The Experimental Economist

Nobel laureate Vernon Smith takes markets places they've never been before.

Nick Gillespie & Michael W. Lynch from the October 2002 issue

(Page 2 of 4)

Reason: What are the policy goals of experimental economics?

Smith: We know markets are efficient. We'd like to see if we can come up with market mechanisms that can be applied where they've never been used before. In electric power, for example, or in landing and takeoff slots in airports.

My colleagues and I have developed techniques to design market mechanisms that are likely to work in the real world. But we don't trust ourselves without doing experiments. The experiments are the means by which we test our knowledge. We use the laboratory to make our mistakes at low cost-and we make plenty of them. We always learn stuff and end up making changes to our model institutions, to our rules, and to our payoffs.

The next step is to bring in the people who will actually be using the system. They put design elements in, and then we run experiments with them. When they're comfortable with it, we go out in the world with it.

Here's an example dealing with electric power. Let's say you're creating a market for wholesale electricity. You have buyers and sellers of power at different nodes in an electric power network. People put in location-specific asking prices to sell power; they've got to be location-specific because power grids leak, and depending on where you are on the network, your costs will be different. If you're a wholesale buyer, then you put in a bid schedule at which you're willing to pay for power to be delivered to your node. These are all computer-assisted markets. A computer essentially takes all the asks, all the bids, and all the location costs and it maximizes the gains from trade. It does that by finding prices that clear the markets so there isn't any money left on the table.

We did experiments for this sort of system in Australia in 1993 and again in '96. We ran experiments and had a seminar a day for two weeks, and the participants got really good at it. Australia ended up deregulating its electric power industry, and I think they did a pretty good job.

What's interesting is that it's still not all privatized-that varies from state to state. Victoria, for instance, took all its generation assets and sold them off to private industry. In New South Wales, they're still held by public entities. But the important thing is that all power providers have got to get their money in the market. And all new capacity is completely private in Australia.

Reason: So experimental economics can be a tool to show regulators and industry types how truly price-sensitive markets could and would work?

Smith: It is a tool. In 1995 the Progress and Freedom Foundation sponsored a series of workshops at the University of Arizona, where I was at the time. We brought in 25 executives who were high up in their organizations-Florida Power, Duke, Ohio Edison, Mohawk, Pacific Gas & Electric, Southern California Edison, and so on.

They participated in experiments, and they could see and experience what it was like to make a real market in power. One of the things we emphasized was the importance of demand-side bidding, where wholesalers are able to interrupt power flow to some of their customers to try and keep prices down. We had a client in Ohio that took demand-side bidding very seriously. In fact, they're having customers save money by agreeing to undergo voluntary power interruptions in certain circumstances. There are gadgets available that allow individual users to figure out what appliances they want to keep running at different price levels. Customers can decide, "If the price gets up above a certain place, cut off lower-priority uses-air conditioners, hot water heaters, etc." If you do that even 15 minutes an hour, you can really cut peak demand.

The main problem in electric power is that there's almost no capability of interrupting demand in a selective way below the substation level. If you're in an elevator, if you left the porch light on in the daytime, if you've got a toaster running-those are all the same priority in terms of getting electricity in the current system. There's no way to pick and choose which gets cut off when demand surges, prices spike, and supply gets tight.

Both government and investor-based utilities have this huge supply-side bias: They provide whatever electric power people want all the time at a single, constant price. The reality is that the cost to produce and consume electricity fluctuates all the time because of changes in supply and demand and other conditions. It's like anything else, but it's hard to realize that without a visible market.

Reason: It's pretty easy to see how people will respond to observable fluctuations in price: I'll turn off my soothing water fountain at 25 cents a kilowatt, but I'll keep my iron lung going at $100 a kilowatt. But it's easier said than done to create a functioning market, isn't it?

California's famously botched restructuring of its power market underscores that. Not only did power suppliers help set up the market rules to begin with, they must have known that they would be bailed out if they could make a credible case that they couldn't supply power at the "deregulated" price. The state says sellers manipulated the market in all sorts of ways.

Smith: Sure, they're going to try to game it. That's why it's important to have the right set of rules in place. Nobody knows where exactly demand is going to come out, and sellers have an interest in trying to make that price come out as high as possible.