the experimental study of behaviour in economics: origins and current directions

Contemporary Issues and Ideas in Social Sciences

2012

The Experimental Study of Behaviour in Economics1

Sujoy Chakravarty

Centre for Economic Studies and Planning, School of Social Sciences, JNU,

New Delhi 110067.

Abstract

The study of behavior in economics using paid experiments has

a history of about half a century. This article tracks not just the

chronological history of the field of experimental economics but the

intellectual history of the way agent behavior has been studied in eco-

nomics since the advent of the rational-actor framework in the nine-

teenth century. I examine the methodologies that form the bedrock

of experimentation in economics, their origins, their advantages and

their antecedents. I also explore the manner in which experimental

economics has enabled theories and frameworks from fields in social

sciences like psychology, anthropology and political science to influence

the way behavior is modeled in economics, leading to newer theoretical

1The author would like to thank Bhaswar Moitra, Emmanuel Dechenaux, E. Soman-

than, Gerd Gigerenzer, Parikshit Ghosh and Priyodorshi Banerjee for some particularly

insightful conversations that have informed this essay.

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understandings that go far beyond the traditional view of the agent as

homo-economicus, i.e. - a self interested rational maximizer interested

in merely increasing his material wealth.

JEL Classification: B41, B21, C9, D03

Keywords: Behaviour, Experiment, Rationality, Institution, Norms

1 Introduction

...this theory is not speculative in origin; it owes its invention

entirely to the desire to make physical theory fit observed fact as

well as possible.

Albert Einstein on the theory of relativity, Kings College, 1921

Economics is a discipline that has repeatedly thrown up questions that

are deeply anchored in social phenomena. These questions include ones on

how industries grow and organize themselves, how consumer tastes and pref-

erences evolve and why some societies are poor whereas others experience un-

told riches. All of these questions have led economists to the study of human

behaviour, which from all accounts is fraught with contradictions. Human

beings are capable of great foresight and analysis but they are also guided by

a diffuse set of motivators, some of which are biological and others societal.

Given that these nature and nurture variables may be different over dif-

ferent individuals, individual behavior observed in economic situations may

differ widely depending on the actors involved and the environment in which

Chakravarty: The Experimental Study of Behaviour in Economics 3

they operate. Examples of phenomena in which we see a distribution of be-

havioural realizations include the amount of contribution made to charities,

the proclivity towards acquiring resources through corrupt means, cooper-

ation displayed towards teammates and co-workers and the wherewithal to

take on monetary risks. In spite of this large variance in observed behaviour,

the theory used in economics to model individual behavior has grown to be

highly axiomatized and mathematized. We would not be unjustified in say-

ing that economic theory over the last century has concerned itself more with

rational benchmarks and less with trying to model empirically observed

behavior. According to Smith (1989) most economists feel that economics

is an a-priori science rather than an observational one. According to Mil-

grom and Roberts (1987, p. 185) no mere fact was a match in economics

for a consistent theory. Thus most economic theorists believe that economic

problems and agent behavior therein can be fully conceptualized by thinking

about them. Accordingly after the thinking has produced sufficient techni-

cal rigour, internal coherence and interpersonal agreement, economists can

then apply this to the world of data. (Smith, 1989, p. 152)

The rational agent thus modeled is a self-interested maximizer always taking

a decision that maximizes his expected wealth. However, if we look around us

we see serious violations of this behavioural norm. Human beings are prone

to voluntary acts of kindness sometimes motivated by altruism. Most peo-

ple cooperate with their neighbours in the upkeep of their neighbourhoods

and most would trust another human being unconditionally often suffering

negative consequences from this trusting behavior. Are most people then

irrational? If that were the case shouldnt theory reflect this divergence

from the norm especially as this divergence is often systematic and not ran-

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dom? Ariely (2008) refers to these divergences as predictably irrational

ones. Basu (1983), Sugden (1986) and Coleman (1990) have attributed so-

cial norms (especially those that inculcate values and a sense of morality) as

modifiers on our desire to maximize our material wealth.

The field of experimental economics (not to mention experimental social psy-

chology) stands at the centre of this debate on observed behavioural devia-

tions from rational theoretical prediction. The method of controlled experi-

ments from the fifties onwards has allowed us to test game theoretic models as

well as individual choice models with human subjects in the laboratory. Ob-

served economic behaviors are compared to rational theoretical benchmarks,

divergences from the rational norm are noted and in certain cases theories

are advanced to explain these deviations. This article attempts to trace the

evolution and success of using experimental methods in the form of paid ex-

periments that test economic theories and principles. In doing so we also

explore the interrelationships that experimental economics has spawned with

other fields in social science like psychology, political science, sociology and

anthropology.

In the new millennium, experimental economists have ventured out beyond

the laboratory to the field, using participants who are not college students

and framed environments, which bear resemblance to natural contexts for

studying specific economic behaviour. Today we stand at the point where

experimentalists studying economic problems may not necessarily be individ-

uals who are steeped in traditional economic theory. This democratization

has enriched the set of problems that were traditionally studied under the

banner of economics to include work on the evolution of social norms and the

role of culture on economic behaviour, which is a far cry from the modest


and narrow goals of theory testing originally posited by the founders of this

sub-field.

The next section discusses the evolution of the study of human behaviour in

economic theory.

2 The study of human behavior in mainstream

economic theory

At the heart of the microeconomic model (and the set of axioms that drives

the majority of its results) stands the homo-economicus or the economic

man - a representative agent who can attach a well defined probability dis-

tribution over the entire set of outcomes that are available to him from any

choice problem and choose the one that would yield to him the highest ex-

pected payoff. Legions of self-interested rational maximizers such as these,

armed with private endowments and no barriers to exchange form a market in

which they can mutually trade to increase agents welfare. Yes, purportedly

the invisible hand of the market manages to coordinate buyer and seller

decisions, so that people with none other than purely selfish motives may

conduct mutually beneficial trade. The idea of the economic man has found

place in the writings of Mill (1836) who proposed an arbitrary definition of

man, as a being who inevitably does that by which he may obtain the greatest

amount of necessaries, conveniences, and luxuries, with the smallest quantity

of labour and physical self-denial with which they can be obtained.

The idea of exchange between rational and self-serving individuals has been

around for hundreds of years. Almost a century earlier than Mill, Adam

Smith refers to it in the Theory of Moral Sentiments (1759) as well as his

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better known later work, The Wealth of Nations (1776). It is however in

Moral Sentiments where we see glimmers of what would ultimately be a

behavioural revolution in economics two centuries later. In this treatise

Smith writes about an important psychological motivation that governs the

way that economic agents conduct exchange. The particular moral sentiment

that Smith describes at length is sympathy, i.e. the feeling of compassion

or concern for others. This tempers self-interest in socio-economic transac-

tions and leads us to sacrifice narrow profiteering in order to maintain ties

of affection with our fellow human beings. In positing this opinion Smith

builds on the work of Scottish moral philosopher David Humes A Treatise of

Human Nature (Hume, [1740], 1978). In this work Hume argues that morals

and belief rather than reason governs human nature in stark contrast to the

rationalists like Descartes who preceded him.

These initial behavioural asides notwithstanding, the dominant and mathe-

matized microeconomic framework developed in the late nineteenth century

by Leon Walras, Alfred Marshall, William Jevons and Vilfredo Pareto did

employ the rational-actor framework in extending the work of Smith, Mill

and David Ricardo, and came to be known as neoclassical economics. In the

first fifty years of the twentieth century Lionel Robbins, Frederick Von Hayek,

John Hicks and others further refined and extended this framework to create

elegant mathematical frameworks for consumer behavior, the IS-LM model,

the business cycle, welfare economics and various other theories that have

become the bedrock of modern mainstream economics.

Neoclassical economics went through a paradigm shift in the forties with

two works of great import. They were The Theory of Games and Economic

Behaviour by John von-Neumann and Oskar Morgenstern (von Neumann


and Morgenstern, 1944), and John Nashs doctoral dissertation from Prince-

ton University on non-cooperative games (Nash, 1950), which included the

powerful idea of Nash Equilibrium. Put simply, the main contribution of von-

Neumann and Morgenstern (v-NM) was to develop a framework of individual

decision making under uncertainty and that of Nash was to find an internally

consistent set of strategies that decision makers would employ in a situation

of strategic interaction, from which no one had any unilateral incentive to

deviate. v-NM and Nashs theories allowed us to obtain behavioural predic-

tions incorporating two very important features of economic decision making,

namely, the presence of uncertainty (embodied in probability distributions)

regarding outcomes in a situation of choice and the effect of the behavior of

other economic agents (other players in a game who may for example have

conflicting interests) on an agents payoffs. These more modern theories had

more directly testable point predictions, which facilitated the formulation

of testable hypotheses that could be compared to behavioural observation.

Though they came up with more test-friendly theories of agent behaviour

both von- Neumann and Nash were pure mathematicians who had never been

involved with any form of empirical or experimental work. Morgenstern, on

the other hand, felt that statistical data collected in economics had inherent

(sample selection) biases which made it difficult to isolate the true causes

of observed behavior. Of the three it was he who was more amenable to

controlled experiments, as is clear from his comments on Chamberlins pio-

neering experiments on competitive markets from the forties (Morgenstern,

1954).

According to Morgan (2003), in the middle of the twentieth century, eco-

nomics was in the process of becoming a tool-based science and distanc-

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ing itself from the old, discursive moral science of the political economy

framework of the late nineteenth and early twentieth centuries. This led to

theoretical models with sharp equilibrium predictions and more involvement

of computational scientists and mathematicians in theory formation and test-

ing. By the early fifties (fuelled no doubt by the rapid growth in computing

power) computer simulations followed by controlled experiments entered the

economists toolkit. The next section discusses the applicability and ad-

vantages of experimental methods as applied to social sciences particularly

economics.

3 The advantages of the experimental method

In this section we trace the main ways in which the experimental method

has enriched economic theory building. Economics experiments have opened

intellectual directions that would have been impossible if we were not able to

observe human agents interacting in laboratory environments that attempted

to model specific theoretical contexts. As discussed below, the observations

on human behavior in the laboratory has led to a deeper understanding of eco-

nomic motivations that took researchers far beyond simple laboratory games

into field contexts, institutions and culture. This interest in variables which

were not considered traditionally to be important to the behavior of economic

agents has over time brought the discipline of economics closer to the other

more non-mathematized social sciences.


3.1 The usefulness of the laboratory

Before experiments entered the analytical toolkit for economists, happen-

stance (naturally occurring) data was the only way in which economic prin-

ciples could be tested. However happenstance data is not generated as per

the convenience of the researcher, and it is most often prohibitively expensive

to be present at the site of data generation, like a factory (cost data) or a

marketplace (transactions data) to record it. The presence of the researcher

who merely observes and records naturally occurring processes (and hence

can control for environmental variables that could be ex-post unknown) cre-

ates a natural experiment, which if performed carefully may be the best way

to test economic theories and principles. However besides the expense in-

volved, there is another basic problem with natural experiments. This is the

problem of bias in the behavior of agents that is introduced because of the

presence of someone recording data. A way around this is of course to be

purely anonymous which may be very difficult to do in all situations.2 The

ideal natural experiment (and indeed the purest form in which behavior can

be recorded) is the randomized natural experiment, in which we can study

the actions of agents by selecting our experimental unit randomly over the

2The main problem with using natural experiments on human behavior is that unlike

inanimate matter, human beings are sentient and can at will modify their responses to

stimuli. Thus unless the experimenter/observer is completely invisible to the agent, the

behaviour we observe will be necessarily different from what is natural to them. Contrast

this for example with observational astronomy, a branch of physics that deals with the

study of movements of celestial objects. In this scenario, natural experiments are the only

empirical methodology available and they have no bias, as we are dealing with celestial

objects that are largely invariant to observation.

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entire set of available focus variables that influence behavior.3 Banerjee et al.

(2007) perform a randomized study in Vadodara and Mumbai in India, where

they evaluate the effect of two remedial programs on childrens performance

in school.

At the other end of the spectrum from the natural experiment is the labora-

tory experiment. Here we dont attempt to observe behavioural phenomena

in a naturally occurring setting. We usually design a stylized version of the

problem to be studied in a non-natural environment. Unlike in the natural

sciences where laboratory environments that are very close to the naturally

occurring phenomena can be created, in the social sciences, the environments

created tend to be stylized versions of the naturally occurring field environ-

ments. These stylizations often allow us to collect data related to economic

problems for which it is very difficult (or impossible) to obtain happenstance

data. Examples include studying the effect of insider information on traders

in asset markets, studying agent behavior in principal agent models and ex-

ploring labour market discrimination. The usage of treatments allows us to

also create the counterfactuals in theory, which may be impossible to obtain

with field data.4

3In experimental design, we can broadly delineate all variables that affect subject re-

sponse into focus variables and nuisance variables. For example suppose we are trying

to study the behavior of traders in a market. We may be interested in how the trading

institution and level of seller costs affect performance. These would be our focus variables.

There may be other variables such as the gender of traders, which may well influence their

behavior but we are not explicitly interested in it. We deem this to be a nuisance variable.

Our purpose in designing treatments is to minimize the impact of such a nuisance variable.

For more on experimental design techniques see Box et al.4For example we may be interested in how asset traders in a stock market aggregate

diverse information regarding the assets they buy and sell. Real world stock market data


3.2 Anomalies and the emergence of behavioural eco-

nomics

An important aspect of laboratory experiments in economics and psychology

(the two main social science disciplines that use experimental methodology)

is the degree of parallelism, i.e. - how closely does the laboratory problem

correspond to the problem in the field? Often this parallelism is low in labo-

ratory environments where closeness to the field is sacrificed in order to gain a

high degree of experimental control. Observing subjects in a specially set up

environment necessarily increases the level of bias but allows us to fine tune

focus variables in a way that would be impossible in the field. As economic

theory (rather than psychological theory) is concerned with more abstract

behavioural consequences that depend less on the environment and the in-

stitutions (for example Nash equilibrium in games or the Walrasian equilib-

rium), a stylized interface that distils the essence of these models without too

much operational detail may be enough to test theory somewhat satisfacto-

rily albeit in a narrow fashion.

However, can we make the claim that experimental methods allow us to

test theory in a foolproof manner? If indeed subjects display behavior con-

cordant with theory can we say that the theory is correct? What about if

behavioural violations of theory are observed? Will it then inform us that

the theory is incorrect? Unfortunately an economics experiment does not

will obtain for us the behavior of agents who possess such fragmented pieces of information.

However to really comprehend how information gets aggregated we need a counterfactual,

i.e. how do agents behave when there is no probabilistic information regarding the assetsthat they possess? Real world data cannot provide this to us but laboratory procedures

allow us to create this situation with comparative ease.

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give us the wherewithal to accept the theory in the first case and reject it

in the second. According to Friedman and Sunder (1994), experiments can

never exactly replicate the conditions laid out in formal economic theory. All

theories leave out significant operational detail and so any attempt in the

experimental design to try to fill these in necessarily alters the theoretical

model, i.e. the laboratory version of the theory is necessarily differentfrom the written version of theory. What then do laboratory experiments

contribute? They provide another understanding of economic phenomena

separate from economic theory and empirical analysis of happenstance data.

It would be fair to say that theory, empirical data analysis and laboratory

experiments move on parallel tracks, reinforcing our understanding of the

behavior being modeled in a subtly different but ultimately unified manner.

For the first half-century of the application of experimental methodology to

economics, laboratory studies were the mainstay of the sub-discipline. The

laboratory allowed us to comprehend the power of the market in aggregating

trader bids and asks in a decentralized manner to clear markets. It also blew

the door open on many anomalies, or persistent violations of theoretical

equilibria. In game theory experiments, these anomalies often take the form

of paradoxes of rationality, where the rational outcome predicted by the-

ory is consistently violated by behavior observed amongst human subjects.

The Prisoners Dilemma (Axelrod, 1970, 1984; Andreoni and Miller, 1993),

the classic Bertrand duopoly game (Dufwenberg and Gneezy, 2000), the Ul-

timatum Bargaining Game (Guth, et al., 1982) and the Travellers Dilemma

(Holt, 1999) provide such examples. These anomalies led to the adoption of

approaches from cognitive psychology such as bounded rationality. As the

problems involved more and more complex computation to reach the equi-


librium, the limits on human computational ability necessitated the use of

thumb rules or heuristics in order to be able to optimize over a small set

of variables, (a subset of the larger set of variables that govern the problem)

which were considered central to solving the problem. Over time to cite an

evolutionary argument, the heuristics that got adopted were ones that op-

timized over a smaller set of variables and obtained desirable outcomes for

agents. The other rules which got less than desirable outcomes got discarded.

The origin of this boundedly rational approach is from Simons (1955) idea

of procedural rationality whereby agents follow reasonable heuristics and

on average achieve close to optimal outcomes. This is distinct from substan-

tive rationality, where the agent considers the entire set of variables to make

her decision.5 The integration of psychological motivations/limitations into

economic decisions led to theory building and experimental studies that went

well beyond testing simple economic models and over time led to the more

cross-disciplinary sub-field of behavioural economics that combines analytical

tools from primarily the fields of psychology and economics. See section 4 for

more discussion on behavioural economics.

3.3 Institutions matter as do culture and norms

Institutions provide the rules by which agents transact in an economy. Tra-

ditional economic theory is free of institution specific cues on behaviour. For

5The idea of heuristics as a second best approach, originating because of mental lim-

itations has been recently questioned. Studies such as Gigerenzer and Brighton (2009)

have shown us that very often, fast and frugal computations give us much more predictive

accuracy (not in terms of mean prediction but with respect to individual prediction) than

models that compute over the entire set of variables.

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example, market clearing is not influenced by the trading rules specified for

the agents in the Arrow-Debreu (Arrow and Debreu, 1954) model. Another

example would be the four major auction formats, the English ascending price

auction, the Dutch descending price auction, the first price sealed bid auction

and the second price sealed bid auction, all of which are revenue equivalent

for risk neutral agents. Experimental data from auction experiments do not

bear out the equivalence of these four formats.

Smith (1989) presents a schematic diagram of the way behavior has been

conceptualized and studied in economics over the twentieth century. I up-

date it below in figure 1 to include newer developments some of which are

from literatures other than economics such as psychology, political science

and anthropology. Before 1960, economic theory was largely not concerned

with institutional differences, asserting that as long as agent preferences and

firm costs were the same, it did not matter what the specific rules of interac-

tion were for the agents.6 The outcome in such theory is determined directly

from environment (given by cost and preference parameters), whereas in an

institution-specific theory the outcome is determined both by the institution

as well as the environment. The two most important market institutions

explored in experimental economics are the double auction and the posted

offers markets. From laboratory studies it was evident that human agents

did not behave the same way in these different institutions (Ketcham et al.

6According to North (1991, p. 97) institutions are the humanly devised constraints

that structure political, economic and social interaction. Throughout history, they have

been created by human beings to promote order and reduce uncertainty in markets. To-

gether with the standard constraints in economics (i.e. - those imposed by preferences and

costs) they define the choice set and therefore determine transaction and production costs

and hence the profitability and feasibility of different economic activity.


(1984)). Kagel and Levins (1986) study of common value auctions, Fried-

mans model (1991) of the double auction market are two institution specific

theoretical studies. For a detailed discussion on the role of institutions in

economic theory see Aoki (2001).

A very important intellectual direction that emerged out of the paradoxes

of rationality observed in laboratory games was the study of the effect of

culture and demographics on economic behaviour through the formation and

enactment of social norms. Sen (1973) alludes to social norms when he dis-

cusses the prevalence of cooperative action in the Prisoners Dilemma game.

Arrow (1982) clearly states that The model of laissez-faire world of total

self-interest would not survive for ten minutes; its actual working depends on

an intricate network of reciprocal obligations, even among competing firms

and individuals. The interest in social norms and culture in turn has fed

back to the design of experiments with the emergence of the Artefactual Field

Experiment (AFE). An AFE lies between a laboratory and a natural exper-

iment in that laboratory tasks are now performed not by college students

(the usual subject group used in Economics and Psychology experiments)

but by more unsophisticated subjects from the field.7 Some early work in

field experiments includes Lichtenstein and Slovic (1973), Kagel et al. (1979),

Binswanger (1980, 1981) and DeJong et al. (1988) who study decision and

game theoretic problems in the field.

North (1991) in his essay on institutions recognizes the power of norms as

informal constraints on behavior which include sanctions, taboos, customs,

7In a related class of field experiments, Framed Field Experiments, the experimental

tasks given to the subjects in the field are framed in a context that is relevant to the field.

See Harrison and List (2004) for a more detailed discussion.

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traditions and codes of conduct. These non-legally binding but morally en-

forceable informal institutions have become very important in the study of

economic outcomes today. Hume ([1740], 1978) was the first to discuss the

central role that norms play in the construction of social order. Since the

evolution of norms is necessarily culture specific, the study of these norms

and their effect on economic equilibria has meant that cultural and demo-

graphic variables which were hitherto unstudied have found their way into the

economics literature. Norms influence the choice of equilibria and sometimes

cause outcomes to be adopted which may not necessarily be equilibria in a

game theoretic sense. Accordingly, fairness norms may influence the playing

of the cooperation (dominated) strategy in an N-player Prisoners Dilemma

(NPD) game such as the public goods game. Furthermore, informal social

sanction such as threat of ostracism in communities may cue agent behav-

ior towards more equitable outcomes in spite of the presence of short term

economic incentives for self aggrandizement. Coleman (1990), Henrich et al.

(2004), Bowles (2004) and Ostrom (1995, 1998) provide empirical evidence

as well theoretical frameworks that analyse the role of culture, demographics

and social norms on economic outcomes.

As indicated in figure 1, social norms influence behaviour both directly and

indirectly. Norms related to social incentives and sanctions influence agent

behavior directly by identifying focal points (some of which may not even be

equilibrium in the game theoretic sense).Furthermore, norms indirectly affect

agent behavior either by altering the evolution of institutions and the rules

of interaction therein or affecting the evolution of preferences and costs over

time.


4 Experimental economics contrasted with ex-

perimental psychology

The methodologies used to study bounded rationality and divergences from

normative behavioural paradigms are different in Social Psychology from

Experimental Economics, which had initially led to very little joint exper-

imental work between the two disciplines. Over time a significant number

of economists have actually started to appreciate the problems investigated

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and methodologies used by psychologists, which has led to some convergence

between the fields though serious divergences regarding procedure and impli-

cations remain.

The main methodological conflict between economists and psychologists arises

on the issue of subject payments. A significant number of psychology exper-

iments do not actually pay subjects for their responses. This includes the

classic Kahneman and Tversky (1979) study on Prospect Theory. Even when

experimental psychologists pay their subjects, often these are flat payments

and not contingent on the decision they make.8 9 Psychologists have de-

fended the no/low payment paradigm in psychology studies variously, as a

large number of individual choice experiments in psychology deal with non-

monetizable utilities or even payoffs that are difficult to measure.10

A second point of contention deals with deception, i.e. misleading subjects

regarding the actual objectives of the experiment. Again, according to many

psychologists who study boredom, cheating, excitement, pain and anger, the

treatments critically hinge on the subjects not being aware of the stimuli they

are going to be subjected to, or the purpose behind the experiment, as this

8See Harrison (1989, 1992 and 1994) for a payoff dominance critique of experiments in

economics.9The three main principles that should govern payments in an economic experiment

are salience, dominance and monotonocity. Salience requires that the payment given to a

subject must be different for different outcomes in the game/decision theoretic situation.

Dominance requires that the reward medium dominate decision costs for the subjects and

monotonicity implies more of the reward medium is preferred to less of the reward medium.

See Friedman and Sunder (1994), Harrison (1989, 1992 and 1994), Plott (1991) and Smith

(1989) for more detailed exposition on monetary incentives in economic experiments.10For studies where the payoffs are non-monetizable see Ariely and Loewenstein (2005),

Ariely, Loewenstein and Prelec (2003) and Berns et al. (2007)


would lead to biased actions.

Another important point of divergence between experimental psychology and

experimental economics is related to the theoretical underpinnings behind

various results that may be obtained from an experiment. Most economists

dont really need a precise and accurate theory at the individual level, just as

long as it is general enough to explain some of the observed behaviour accu-

rately and generate an aggregate prediction that is more or less accurate. So

elegance and generality are generally desirable in economic theory, whereas

psychologists and cognitive scientists are interested in modeling the precise

nuances of behavior displayed by individuals.

An example should make this clear. A typical economics experiment on atti-

tudes towards risk would have the researcher make an assumption about the

form of the utility function (say constant relative risk aversion or CRRA) that

the agents purportedly follow. Using this function and the choice response

in the experiment, one can calculate some measure (maybe Arrow-Pratt) of

risk aversion and then compare this across agents, over time, cross-culturally

etc. If anyone questions the validity of using this functional form over another

one, most of the time the answer that a theorist or an experimental economist

would give would be that it doesnt matter as long as everyones attitude to

risk is measured using the same CRRA specification. Most psychologists and

cognitive scientists would be quite unhappy with this as if way of evalua-

tion. They would be more interested in the cognitive processes that govern

the choice made by the decision maker, rather than obtaining some measure

which has good internal validity but potentially scanty external support.11

11In fact the evolutionary biologist Dawkins (1989) too expresses some reluctance at

accepting this as if approach to decision making when he states that in problems that

involve spatial computation like a baseball player running to catch a ball he behaves as if

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According to Camerer (1995), most economists have a one-size-fits-all ap-

proach to studying economic problems vis--vis psychologists. So if a task in-

volves elicitation of a probability, most psychology experiments would frame

the problem in a natural setting using a vignette. This would anchor the

tasks to certain specific stimuli. Most economists would go ahead and at-

tempt to elicit the same probability using a more decontextualised device

such as a pair of dice or a bingo cage. This is in keeping with the institution

free pedagogy of neoclassical economics where elicitation of a probability is

coming up with a specific statistical measure rather than an assessment of

a contextualized measure of uncertainty. Economists are also interested in

static repetition of tasks with a view to studying convergence to equilibria or

some non-equilibrium outcome. On the contrary psychologists would be the

most interested in the behaviour of a subject the first time they experience

the stimulus as they feel that quick static repetition overstates the speed and

clarity of feedback that would be provided in a natural setting.

The development of the hybrid field of behavioural economics in the 1970s

represented a convergence between the fields of economics and experimental

psychology. However, given that psychology as a discipline has a significant

interface with other social sciences such as anthropology and the biologi-

cal sciences, especially evolutionary biology, these too have found their way

into behavioural economics. This sub-discipline draws from a lot more than

economic theory and attempts to actually provide a handle on the more prim-

itive elements that make up behavior by studying context specific biases and

documenting deviations for norms in a precise and detailed manner. Some

he had solved a set of equations in predicting the trajectory of the ball at some subconscious

level, something functionally equivalent to the mathematical calculations is going on.


behavioural economists are also interested in finding how behaviour correlates

with neural substrates or pathology, which may sometime in the future give

us a more precise medical answer to questions like why some people are risk

loving (which is manifested in the theory as a convex utility function) and

others risk averse (concave utility function). Indeed, behavioural economics

studies behaviour such as procrastination or explores physical or emotional

states such as boredom, pain and sexual arousal, which may not have re-

ceived much (or any) importance in economic theory, but which have huge

implications for economic behaviour.12 For more detailed analyses regarding

the methodological differences between experimental psychology and experi-

mental economics see Camerer (1995), Sonnemans (2007), Ariely and Norton

(2007) and Zwick et al. (1999).

At the crux of this methodology debate is the fact that the raison-d etre

of experimental economics for many decades was to test highly axiomatized

economic theories. Not much was asked by way of speculation regarding de-

viations from normative behaviour. According to Erev and Roth (1998, p.

848) Economists have traditionally avoided explaining behavior as less than

rational for fear of developing many fragmented theories of mistakes. Thus

the appeal of utility maximization and Nash equilibrium is that they provide

useful approximations of great generality, even if they do not precisely model

human behavior (Roth, 1996).

12The idea that motivations beyond the simple calculus of self-aggrandizement could

drive human behaviour was noted more abstractly by Hume (1739) and extended by Smith

(1759) in his Theory of Moral Sentiments. Smith may have been the first economist (or as

they were then known, moral philosopher) to attribute psychological motivations towards

economic activity such as other-regarding preferences and bounded rationality.

22 CIISS 2012

5 Historical progression of experiments in eco-

nomics

The earliest experiments were run in the forties by Edward Chamberlin at

Harvard to show his graduate students the falsity of the theory of competitive

markets. Although the results of such experiments were published in Cham-

berlin (1948), nobody at the time, including Chamberlin himself, attributed

much scientific value to them.

Merrill Flood and others were also performing experiments at the RAND

Corporation in the early fifties. In 1952, the Ford Foundation and the Uni-

versity of Michigan organized a two-month seminar in Santa Monica on the

design of experiments in the study of decision processes in which Flood and

his group participated. This seminar did not yield significant research work

in experimental economics but sensitized many researchers who participated

in it to the possibilities of using controlled experiments to study behaviour.

As an interesting aside, a game entitled the Prisoners Dilemma, originated

by Melvin Dresher and Flood a few years before and discussed at the Santa

Monica seminar, proved to be an important game in experimental economics

as it provided a stark example of a broad class of game theoretic problems

in which the rational maximizing strategy when played by all would lead to

an equilibrium outcome in which everyone is worse off.13 This paradox of ra-

tionality would capture the imagination of experimental researchers in later

decades and many other dilemma games such as the Trust game (Berg

et al., 1986), the Voluntary Contributions Mechanism (Isaac at al., 1988a,

13See Flood (1952) for accounts of early experimental examination of zero and constant

sum games.


1988b) and the Travellers Dilemma (Basu, 1984, Capra et al., 1999) would

be studied to actually see if players played like rational fools (Sen, 1977)

and displayed behaviour according to the normative theoretical paradigm.

In all such games, human subjects in paid experiments deviated significantly

from theoretical predictions, i.e. - they were less rationally foolish than

predicted by theory.

At the same time as the Santa Monica seminar, Sidney Siegel and Lawrence

Fouraker studied bargaining behaviour at Pennsylvania State University. They

combined aspects of methodology from both Economics and Psychology and

provided one of the first examples of the study of how behaviour alters with

monetary incentives and amount of information provided to experimental

subjects (Siegel and Fouraker, 1960). In this way, Siegel and Fourakers ex-

periments profoundly influenced younger researchers like Vernon Smith who

would incorporate this idea of salient monetary incentives and double blind

experimental procedures in important publications in the seventies and the

eighties. Smith would later formalize these methods in the precepts or rules

related to his proposed induced value theory, (the use of monetary incen-

tives to control subjects preferences) which would be the methodological

touchstone of laboratory experimentation in economics (Smith, 1976, 1982).

This practice of using salient payments (subjects obtain payments that are

monotonically linked to the outcomes in an experiment as opposed to flat

payments that were common in psychology experiments) also allowed Smith,

Charles Plott and other newly christened experimental economists to differen-

tiate themselves on the academic spectrum from researchers in experimental

psychology and contributed greatly to establishing a distinct methodology in

this new sub-field of economics.

24 CIISS 2012

Though not an economist himself, Herbert Simon of Carnegie Mellon Uni-

versity was a cognitive scientist who studied individual decision making in

the fifties and his experiments largely in a managerial environment indicated

that individuals made decisions in a boundedly rational manner, i.e. - with

an intent to do as well as possible for themselves, but unable or unwilling to

take into account all possible contingencies and/or outcomes. Thus Simon

posited that agents satisficed rather than optimized, i.e. - they played

in a boundedly (or procedurally) rational manner and obtained a suffi-

ciently high payoff with which they were satisfied (Simon, 1955, 1956). In

this way Simon can be said to be the first behavioural economist and laid

the foundations for the study of systematic bias, the use of heuristics and

other psychological underpinnings of economic behaviour that were studied

by both psychologists and economists through the next four decades. The

two most well known behavioural economists of the next two decades were

Daniel Kahneman and Amos Tversky of the Hebrew University whose most

important contribution was the formulation of Prospect Theory (Kahneman

and Tversky, 1979), a behavioural alternative to von-Neumann and Morgen-

sterns Expected Utility Theory (von Neumann and Morgenstern, 1944) that

they established in the seventies. Used to explain deviations from Expected

Utility Theory (notably the Allais Paradox, see Allais (1953)), Kahneman

and Tversky made several behavioural assumptions (that were psychological

in nature) regarding agents state dependant attitude to risk, their under-

estimation or overestimation of probabilities that they confront and their

inability to process compound lotteries. In doing so, they made one of the

first and maybe the most celebrated theories that were created in order to

explain deviations from mainstream theoretical predictions among laboratory


subjects. Over the last two decades Gigerenzer (2008) and Guth (1995, 2008)

have criticized Kahnemann and Tversky for their methodology, describing it

as repair program for neoclassical economics. According to them Prospect

Theory models decision making under risk in an as-if manner by adding

transformations and free parameters to the standard expected utility frame-

work, instead of attempting to actually map psychological processes that may

lead to the observed behavior of agents.

In the sixties and seventies experiments in economics went through a period

of slow growth and certain experimenters distinguished themselves by both

their prolific output and their desire to posit economics as an experimental

science. Vernon Smiths study of competitive market behavior (Smith, 1962)

showed that the institution of the Double Auction market with financially

motivated agents worked well in reaching equilibrium. In doing so Smith

replicated Chamberlins earlier classroom experiments on competitive mar-

kets using students of Purdue University, where he was employed as Assis-

tant Professor. To his surprise he got the opposite results from Chamberlins

experiments using careful laboratory procedures and financially motivating

subjects. Over the next two decades Smith studied market behaviour, dif-

ferent auction formats, public goods and models of altruism and reciprocity

until the eighties when his prolific research output in both experimental game

theory and competitive markets brought him to the forefront of the this new

area of research. Smith ultimately received a Nobel Prize in 2002 for being

a leading light in establishing laboratory experiments as a credible tool for

economic analysis, especially in the study of different market mechanisms.

He shared the 2002 Nobel with Daniel Kahneman whose cited contribution

was in incorporating insights from psychological research into economics, es-

26 CIISS 2012

pecially with respect to individual decision making under uncertainty.

The eighties and nineties were good decades for experimental economics and

by the turn of the millennium major universities in both the US and Eu-

rope had groups of experimental researchers who worked on problems in

game theory, decision theory and market behaviour. An influential researcher

who made significant contributions to experimental economics in this era was

Charles Plott, an ex-colleague of Vernon Smiths from Purdue who was now

a professor at the California Institute of Technology. Like Smith, Plott too

was interested in market behaviour especially experimental asset markets.

His studies with Thomas Palfrey and Shyam Sunder on securities markets

(Forsythe et al., 1982, 1984, Plott and Sunder, 1982, 1988) were very in-

fluential in sparking off interest in the then nascent sub-field of behavioural

finance. An important reason why experimental economics flourished in the

eighties and nineties was keen interest taken in it by theorists. The reason

that a lot of theorists felt attracted to experiment was that especially in

game and decision theory, many anomalies (unanticipated divergences from

the normative prediction) had emerged from experimental studies. Impor-

tant theoretical results had been seen to not hold when human subjects were

asked to make decisions in the laboratory. Thus there was a need felt to

perform stress tests in the laboratory in order to help formulate theories

with better empirical support. The most notable of the early theorists who

took an interest in experimenting was Reinhardt Selten, who shared a No-

bel Prize in 1994 with John Harsanyi and John Nash, for his work on the

theory of dynamic games. From the early seventies Selten had a keen inter-

est in the experimental verification of theory. His experimental publications

largely dealing with learning and evolution of behavior in laboratory games


in the seventies and eighties had an empirical flavor that would be in vogue

in the field in the new millennium (see Selten and Stoecker, 1986; Selten

et al., 2005 and Ockenfels and Selten, 2005).Many other theorists such as

James Andreoni, Alvin Roth, Daniel Friedman and Thomas Palfrey pub-

lished thought provoking experimental studies on altruistic motivation and

charitable giving (Andreoni, 1990, Andreoni and Miller, 2002), reinforcement

learning in games (Erev and Roth, 1998), equilibrium in evolutionary games

(Friedman, 1997), belief learning (Cheung and Friedman, 1996) and quantal

response equilibrium (McKelvey and Palfrey, 1995). In this era, experiments

in economics were posited primarily as being of the theory testing variety, of-

ten involving stylized laboratory games, markets and decision problems with

negligible parallelism to the corresponding field institutions. External valid-

ity of laboratory environments used was not considered important (as long

as the laboratory economy was internally consistent) and subject pools were

often limited to undergraduate students of US and European institutions. It

is true that some studies explored scaled down laboratory versions of vari-

ous real world mechanisms such as airport time slot allocation (Rassenti et

al. (1982), telecommunication spectrum auctions (Plott, 1997) and pollution

permits (Cason (1995), Cason and Plott (1996), Cason and Gangadharan

(2003)), but these were relatively rare.14

14Experiments that study mechanisms from the real world using scaled down environ-

ments in the laboratory are referred to as testbed experiments. The results from testbed

experiments can be then used to refine institutional rules or design new rules of interaction.

28 CIISS 2012

6 New millennium, new directions

Today half a century after the first economics experiments were performed we

stand at an interesting juncture in the field where the desire to test theory

has given way to actually attempting to understand behavior and its un-

derpinnings. This has led to economists collaborating with researchers from

other fields in basic and social sciences such as cognitive psychology, evolu-

tionary biology and sociology/anthropology. Henrich et al. (2001) was the

first major study that investigated the impact of demographics on human

cooperation using the ultimatum game.15 They obtained the results that far

from the rational-actor framework of the canonical microeconomic model,

peoples cooperative behavior is not exogeneous, and critically depends on

the economic and social realities of everyday life. The fact that culture and

demographics matter in determining choice in humans is here to stay in eco-

nomics and several studies after Henrich et al. (2001) such as Kurzban and

Houser (2001), Harrison et al. (2002), Sosis and Rue (2003), Cardenas and

Ostrom (2004) and Andersen et al. (2008) investigate the effect of culture

and individual (non-economic) characteristics on economic choice behavior.

An important consequence of the diversification of the subject pool brought

about by these field experiments is the comparisons that are starting to be

15An ultimatum game, first studied experimentally by Guth et al. (1982) is one where a

proposer sends an offer to a responder splitting a rupee in the proportion that is acceptable

to him. If the responder agrees to the split (say 60p./40p.) then these are the final

allocations. If the responder does not agree to the split, both get zero. The subgame

perfect Nash equilibrium (SPNE) of this game is for the proposer to keep the full rupee

and offer the responder nothing. The responder in equilibrium should accept this offer.

Empirically however, this SPNE is rarely played: proposers are mostly equity preserving

in their offers and responders often reject moderately non-egalitarian offers.


made between results obtained from decades of laboratory experiments in

the behavioural sciences that involve primarily undergraduate students from

industrial nations and the newer results from societies in developing nations.

Henrich et al. (2010) show that the behaviours in a variety of decision-making

situations differ significantly in this larger slice of humanity from that dis-

played by subjects from what they refer to as the WEIRD societies.16 They

conclude that members of WEIRD societies are among the least representa-

tive populations one could find for generalizing about human behaviour.

The prevailing atmosphere of interdisciplinarity has also led to collaborations

between economists and clinical neurologists leading to the sub-field of Neu-

roeconomics, which attempts to find the roots of behavior as reflected in the

working of neural substrates. Both game and decision theory problems have

been investigated by projects in Neuroeconomics that have both social scien-

tists as well clinicians who are familiar with the working of fMRI (Functional

Magnetic Resonance Imaging) machines. The idea is simple: put subjects in

MRI machines with the electrodes connected. Then give them tasks to do

and observe which sets of neurons fire up. McCabe at al. (2001) was the first

major research study in Neuroeconomics, which posited that mentalizing was

important in games involving trust and cooperation.17 They found that play-

ers who were more trusting and cooperative showed more brain activity in

Brodmann area 10 (thought to be the locus of mentalizing) and more activity

in the limbic system which processes emotions. In the Smith et al. (2002)

16WEIRD stands for Western, Educated, Industrialized, Rich, and Democratic.17Many neuroscientists believe there is a specialized mentalizing (or theory of mind)

module, that controls a persons inferences about what other people believe, feel, or might

do. This is of particular interest to game theorists who create theories regarding how

agents behave in strategic environments.

30 CIISS 2012

experiment, payoffs and outcomes were manipulated independently during

choice tasks in the form of gambles (involving risk or ambiguity) as brain ac-

tivity was measured with positron emission tomography (PET) scans. Their

analyses indicate that the interaction between belief structure (whether the

prospect is ambiguous / risky) and payoff structure (whether it is a gain

frame / loss frame) shapes the distribution of brain activity during choice.

Accordingly, there are two disparate, but functionally integrated, choice sys-

tems with sensitivity to loss. A neocortical dorsomedial system is related to

loss processing when evaluating risky gambles, while a more primitive ven-

tromedial system is related to the processing of other stimuli. See Camerer et

al. (2005) for a detailed survey of Neuroeconomics studies and their impact

on mainstream economics. Though Neuroeconomics claims that many fun-

damental insights in economics can be generated from these imaging studies,

Harrison (2008) and Rubinstein (2008) have criticized this sub-field for adding

no fundamental insight in our understanding of how economic decisions are

made, and have variously referred to it as a faddist technological gimmick,

attempting to provide hard evidence for violations from normative behav-

ior. According to them, results from Neuroeconomics studies are inconclusive

and the insights if any are far from re-shaping the way we think about eco-

nomics. The crux of the problematic nature of Neuroeconomics presented in

Rubinstein (2008) is as follows- even if we know the exact centre of the brain

that engages (and the extent to which it engages) when we perform certain

activities, it is unclear how that would help us design mechanisms or devise

strategies (short of surgical intervention) that would help humans make bet-

ter decisions. Furthermore, unless imaging techniques available allowed us to

monitor brain activity in real time for all humans (a proposition that harkens


to a dystopic worlds portrayed in science fiction novels), it would be really

difficult to use this information for anything meaningful.

In conclusion, the recognition of the fact that behavior as modeled in eco-

nomics cannot be treated independently of human behavior observed in stud-

ies in psychology or anthropology or even medical science has greatly aug-

mented the breadth and depth of experimental work in economics. This has

also spurred numerous interdisciplinary collaborations some of which have

been more fruitful than others, but the writing on the wall is clear it is nolonger possible to think of economic choice problems to be mutually exclusive

to similar problems studied in other disciplines in social and biological sci-

ences. A healthy concomitant of this is the relatively smaller weight put on

narrow results arising from specific formulations of problems that are studied

in research programs. Behavioural researchers today seem more interested

in the direction of their results than the magnitude of their divergence from

some field-specific theoretical norm. This is important because we do ul-

timately need to correlate our results with those from other disciplines that

have different parameterizations of the same problem. Today it is increasingly

becoming clearer that just numerical averages on outcomes help us very little

in terms of generating insights pertaining to populations. As researchers, we

often have to actually spend some time connecting the dots and synthesising

observation from across two to three fields in an attempt to actually gain an

insight into the behavior being explored.

32 CIISS 2012

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