Laboratory Experiments in Economics

How economists test theories with controlled experiments in the lab, what Vernon Smith's market experiments showed, and the debate over how far lab results apply.

Economists once assumed their subject could not be studied in a laboratory, like chemistry or psychology. That changed in the second half of the twentieth century with experimental economics, which tests economic theories using carefully controlled experiments, usually with real money at stake.

How a lab experiment works

Participants, often university students, come to a lab and make economic decisions: trading goods, bidding in auctions, sharing money or choosing between gambles. They are paid according to their decisions, so their choices have real consequences. Because researchers control the rules and the information, they can test exactly how behaviour changes when one feature changes.

Vernon Smith’s markets

Vernon Smith, who shared the 2002 Nobel prize with psychologist Daniel Kahneman, ran pioneering market experiments from the 1950s onward. He gave some participants the role of sellers, each with a private cost, and others the role of buyers, each with a private value. Participants traded in a double auction, where buyers and sellers call out bids and offers.

Remarkably, even with small numbers of traders who knew only their own values, prices quickly moved close to the level economic theory predicts, where supply meets demand. The experiments showed that markets can find efficient outcomes without traders having full information.

The ultimatum game

In a common experiment, one player is given 10 dollars and must offer some of it to a second player. If the second player accepts, both keep their shares; if not, both get nothing. Simple theory predicts the first player offers almost nothing and the second accepts. In practice, offers of around 4 or 5 dollars are common, and low offers are often rejected. Experiments like this revealed how much people care about fairness.

Strengths and weaknesses

Lab experiments give researchers tight control and make it easy to repeat studies. They have been especially useful for testing auction designs before real auctions are run, and for studying behaviour like trust and cooperation.

The main criticism is about external validity: whether behaviour in a lab, with small stakes and student participants, reflects behaviour in the real world. Researchers respond by varying stakes, recruiting different populations, and comparing lab results with field evidence.

Dismissing lab experiments as games with students

It is easy to wave away lab results as artificial. But many lab findings, like the importance of fairness and the ability of markets to find equilibrium prices, have been confirmed in real-world settings. Labs are one tool among several, most useful when combined with field evidence.

Key takeaways

Experimental economics tests theories with controlled, paid decisions in a lab.
Vernon Smith showed that double auction markets quickly reach efficient prices.
Experiments such as the ultimatum game revealed the importance of fairness.
The main concern is whether lab behaviour reflects real-world behaviour.