1. Introduction to Experimental Economics

Abstract

Market ExperimentsChamberlin's The Theory of Monopolistic Competition (A Re-orientation of the Theory of Value), first published in 1933, was motivated by the apparent failure of markets to perform adequately during the Depression.Chamberlin believed that certain predictions of his theories could be tested (at least heuristically) in a simple market environment, using only graduate students as economic agents.Chamberlin reported the first market experiment in 1948.He induced the demand and cost structure in this market by dealing a deck of cards, marked with values and costs, to student subjects.Through trading, sellers could earn the difference between the cost they were dealt and the contract price they negotiated.Similarly, buyers could earn the difference between the value they were dealt and their negotiated contract price.Earnings in Chamberlin's experiment were hypothetical, but to the extent his students were motivated by hypothetical earnings, this process creates a very specific market structure.A student receiving a seller card with a cost of $1.00, for example, would have a perfectly inelastic supply function with a "step" at $1.00.This student would be willing to supply one unit at any price over $1.00.Similarly, a student receiving a buyer card with a value of $2.00 would have a perfectly inelastic demand at any price below $2.00.Sellers and buyers received different costs and values, so the individual supply and demand functions had the same rectangular shapes, but with steps at differing heights.Under these conditions a market supply function is generated by ranking individual costs from lowest to highest and then summing horizontally across the sellers.Similarly, a market demand function is generated by ranking individual valuations from highest to lowest and summing across the buyers.Competitive price and quantity predictions follow from the intersection of market supply and demand curves.Trading in these markets was both unregulated and essentially unstructured.Students were permitted to circulate freely around the classroom to negotiate with others in a decentralized manner.Despite this "competitive" structure, Chamberlin concluded that outcomes systematically deviated from competitive predictions.In particular, he noted that the transactions quantity was greater than the quantity determined by the intersection of supply and demand.Chamberlin's results were initially ignored in the literature.In fact, Chamberlin himself all but ignored them. 4 Given the novelty of the laboratory method, this is perhaps not surprising.But Vernon Smith, who had participated in Chamberlin's initial experiment as a Harvard graduate student, became intrigued by the method.He felt that Chamberlin's interpretations of the results were misleading in a way that could be demonstrated in a classroom market.Smith conjectured that the 4 The 1948 paper was mentioned only briefly in a short footnote in the eighth edition of The Theory of Monopolistic Competition.

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