Vernon Smith, Economic Experiments, and the Visible Hand

The first thing to say about economic experiments is what they are not. Economic experiments are not simulations or role-playing exercises. They involve real people who must make serious choices. Their decisions in the laboratory are as acute and as poignant as those made outside the laboratory. Through their efforts participants stand to make or lose substantial amounts of money.

The simplest form of economic transaction—and the simplest experiment to conduct—is a two-person exchange. This experiment addresses how a single buyer and seller of an object reach, or fail to reach, mutually agreeable terms of trade for that object. In this experimental setting the researcher induces value on the object for the buyer and the seller. For example, the person assigned the role of seller of the object might be handed a card that indicates that his cost of production for the unit is $10. If he can sell this unit to the buyer in the experiment, then he will be awarded the difference between his sales price and $10. Likewise, the person assigned the role of buyer of the object might be handed a card that indicates his resale value of the unit is $22. This means that if he is able to acquire the unit for less than $22, he can then sell it back to the experimenter for $22 and keep the difference.

It is important to note here that although there is no actual physical object being traded, both the seller and the buyer have an incentive to behave exactly as if there were. The seller will desire a price well above $10 for his unit; the buyer will wish to pay as little as possible for his unit. What will happen? Logic says that two outcomes are possible. Either the seller and buyer find a mutually agreeable price between $10 and $22 or they fail to reach agreement and do not consummate a trade. Economics says that both sides have an incentive to make a deal , but nothing to say about how the benefits of that deal will be divided. Nor do we understand the conditions that would produce an equal division of the gains at a price of $16. We also do not have much to say about the frequency of occasions where the seller and buyer part company without making a trade. Many versions of this simple experiment have been conducted to explore these empirical issues.

The simple experimental design outlined above provides a building block for all
subsequent experimental market designs. After all, a market at its core is nothing other
than a place where bilateral trades are facilitated between multiple buyers and sellers.
Suppose we want to construct a market with 5 sellers and 5 buyers. In this case we
would hand a card to each seller indicating the cost of production. For example, one
seller would be given a card indicating a cost of $10. The other four sellers would
have costs of $12, $14, $16, and $18. People assigned to be buyers would receive a
card indicating their resale value. Continuing the example, suppose these values were
$22, $20, $18, $16, and $14. Each seller and each buyer in this design have the
opportunity to make one transaction.

Given the range of values for buyers and the range of costs for sellers, what will occur when they are allowed to trade? Will sellers have the upper hand? Will the buyers? Will all trades that might benefit both buyers and sellers occur or will some beneficial trades fail to take place because of incomplete information or so-called market failure? When trades do take place will they be across a wide range of prices or a narrow band?

Economic theory in its simplest incarnation of supply and demand makes a strong set of predictions. What are the supply and demand schedules here? Consider an axis set that has price on the vertical axis and quantity on the horizontal axis. The supply schedule answers the question “How many units would voluntarily be brought to the market at different prices?” Thus supply in this experimental structure is an ascending stair-step pattern that starts at $10 and rises $2 per step for each unit in the market. Above $18 the supply curve is vertical for no other than the fifth unit can ever be purchased in this setting. Likewise, the demand schedule answers the question “How many units will be voluntarily purchased in the market at different prices?” Using the same analysis as that for the sellers, we find that the demand schedule is a descending stair-step pattern that starts at $22 and falls $2 per step for each unit demanded in the market. Below a price of $14 the demand schedule also is vertical for no more than the five units are desired in this setting. For this scenario, textbook economics predicts that equilibrium will be reached where supply equals demand. In this case that means that four units would be traded at the identical price of $16.

Vernon Smith developed this basic structure for creating an experimental market almost fifty years ago. But his first creative insight was motivated by the severity of the textbook prediction for all prices to be exactly $16 as noted above. How could everyone in the market be forced to this conclusion? Neither the sellers, wanting high prices, nor the buyers, wanting low prices would necessarily be happy with this outcome. In other words, how was Adam Smith’s invisible hand to do its work? Should we as economists really think of the “hand” as a guideline or rule of thumb? Was the “hand” really just an abstract construct useful for the parsimony of our models and the placation of our students.

Smith’s second creative insight was that exploring these questions could not be done in an institutional vacuum. Half of the experimental structure was missing. The sellers and buyers in this structure cannot trade unless specific rules, forming the structure of a trading institution, are employed. In his early work Smith selected to use the rules of a double-oral-auction. These auction rules are similar to the rules used for trading at the New York Stock Exchange or the Chicago Board of Trade. It is “double” because both sellers and buyers participate (for example as opposed to a silent auction at a fundraising event where the seller is passive). It is “oral” because the participants call out their bids and offers publicly. They do this using an important rule called the bid-asked-price-reduction-rule. What it means is that sellers call out asking prices, these are posted publicly, and all subsequent asking prices must descend from this starting asking price. On the other side of the market, once the first buyer makes his bid, all subsequent bids must ascend from this starting bid price. Trade can occur in two ways. As a seller any buyer can accept your asking price or you can accept any buyer’s bid. As a buyer any seller can accept your bid price or you can accept any seller’s asking price.

When Smith ran these first experiments, the mechanics of the invisible hand became visible for the first time! Undergraduate student subjects were found to produce single-price market equilibria even though no one of them desired this outcome. When they repeated the exercise, prices were even tighter around the equilibrium. The number of units being transacted was also “efficient”, exhausting the gains from trade without anyone being in charge of the market.

These results were big surprises. The textbook says that there should be perfect information for the market to equilibrate. But the subjects produced market equilibria having no knowledge about others and with little experience, if any, with trading in the double-oral-auction. Finally, when Smith manipulated the number of sellers and buyers he found that astoundingly small numbers of sellers and buyers would produce competitive equilibrium. A market with as little as four sellers and four buyers will produce the competitive outcome. Prior to this research, the textbooks said you needed infinite or “numerous” numbers of each. Smith’s early research challenged this convention and opened up the possibility that many apparently “thin” markets (having few sellers and buyers) in the real world produce competitive outcomes.

By the late 1970s Smith was off to the races. All types of market institutions were being examined. English and Dutch single object auctions, sealed-bid auctions, posted-offer markets (like a grocery market where stores place take-it-or-leave-it prices), Treasury Bill markets, and others were all in play. At this time, Smith found a computer system at the University of Arizona that for its time was progressive. It offered both real time networking and touch-screen communication. All of his experimental markets were in the process of becoming computerized.

Before continuing the narrative of Smith’s scholarship I want to say a few things about the simple oral double auction. I have left out only a few details about how to conduct such an auction in the classroom. I have used the double auction every year for the last 20 years. I conduct experiments mostly as an exercise for my undergraduate and graduate students. But I have conducted experiments with groups diverse enough to include eight year olds, communists, and professional traders. In all of these years and across all of these groups, the auction has never failed to produce the competitive result. Students learn so much from the experience and the post-experiment discussion. All of the important lessons of economics are right in their face. I have said for years that it is the best economics education a student can absorb if you only have an hour.

I started graduate school at Arizona in 1978 and Smith hired me to be one of his graduate assistants / programmers. I spent four years in the classroom and learned my economics. But I also spent four years in the back room of a computer laboratory with Vernon and other students watching the results of experiments in progress come flashing out onto the screen. What an education that was. We could see how different market institutions produced more efficient outcomes in different situations. We could see how monopolists and members of oligopolies could, or could not, wield their powers. We could see how command and control regulations in the market affected behavior and produced unexpected consequences. We also began to explore how problems with public goods might be addressed using market principles.

Smith’s imagination was not limited to studying the extant taxonomy of market institutions. He was constantly on the prowl for novel trading structures that could expand the reach of economics into public affairs. Following are just two of the many areas where his research has had pragmatic affects on public policy.

At certain times of the day at large American cities more jets want to land and depart than can be handled by the airport. Demand for take-offs and landings exceed supply capacity during these periods. One obvious economic solution to this problem is to auction off the right to land and take off during the congested periods; to take the fixed number of scarce “slots” during this period and sell them to the highest bidders. This logic is correct. But Smith realized that it was incomplete. The problem is not just the fact that you want to land at O’Hare airport in Chicago on Friday in the 4:00 through 5:00 P.M. time slot. Typically you want other side conditions to be met. You might also want a slot out of O’Hare between 6:00 and 7:00 P.M. Additionally you may be flying from Chicago to another congested airport like Atlanta, so you will want a landing slot there as well and so on.

At its essence, slot allocation is a problem of balancing supply and demand. But the constraints associated with so many crowded, interconnected airports with so many airlines and aircraft competing for space make the simple problem seem impossibly complex. Smith did not think so. He was able to develop a system of combined auctions that solve this problem. These auctions were exhaustively tested in his laboratory and are now used as allocation tools in national airport management.

Electricity has three properties that make it different from other economic commodities. First, it is the only product where supply and demand have to be equal at all moments in time. Electricity suppliers promise to meet the use by demanders—when you switch on your lights, you expect them to come on. Second, electricity is hard to store. Third, electricity does not really move directly from its source to its ultimate user. Rather, when electricity is provided to a power grid, it is better to think of the grid as a great pond whose water level has just increased. These three factors have inhibited the trading of electricity across regions in this country. Smith, always on the lookout for market solutions that could improve efficiency cracked the complex technical problems associated with how to trade something so seemingly amorphous as electricity. His work in this area provided the basis for a radical new system of electricity and energy trading that swept the country during the 1990s. Smith advocated an open trading system for electricity in both the wholesale and retail markets. States that have adopted his system fully have benefited greatly. Other states that still use old regulatory regimes or, like California, only applied a partial market framework have struggled.

Vernon Smith fathered an entirely new research tool for understanding human behavior. To the non-economist an analogy from astronomy might be useful to explain the impact of his work. Were Smith an astronomer, he would not be the type that utilized existing optical telescopes to discover and explore ever more distant objects. Think of him as the inventor of the radio telescope. This new tool allowed us to understand known astronomical objects with a new precision. But more importantly, it allowed us to discover whole new classes of otherwise unknown objects and phenomena.

His work has had a profound effect on a generation of his, and others’ students. The four years I spent with Vernon were intellectually the richest of my life. Each day in the laboratory promised the possibility of finding another economic Atlantis. When thinking of Vernon, as I have been doing so jubilantly since the Prize was announced, almost all of my thoughts hearken to the back room of his laboratory. It was where he shared with us an appreciation and understanding for the science in “economic science”. But there was so much more. It was where so many of us learned from him the art of economic insight.

See, in particular:

• “Microeconomic Systems as an Experimental Science”, American Economic Review, December 1982.

See also:

• “Economics in the Laboratory”, Journal of Economic Perspectives, Vol. 8, No. 1, Winter 1994, pp. 113-131.
• “Experimental Economics: Induced Value Theory”, American Economic Review, May 1976.
• “Experiments with a Decentralized Mechanism for Public Good Decision”, American Economic Review, September 1980.

For a complete bibliography of Vernon L. Smith’s writings, see this George Mason University pdf file of Smith’s C.V.

To read more about Vernon L. Smith and Daniel Kahneman’s Nobel Prize, see the Nobel Prize in Economic Sciences, 2002.