Experimenting In The Laboratory Of Economics

Nobel Prize-winning economist Vernon Smith was in Australia last week to lecture at the Macquarie Graduate School of Management in Sydney. In addition to his academic obligations, he caused a minor flurry in the region’s financial press by suggesting that Australian housing prices were currently in a “bubble,” similar to the U.S. real estate bubble that saw total housing equity fall by over half from 2006 to 2009.

His economic assessments come highly recommended. As Robert Harley of Australia’s Financial Review recently wrote, “Professor Vernon Smith is an expert on bubbles. He has studied them in the laboratory, winning the Nobel Prize for Economics in 2002 for his experimental work.” It’s that work helping create the field of experimental economics that is the basis for the relationship between him and my organization, the Competitive Enterprise Institute.

This year, Vernon accepted CEI’s Julian L. Simon Memorial Award, named after the late economist and inveterate optimist. Julian himself had an amazing faith in mankind’s ability to solve problems and advance human progress. He was the intellectual scourge of the perennial prophets of societal doom including – not surprisingly – the butterfly ecologist, Paul Ehrlich.

Julian famously challenged Ehrlich to a wager to illustrate their competing theories on resource depletion and the future prosperity of mankind. Ehrlich would pick any five commodities, and Julian bet $10,000 that in ten years, the real price of that bundle would decline. Ehrlich accepted and selected chromium, copper, nickel, tin, and tungsten. Ten years later, the prices of all these commodities had declined. Ehrlich paid up – but remains a Doomsayer to this day. When Julian died, CEI was moved to honor his work by creating the prize in his name.

Vernon’s research comparing long-standing economic theory to real-world experimental outcomes has produced results that Julian Simon would have been very encouraged by. His pioneering work breaks economics out of the “perfect competition” model of the economy – not necessarily replacing other methods of inquiry, but adding an experimental approach to the economist’s tool chest. For example, how close to efficient outcomes will markets be, if one or more of the assumptions of the perfect competition model are dropped? The findings? Markets remain effective wealth-creating institutions in many cases – despite “theory.”

Experimental economics importantly creates a tool for reconciling the two distinct insights of Adam Smith, godfather of modern economics. The first is the well-known economic principle developed in The Wealth of Nations that the complex network of mutually-advantageous voluntary exchanges – the market – needs no central planner; it evolves as if organized by an invisible hand. This theme is the basis of economics. However, in his earlier work – the Theory of Moral Sentiments – Smith developed a distinct but supporting theme. Mankind had also evolved a sensitivity to the plight of others – the other-regarding value of empathy.

Experimental economics creates a tool to explore the relevant significance of these motivations and to vary the institutional framework in order to better understand society.

By so doing, it enriches our understanding of markets, addressing the challenges posed by “market failures” and the arguments that government intervention is presumptively needed in such cases. Experimental economics demonstrates how individuals often find work-arounds for such situations, remediating theoretical failures. Its findings demonstrate how capitalism, by evoking both self-interest and empathy, finds voluntary approaches which are “pretty good” when compared to coercive political alternatives.

Vernon’s work has enriched our understanding of how Adam Smith’s two great works better explains the creative, wealth-producing achievements of mankind. The two Smiths both understand well that progress occurs not because we solve analytic equations, but rather because mankind finds ways to advance self-interest in societally legitimate ways.