Experimental Economics: Definition, Application, and Insights

Experimental economics is a branch of economics that studies human behavior in a controlled laboratory setting or out in the field, rather than just as mathematical models. It uses scientific experiments to test what choices people make in specific circumstances, to study alternative market mechanisms, and test economic theories.

Experimental economics is used to help understand how and why markets function the way they do. These market experiments, involving real people making real choices, are a way of testing whether theoretical economic models actually describe market behavior and provide insights into the power of markets and how participants respond to incentives—usually cash.

The field was pioneered by Vernon Smith, who won the Nobel Prize in Economics in 2002 for developing a methodology that allows researchers to examine the effects of policy changes before they are implemented to help policymakers make better decisions.

Experimental economics is mainly concerned with testing in a laboratory setting with appropriate controls to remove the effects of external influences. Participants in an experimental economics study are assigned the roles of buyers and sellers and rewarded with the trading profits they earn during the experiment.

The promise of a reward acts as a natural incentive for participants to make rational decisions in their self-interest. During the experiment, researchers constantly modify rules and incentives to record participant behavior in changed circumstances.

Smith’s early experiments focused on theoretical equilibrium prices and how they compared to real-world equilibrium prices. He found that even though humans suffer from cognitive biases, traditional economics can still make accurate predictions about the behavior of groups of people. Groups with biased behavior and limited information still reach the equilibrium price by becoming smarter through their spontaneous interaction.

Along with behavioral economics—which has established that people are a lot less rational than traditional economics had assumed—experimental economics is also being used to investigate how markets fail and to explore anticompetitive behavior.

The applications of experimental economics can be seen in various policy decisions. For example, the design of carbon trading emissions schemes has benefitted from experiments conducted by economists in different regions of the world in a laboratory setting. Different perspectives of political science have also come to the surface through experimentation and exposure to experimental economics.

Experimental economics, while valuable, has its limitations. One such limitation is that results from laboratory experiments may not always generalize to real-world market settings due to controlled conditions. Additionally, conducting experiments can be costly and time-consuming, and researchers may face ethical considerations in designing experiments involving human participants.

Experimental economics provides policymakers with valuable insights into the potential outcomes of policy changes before they are implemented. By conducting experiments in controlled settings, researchers can simulate the effects of various policy interventions and help policymakers make informed decisions based on empirical evidence.

While experimental economics primarily takes place in laboratory settings, its findings can often be applied to real-world markets. By testing economic theories and market mechanisms in controlled experiments, researchers can gain insights into how participants behave in different scenarios, which can inform our understanding of real-world market dynamics.