double-oral auction for a fictitious good.
He then gave each buyer and seller a different reservation price. Each
buyer was to buy one unit of the good at a price not to exceed his
reservation price and each seller was to sell one unit at a price not
below his reservation price. The difference between the subject’s
reservation and transaction prices was to be his profit. Smith
assigned reservation prices $32, 30, 28, 26.... to buyers and $8, 10, 12,
14... to sellers. The sequences implied seven buyers with reservation
prices of $20 or more and an equal number of sellers with reservation
prices of $20 or less. Thus, if we draw demand and supply curves based on
the sequences, they would intersect at the price of $20 and quantity of
seven units. The
subjects knew only their own reservation prices and were forbidden from
colluding. They were informed of all bids, transactions and prices,
however. Smith, who had all the information, hypothesised that if the
exchanges took place at or near $20, perfect competition model would be
validated. Much
to his surprise and contrary to the expectation based on Chamberlin’s
(flawed) experiments, Smith found that most transactions were at prices
close to $20. Moreover, over successive time periods, the variance of the
price declined and it rapidly converged towards the theoretical
equilibrium of $20! Smith’s
subsequent work has focused on testing the role of alternative
institutional mechanisms, particularly in the context of the auction
theory. He has tested the predictions of alternative auctions such as the
English, Dutch, and first- and second-price sealed-bid auctions. He has
also initiated the use of the laboratory as a “wind tunnel” (a
laboratory set-up used to test prototypes for aircraft) to study
alternative institutional mechanisms for deregulation, privatisation, and
the provision of public goods. Turning
to Kahneman, he is credited with both a compelling critique of the
traditional theory of decision-making under uncertainty and construction
of an alternative theory (with Amos Tversky, deceased in 1996). Based on
survey and experimental research, he argued persuasively that in complex
decision situations under uncertainty, individuals do not make rational
calculations as assumed by the traditional theory. Instead, they rely on
heuristic shortcuts or rules of thumb. For example, they would overstate
the probability of violent crimes in a city if they personally knew
someone who had been assaulted even if they had access to more relevant
aggregate statistics. Kahneman
and Tversky have gone on to offer what they called the “prospect
theory” of decision-making under uncertainty. Relying on experimental
data, this theory departs from the traditional theory in two key respects.
First, individuals are assumed to be sensitive to the way an outcome
deviates from the status quo rather than to the absolute level of the
outcome. Second, individuals are more averse to losses relative to the
status quo than they are partial to gains of the same size. Prospect
theory is able to explain several regularities that appear anomalous in
the traditional theory. For example, it explains the propensity for people
to take out expensive small-scale insurance when buying appliances. It
also explains the willingness of individuals to drive to a distant store
to save a few dollars on a small purchase but not for an equally large
discount on an expensive item. MONDAY,
OCTOBER 14, 2002 |
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