TCS Daily

Economic Wind Tunnels

By Jennifer Zambone - October 15, 2002 12:00 AM

If you've ever taken a "hard" science class, you know that thought isn't enough; eventually you'll have to go to into the field or into the lab to find out whether the theory holds up in reality.

For a long time, the social science of economics lacked this critical dimension. But the path breaking work of Dr. Vernon L. Smith in experimental economics has changed all that. For his work, Dr. Smith was one of two people awarded the 2002 Nobel Prize in Economics.

Looking back, it seems that Vernon Smith was destined for the discipline of experimental economics. Born to an avowedly socialist mother, Smith took his socialist leanings to Cal Tech. While he was studying electrical engineering, Smith took a general course in economics and became intrigued. When he decided to pursue an advanced degree, he did so in economics, rather than electrical engineering, eventually receiving his Masters degree in economics from Kansas University and a doctorate from Harvard in1955.

But the lessons of his early scientific training never left him. He wanted to apply the experimental method to some ideas he had about the inefficiency of markets. So he designed some experiments, in part to help put a human face on markets for his students. In the process he ended up doing more than that. By trying make his microeconomic classes more interesting, he inadvertently founded what later became known as experimental economics.

As often happens in experimentation, Dr. Smith got results that didn't square with theory. Economic theory at the time held that one needed a horde of "perfectly informed economic agents" to create a competitive market equilibrium. However, the results of his experiments indicated even a few relatively uninformed people can rapidly create an efficient market.

When he first saw these results, Dr. Smith thought something was wrong with the experiment. He kept running the experiment, and he kept getting the same result. Convinced, he wrote an article describing his work but had a difficult time getting it published. The article, "An Experimental Study of Market Behavior," was eventually published in the Journal of Political Economy in 1962, and is now considered the landmark paper in experimental economics.

Economic Wind Tunnels

Seeing the value of experimentation in economics, Smith turned his attention to broadening the application of the area. He conducted seminal experiments on the nature of auctions. He laid out crucial methodology for experimentation, and he envisioned laboratory experiments in economics serving the same function that a wind tunnel does in aeronautical engineering. Wind tunnels are a vital testing ground in aeronautical engineering. Rather than cobbling together an airplane based on their understanding of the best theories of aerodynamics and physics and then sticking in a pilot and crew to see if a plane will fly, aeronautical engineers use wind tunnels to test whether the design will work in the larger environment.

Economics lacked such a testing chamber. If a country wanted to introduce a privatization scheme, it simply cobbled one together based on the regulators' best understanding of current economic theory and hoped that the scheme would fly. But Smith reasoned that if such theories could be tested in an experimental setting - an economic "wind tunnel" - before being introduced to the larger environment, time and effort would be saved and considerable anguish avoided. So he designed experiments for energy markets and airport time slots, among others.

He soon discovered the most important aspect of markets - the institutions or the rules of those markets. This discovery led to his focus on experimenting with different institutional arrangements (rule systems).

Today, Smith and colleagues work on developing and testing complex market mechanisms in what they call "market engineering." Their experiments have influenced the actual design of markets, such as the energy markets in Australia and New Zealand.

This interest in applying economics to real world situations brought Dr. Smith and his entire lab from the University of Arizona to George Mason University in Virginia in 2001 where he established the Interdisciplinary Center for Economic Science (ICES). Here he hopes to make ripples in public policy circles by applying experimental work to public policy questions and concerns.

The author is Associate Director of the Regulatory Studies Program at the Mercatus Center, George Mason University.

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