This week Newsweek has an intelligent article on experimental economics and its value in application to real-world problems. It starts with a profile of Vernon Smith and the work he pioneered that won him the Nobel last year, and illustrates the origins of experimental research:
Smith did not set out to bring down the establishment. Back in 1956, when he was a young professor at Purdue University in Indiana, economists took certain assumptions as fact. One was that markets can’t reach “competitive equilibrium,” the point where buyers and sellers agree on a set price, unless they are made up of an infinite number of players, each possessing perfect knowledge of the marketplace. In a bout of insomnia one night, Smith concocted a plan to demonstrate this notion by putting his students through a trading game. Buyers were given a maximum price they could pay, and sellers were given a minimum they could demand, for an unspecified good. Classical theory said that with such imperfect knowledge of the market, players could never agree on the best price. To Smith’s shock, the unwitting buyers and sellers agreed on the best price —after a few rounds of bidding. Smith was convinced he’d fouled up and kept running experiments to prove the old assumptions correct. He couldn’t. The field of experimental economics was born.
The article goes on to describe how experimental economics is a useful tool for business and for policy, from seeing how posted price rules affect consumer welfare to seeing the consequences of complex combinatorial auctions. A good profile, and a must read.