Free Minds & Free Markets

The Experimental Economist

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

When Reason interviewed George Mason University economist Vernon L. Smith back in May, one of the first questions we put to him was, "You're always mentioned as a short-lister for the Nobel Prize in economics. What do you think of that?" The 75-year-old Smith, the founding father of experimental economics, responded with a hearty laugh. "It's nice, but whenever I hear that, I always ask, 'Do any of the people saying that have a vote on the selection committee?'" It turns out that they did. Today, the Royal Swedish Academy of Sciences awarded Smith the Nobel "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms."

What do experimental economists do? "We take propositions of economic theory and we test them with real people in controlled settings," explains Smith, who's also a research scholar in the Interdisciplinary Center for Economic Science and a fellow of the Mercatus Center, both affiliated with George Mason. "Take the idea that there's a tendency for markets to achieve price levels at which they'll clear-at which buyers and sellers agree with one another and no money's left on the table. I'll run experiments where I motivate buyers to buy low and sellers to sell high." Smith helps keep living, breathing human beings at the center of a discipline notorious for transforming flesh and blood into impersonal theoretical equations.

"We're less interested in what people think than in what they actually do in specific situations," says Smith. "The thing that's not very explicit in much of economics is what the rules of trading are and how they affect outcomes. Experimental economics asks how the performance of a market is influenced by its rules."

Over the past 50 years, Smith has overseen thousands of experiments, with everyone from school kids to business tycoons to congressional staffers. He also has been instrumental in developing policies that create true markets where they've never existed, such as in electricity sales.

Smith has found that even when people have no clear idea of how or why markets work, they nonetheless tend to be both savvy and surprisingly generous. "I think we're born traders," he says. "We're social animals, very much into social exchange. This propensity of humans is very likely what led ultimately to trade and markets that produce wealth. The benefits of market exchange are easy to see in personal interactions, where you do something for me and I do something for you. Out there in 'markets,' though, they're not always clear. If the price goes up, the oil companies get more money and I have less. That's the average person's perception and experience. Experimental economics helps put a human face on markets."

Smith's professional odyssey began at Caltech, where he studied electrical engineering before getting a master's degree in economics at the University of Kansas in 1952 and a Ph.D. at Harvard in 1955. Prior to joining George Mason's faculty in 2001, he taught at the University of Arizona, Purdue, Brown, and the University of Massachusetts. En route to winning the Nobel, he served as president of the Public Choice Society and the Economic Science Society, received countless awards, and published widely (Cambridge University Press has published two volumes of his papers in experimental economics).

Smith's ideological journey has been no less wide-ranging. He started out as an avowed socialist who believed that the good society was one in which a few wise men made most social, economic, and political decisions. Over the years, he gravitated toward a libertarian position that holds that individuals should be as free as possible to make their own tradeoffs. "Whether we're talking about politics or economics, or even social interaction," says Smith, "the best systems maximize the freedom of the individual, subject to the constraint of others in the system."

Contributing Editor Mike Lynch and Editor-in-Chief Nick Gillespie interviewed Smith at his George Mason office and a nearby restaurant in late May. This interview will appear in the December issue of Reason.

Reason: Experimental economics stresses the importance of institutions-the rules and regulations of markets and systems of exchange. Yet people often talk about the "free" market and property rights as if they exist in nature the same way a mountain or lake does. Your work suggests that these rules are created for specific people in specific situations.

Vernon Smith: I think a lot of market conventions and property rights come from norms that emerge through people's interactions. Often the state comes along later and codifies them.

Robert Ellickson's book Order Without Law (1991) documents this. He went and looked at what fence law is in Shasta County, California. The law makes it clear that you're liable for the damage your cattle does, so you have an incentive to build fences. But that's not quite the way it works. The reality is that people share fences. If you're a guy who gets known in the community as careless, as someone who doesn't keep your fences up and whose cattle keep getting out, your neighbors are much harder on you than if it's just a one-time-only mistake. Most of these disputes don't even go to court. There's pressure on you to pay up and settle out of court at a more expensive level.

It's interesting because people work out exchange systems that are not necessarily related to formal law. If you read [economist] F.A. Hayek, you know that the early lawgivers were not people who made law. They just wrote down the existing practices. This is what people are doing in Shasta County. It's "discovered law." "Made law" starts to come in later.

Of course, not every transaction is local or face-to-face. That's why you need more formal markets and property rights. What's the old saying? "Everything for a friend, nothing for an enemy, and the law for strangers." Property rights and markets help to extend the gains from trade to strangers by ensuring payment or ensuring delivery.

Reason: People are more likely to cheat people who live far away.

Smith: Definitely. But even then, perhaps not as much as we'd first think. Consider the Internet. What's remarkable about Internet markets is not that some people don't deliver or pay, but that it's so few. There's practically no way to enforce a lot of the commercial activity. The amazing thing about it is how much of what goes on does so on the basis of trust.

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.

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