Economic science: an experimental approach for teaching and research.

• Author: Holt, Charles A.
• Position: 2002 Presidential Address

1. Introduction

   My doctoral dissertation was a study of the effects of contract provisions on competitive bidding (Holt 1979). The resulting articles contained the word "auction" in the titles, which seemed to have caused journal editors to begin sending me experimental papers with similar-sounding titles to be reviewed. I became interested in laboratory methods after observing that subjects' bidding strategies were approximately linear functions of bidders' private values, as would be predicted by a Nash equilibrium assuming risk neutrality (Vickrey 1962). Moreover, bids in private-value auctions were biased away from Nash predictions in a systematic pattern of overbidding (Coppinger, Smith, and Titus 1980). I wrote Vernon Smith at the time and noted that this bias might be explained by the incorporation of risk aversion into Vickrey's original game-theoretic analysis (Holt 1980). I then arranged for Smith to discuss his work on auctions in a seminar at the University of Minnesota, where I was teaching. We spent some time d iscussing how risk aversion might be induced in the laboratory. His enthusiasm was contagious, and I have been using experiments in my teaching and research ever since.

2. Vernon Smith and Market Efficiency

   Some of my first experiments were motivated by Smith's (1962) discovery of the surprisingly competitive tendency of "double-auction" markets in which buyers and sellers would bargain through a centralized listing of bids, asks, and trades. Like most other economists, I always began a classroom discussion of the competitive equilibrium (C. E.) model of supply and demand with a list of extreme assumptions. In particular, these included the notions of perfect information and "large" numbers of traders. In contrast, Smith (1982, P. 166) observed that "Markets economize on information in the sense that strict privacy together with the public messages of the market are sufficient to produce competitive C. E. outcomes."

   Smith's key insight was that traders have good information about the going market conditions, i.e., about bid, ask, and agreed-on contract prices. This work was motivated, in part, by Chamberlin's (1948) seminal market experiments in which participants could wander about the classroom and negotiate in dispersed groups. This locational decentralization sometimes produced a range of prices that permitted low-value buyers to make purchases at prices that were below the competitive equilibrium and that permitted high-cost sellers to get into the action at supracompetitive prices. In this manner, price dispersion can result in a loss of efficiency associated with the extra transactions that would be excluded in a competitive equilibrium with a uniform price. Smith's experiments generated more price uniformity and high efficiency by (i) forcing all bids and asks to be centrally announced and (ii) reopening the market in a sequence of "periods" or "trading days." In retrospect, it is easy to understand how repetitio n may promote price uniformity, as a seller who agrees to a low price in one period may refuse to go that low if other sellers are observed to obtain higher prices. Conversely, buyers who pay relatively high prices will be more cautious if many others are seen to have secured lower prices. These arguments also suggest how the provision of good information about the going terms of trade will enhance price uniformity and trading efficiency. A comparison of market performance with and without centralized information was the beginning of an impressive string of studies by Vernon Smith and coauthors on the effects of changes in trading rules on market outcomes. This line of research was recognized in Smith's 2002 Nobel Prize in Economics.

3. Teaching from the Trading Pit

   Experimental work is having a major effect on the way economics is taught, as professors try to integrate active-learning exercises into material that is often formal and abstract. Indeed, if I had only one lecture to give to a class, I would begin it with a "pit market" trading experiment (Holt 1996). Figure 1 shows the results of a classroom pit market experiment reported in Holt (2003). The students were given buyer and seller roles and were led to a crowded trading area (the "pit") in front of the class. There were four buyers with $10 cards, who were told that they could "keep the difference" if they could make a purchase for less than $10. There were also four sellers with $8 cards, who were told that they could keep the difference if they could make a sale at a price above $8. If the market had only consisted of these people, then prices would have been in the $9 range, with four units traded and a profit of about $1 per person. In addition, however, there were also four buyers with $4 cards and four s ellers with $2 cards. If these people had been isolated from those with higher values and costs, then the result would have been prices in the $3 range, with earnings of about $1 per person. All together, the four trading pairs with high cards would earn a total of $8 and the four trading pairs with low cards would earn $8, for a total of $16. The total quantity traded would be eight units, and the prices would range from $3 to $9, yielding a high variability in the aggregate.

   The trading pit prevented the isolation of traders into two groups because the buyers and sellers facing each other soon dissolved into a fluid mix of changing groups and loud negotiations. When a buyer and a seller agreed on a price, they came together to the recording desk, where the price was checked, called out, and written on the blackboard. The dots on the left side of Figure 1 represent contract prices in the first trading period, where prices ranged from $3 to $10. Price variability declined in subsequent periods, and there were four units traded in the $5-$7 range in the final period. With prices in this range, the high-cost ($8) sellers are excluded, as are the low-value ($4) buyers. Thus, it was the four sellers with costs of $2 trading with the four buyers who had high values of $10. Each buyer-seller pair had an $8 difference ($10 - $2) between the buyer value and the seller cost, so the earnings total (for the four traded units) was $32, which is exactly double what would have been observed if t he high-cost sellers had traded with the high-value buyers and if the low-cost sellers had traded with the low-value buyers. This exercise illustrates how the pressures of market trading promote a price uniformity that enhances the wealth created by the market.

   The most important secret involved in teaching with classroom experiments is to resist that professorial impulse to show off your knowledge by rushing to the black board and explaining why economic theory was accurate. I have found that it is best to follow the pit trading exercise with a series of carefully thought-out questions that lead students into a self-discovery of the notions of supply and demand in this context. For example, you might call attention to the first-period prices that were above $8 and ask "If those high prices had persisted, would there have been more willing buyers or more willing sellers?" Then you might ask what sellers would do if there were lots of willing sellers and only a few interested buyers at those high prices. These questions lead to the notion that prices would fall until there is more of a balance, which leads students to the type of balance of supply and demand that is inherent in a competitive equilibrium. The final step is to lead them to the construction of the suppl y and demand graph shown in Figure 2. See Holt (1999) for a more detailed discussion of how to use experiments in class. That issue of the Southern Economic Journal also contains a collection of other useful classroom experiments on voting, the law of one price, and macroeconomics.

   One of my Virginia colleagues, Bill Johnson, once described the pit market trading exercise that he does as being "the gift that keeps on giving" because it provides a clear example that students can remember and reconsider later in the semester. For example, the graph in Figure 2 illustrates the notions of consumer and producer surplus, which sum to the $32 earnings amount obtained in the final periods of trading. A tighter band of prices in these rounds prevented the production of inefficient units with costs that were higher than the values for buyers at the margin. The resulting surplus of $32 is double that which would have been achieved if the inefficient units had been traded in a market with wide price variability. This discussion is at the heart of Adam Smith's insight that the pursuit of private gain may generate wealth, resulting in an outcome that is beneficial from a social point of view. But notice that the pursuit of private gain would not have been good enough if the market had been segmented or decentralized, and experiments have provided key insights into the design of efficient trading mechanisms.

4. Market Power

   The most widely used trading institution in experimental work is the "double auction," which has a little more structure than the give-and-take (sometimes push-and-shove) of the pit market. The buyer side in a double auction is somewhat like an ascending-price (English) auction in which each bidder is free to top the highest current bid as it rises in a succession of upward jumps. The word "double" comes from the fact that sellers are operating in reverse, with a downward movement in asking prices as sellers undercut each other's offers. The bid-ask spread narrows as bids rise and asking prices fall, and a contract is made when these meet, that is, when a seller accepts a buyer's bid or a buyer accepts a seller's ask.

   In his widely cited survey of industrial organization experiments, Charles Plott (1982, p. 1486) notes that, with double auctions, "... the overwhelming result is that these markets converge to the competitive equilibrium even with...