Looking for a challenge?

Prove customers create an efficient amount of wealth without perfect information.  Show that gas price zoning is natural and profitable for both wholesalers and consumers.  Explain why flat rates for electricity cause major inefficiencies.  Demonstrate conditions for specialization.

All these questions involve individuals making choices in their respective social contexts, questions likely to be approached by economists.  From July 10th to July 14th 2006, I learned and experienced three researchers’ approaches to these and other questions—the relatively new tool of experimental economics.

The Grassroot Institute of Hawaii sponsored my travel expenses to an Institute for Humane Studies (IHS) Summer Seminar on Experimental Economics at Bryn Mawr College.  Here we had ten sessions with three faculty members of the Interdisciplinary Center for Economic Science who introduced us to their work in experimental economics: Ryan Opera, Ph.D., Robert Kurzban, Ph.D., and Bart Wilson, Ph.D.

All three use laboratory set-ups to examine the way people make decisions in a particular environment.  This approach fills in a gap in economics that theory alone and field data alone could not address.  I will explain one experiment in hopes of describing the kinds of conclusions experimental economics can come to.

The first activity we did was the Oral Double Auction, a set-up similar to that of the New York Stock Exchange.  There were two types of participants: buyers who are purchasing units, and sellers who are selling units.  (The actual identity of each unit is irrelevant.  All units are to be assumed equal and comparable to each other.)  Each buyer receives from the experimenter a unique personal value for a unit, which may vary depending on how many units he or she buys.  Each seller receives a unique predetermined cost on a unit that he or she must pay once a unit is sold.

Both types of participants can make a profit. If a buyer buys under his value, he will earn the difference between “value” and “price bought at” in “experimental dollars,” which are exchanged proportionately to actual US currency at the end of the experiment.  If a seller sells above her costs, she will also receive a proportionate amount to the profit in US currency from the experimenter.

No one talks to each other, and the only action you can take as a seller is to post an asking price through the experimenter, and likewise, post a bid as a buyer.  Transactions occur when a seller and a buyer agree on a price.  Then bids and asking prices are cleared and start over for another potential transaction.  The only information everyone shares is the board on which we can see asking prices, bids, and the final price at which a transaction occurs.  The experiment ends when there is no activity left.

Naturally, everyone bought low and sold high.

Through oral double auction results, we can infer several ideas.  First of all, because the experimenter pre-set the costs and values, he could determine the maximum payout he would have to give at the end of the experiment (to all the buyers and sellers) as well as the competitive price and competitive quantity of units sold.  Buyers’ values are set by the experimenter to start high and decrease as more units are bought.  Sellers’ costs are set to start low, and increase as more units are bought.  At the intersection of these two graphs is an equilibrium point where any further transactions will result in a non-profitable transaction for either or both parties.

In terms of the actual monetary payout at the end of the experiment, if someone engages in a transaction that is not profitable to them, they lose money and altogether, the experimenter hands out less money.  As long as sellers sell above their costs and buyers buy below their values, more wealth is created as is demonstrated and represented by the payout from the experimenter.

The experimenter also creates the institution, or the rules with which transactions occur.  This can be explained in terms of what information is available, and what actions the participants may take.  As stated before, the oral double auction is a system similar to that of the New York Stock Exchange.

These pieces of knowledge allow us to compare the socially efficient outcome, where the experimenter pays out the maximum amount of money (and therefore, the most wealth created), to the actual outcome of the experiment.  Data from trials consistently show that groups of independent buyers and sellers, without perfect knowledge of everyone else’s values and costs, have managed to attain a 100% efficiency.  It is true that one person cannot figure out the competitive price and quantity (values that would automatically attain 100% efficiency) without knowing the other values and costs, but in the experiment, independent buyers and sellers, who all aimed to maximize their profit, unknowingly arrived at the socially efficient outcome.

Out of experiments like this has grown research that has even been used by the Federal Trade Commission.  Bart Wilson and Cary Deck published a paper “Economics at the Pump,” which investigated three economic issues in the gasoline industry: zone pricing, divorcement of refiners and retailers, and the rockets and feathers phenomenon.

The experiment has an automated consumer simulation that takes into account randomized distances, brand preferences, and cheapest price.  With the same amount of consumers per trial, this represents the almost inelastic demand of gasoline we experience in life.  We will buy gas whether it is $2 per gallon, or $4 per gallon.

Participants in the experiment are either one of four store owners, or one of four wholesalers.  Each wholesaler has an exclusive relationship with a store owner, and each pair only does business with each other.

The wholesaler sets his prices based on automated costs of production.  The store owner has two stores, one in close proximity to a store owned by the other three owners and one in isolation.  The store owner receives the price from her wholesaler, the cost to have an open store, and sets her price for the customer accordingly.  Information available to everyone is where the customer ends up purchasing gas, and every store’s price.

Zone pricing naturally occurred.  With each store owner having one store in direct competition with others, prices were much lower in that area.  Each of the stores that were isolated had higher prices, even though they are owned by the same owners who have stores in close competition.  When zone pricing was eliminated—store owners could only set one price for both stores—prices for both the competitive stores and the isolated stores rose.  By keeping the same settings for consumers, Wilson and Deck showed that store owners were the only ones who benefited from uniform pricing.  Both wholesalers and consumers lost money.

In an experiment where vertical integration was allowed, there was no middle-man who had to take a profit (the store owner).  In other words, wholesalers owned stores too.  In the experiment, this meant that the participant as the store owner received the costs that would have otherwise gone to the wholesaler.  (There was no wholesaler position in this round.)  This allowed costs of gas to decrease, and consumer profits soared.

Lastly, the rockets and feathers phenomenon, where prices rise faster than they fall, did indeed occur in this experiment.  As the experiment showed, this is because prices rise in order for the store owner to remain profitable; it is an internal decision.  Prices, however, decrease not because of an internal event, but because of competition.  This external event takes longer because each store owner is watching each other and only reacts to the situation.

As shown, experimental economics provides a new way of looking at economic problems.  Because the experimenter can control values and costs, as well as restrict variables to the bare essentials, the experimenter can collect vast amounts of data that are simply unavailable in real life exchanges.  The experimenter can also account for values that many people don’t ordinarily think of in terms of money, yet acknowledge as profit, such as safety and comfort.  Experiments also work with economic theory in order to incorporate individual differences amount participants—something that theory alone cannot do.  Thus, experimental economics is emerging as an important field of economics that supports established methods in understanding human decision making.

References:

http://ceee.gmu.edu/whatIsExpEcon/index.php

http://www.econlib.org/LIBRARY/Columns/CourseyVSmith.html

http://www.cato.org/pubs/regulation/regv27n1/v27n1-2.pdf

Reid Ginoza is an Intern with the Grassroot Institute of Hawaii and will be entering his Sophomore year at Bennington College in Vermont.

A Fresh Perspective is a project of the Grassroot Institute of Hawaii. Submit proposed articles to mailto:grassroot@hawaii.rr.com