Assertions, assumptions and predictions

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Assertions, assumptions and predictions

• Applications to scientific method discussion

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Theory and reality

• Theories capture logical links between aspects of
  reality
• Ceteris paribus assumption is important in
  theories but data for testing theories violate
  ceteris paribus assumption
• Smith a general discussion auxiliary
  hypotheses
• Cox example of joint tests and confounds,
  example of non-standard objective functions
• McDaniel and Rutström non-standard objective
  function, inferring unobservable processes from
  observable actions
• Cummings, Harrison, and Rutström do theories
  speak to hypothetical circumstances?

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Theory, Experiments and Economics Vernon Smith

• Nobel 2002
• Economics is theory intensive more than
  observation intensive
• An a priori science
• Field data tests are composite tests of all
  assertions and assumptions of the theory jointly
• CETERIS PARIBUS assumption
• If theory fails (is rejected) we dont know which
  element is incorrect

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Field observations

• Natural experiments
• Ceteris paribus assumption is implemented to
  greater extent
• Less common in economics than in natural sciences
• Data normally collected by government agencies
  for other purposes than theory testing
• Exceptions exist
• Deal or No Deal game show

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Elements of a theory

• What is being tested
• Environment
• agents characteristics preferences, technology,
  endowments
• Institution
• Rules, terms and conditions for contact between
  elements of demand and supply
• Behavior
• Optimization, common knowledge, common
  expectations, risk attitudes

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Beauty of laboratory experiments

• Control the environment
• Inducing values and costs
• Control the institution
• Defining and enforcing the trading rules
• Test the theorys assertion of optimization

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Example Double Auctions and Pit Markets

• Theory based on downward sloping demand and
  upward sloping supply curves
• Predicts P and Q based on QdQs
• Experiments
• Chamberlin prices did not converge to
  equilibrium and varied a lot across contracts
• Smith prices converge to equilibrium over time
  and variance becomes small

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Why different findings

• Common elements in experimental design
• Many buyers and sellers
• Homogeneous goods
• Induced values and costs
• Differences

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Differences

• Chamberlin
• allowed traders to walk around and make deals
• No public information on the terms of the
  contracts
• Traders tended to cluster (presumably to minimize
  information search cost)
• Smith
• Central clearing house of contracts
• Public information on the terms of each contract

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If testing using field data

• May not be able to observe the institutional
  details that generate the differences
• Ceteris paribus
• Institutional details are the same

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Institutions matter

• Theory should pay more attention to institutions
• The rules of interactions information flow,
  message space
• The rules of contract enforcement
• Perfect competition theory price taking buyers
  and sellers
• Experimental finding price taking AND price
  making

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Rationality and anomalies

• Sometimes anomalies have been used to declare the
  death of rationality as an assumption in theory
  of choice
• Rationality is based on a small set of very
  attractive axioms
• Agents can compare things at least bilaterally
  and rank things in a consistent manner
• Agents can choose
• If agents are not rational can we even model
  them?

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The most productive knowledge building attitude
is to be skeptical of both the theory and the
evidence. This is likely to cause you to seek
improvements in both the theory and the methods
of testing.

• Smith p 800

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How to identify trust and reciprocity

• James C. Cox, Games and Economic Behavior, 2003

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• Alternative assertions and specifications of
  objective functions
• Include psychological or social values
• Confounds in empirical tests

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Testing assertions joint tests and confounds

• Standard choice theory
• Utility maximization over consumption of goods or
  over income or wealth
• Behavioral extensions
• Psychological values and social preferences
• Utility arguments include other peoples utility
  or income, consumption, wealth
• Social norms
• Trust and Reciprocity

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The investment game

• 2 person game Investor and contractor
• Investor cannot enforce rate of return payment
  from contractor
• Incomplete contracts
• Investor and contractor both get 10
• Investor can send some of that to contractor
• Money sent triples (this is the return on the
  investment)
• Contractor can send some back or not no
  penalties

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Predictions

• Standard assertion of utility maximization
• Contractor will never return any money
• So investor will never send
• Alternative assertion 1 Trust and Reciprocity
• Recognition of efficiency gain if investor trusts
  and contractor reciprocates
• Alternative assertion 2 Equity preferences
  altruism
• Investor beliefs that contractor has inequality
  averse preferences

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Confounding influences

• Observations of sending and returning are not
  proof of Trust and Reciprocity
• Confounded by the possibility that preferences
  reflect inequality aversion
• Triadic game structure to test this
• Remove incentives to trust and test if giving
  still occurs
• Remove incentives to reciprocate and test if
  returning still occurs
• Finds evidence of both

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Decision Making Costs and Problem Solving
Performance

• McDaniel and Rutström, Experimental Economics 2001

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• Alternative assertions
• Costly rationality
• Distractions and externalities in decision process

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Incentives and utility maximization

• Classical utility maximization
• Perfect rationality no decision costs or
  decision errors
• Costly rationality - cognitive production
  function
• Many different ways to model decision errors
• Stochastic noise terms on utility evaluation
• Stochastic noise term on expression of final
  choice

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Cognitive Production Functions

• Mental resources and time enters decision making
• Extrinsic rewards monetary rewards
• Motivational factor
• Positive incentives make decisions better
• Costly rationality hypothesis

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Detrimental rewards

• Intrinsic rewards internal psychological
  evaluations
• Motivational factor
• Extrinsic and intrinsic motivation may be
  dependent
• Introducing extrinsic rewards when intrinsic
  reward is already high
• Detrimental effect on performance
• Extrinsic/intrinsic trade-off hypothesis

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Homegrown Values and Hypothetical Surveys Is the
Dichotomous Choice Approach Incentive-Compatible?

• Cummings, Harrison, and Rutström, American
  Economic Review 1995

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• Do our theories predict behavior in hypothetical
  situations
• Can we study behavior using surveys of intentions?

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Contingent Valuation Method

• Questionnaire instrument to ascertain how people
  value public goods or bads
• Cannot use market price information since markets
  do not exist
• Dichotomous choice Take it or leave it offer
• Would you favor a policy that requires higher
  smoke stacks on coal burning generation
  facilities if it implies a 10 increase in your
  annual federal income tax?

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Hypothetical incentives

• Respondents are in a hypothetical situation
• They will not have to take the consequences of
  their decisions
• This experiment tests for hypothetical response
  bias in valuation of
• Calculators
• Chocolates
• Citrus juicers

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• Proportion of yes responses significantly higher
  in hypothetical setting
• 41 16 for juicers
• 42 4 for chocolates
• 21 8 for calculators
• Did the preferences change?
• Or did the opportunities change?

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Conclusion

• Dont be fooled by the simplicity of theory
• Reality is very messy and hard to understand