Laboratory Experiments With Market Economics
Even the most casual student of the economy soon discovers the Iron Law of Diminishing Economists: If you lay all the economists in the world end to end, you’ll never reach a conclusion.
This sad, but true, observation means that economics has all the predictive validity of a fortune cookie-- You will soon meet a mysterious interest rate --but with none of the redeeming entertainment value. As sciences go, economics is more a method to explain the world than a tool to shape it.
“Economists have yet to prove they can do anything useful,” acknowledges Vernon Smith, an economics professor at the University of Arizona. “We think that usefulness can come out of a lab.”
Smith is a father of experimental economics--a rapidly growing research sect that applies the scientific method to economic theory. At Arizona, the California Institute of Technology and a score of other universities, researchers have built laboratories to test basic assumptions about how people actually behave in market environments.
Experimental economists observe budding Ivan F. Boeskys conducting insider trading over International Business Machine PC network simulations of Wall Street. They watch speculative market bubbles burst on screen. They can see how--and why--people respond to price changes and bid in auctions. These electronic markets are wind tunnels for the real world.
“Looking at people as if they were greedy, perceptive, bright and willing to behave strategically seems to be the way to go,” says Caltech Prof. Charles Plott, another pioneer in the field.
What’s so exciting isn’t that this research confirms basic economic axioms, it’s that it offers the potential that we will be able to intelligently design and engineer better markets. Just as knowledge of molecular biology enables us to splice genes to create new organisms, a fundamental grasp of economic behavior may let us splice market mechanisms into organizations to make them more efficient, more effective and more humane.
What do we really want our markets to look like? Genteel auction houses like Sotheby’s? The rabid commodity pits of Chicago? A Marrakech bazaar? A home-based, personal computer-mediated, bid-ask hookup with Sears? Nordstrom’s? Combine new technology with experimental economics insights and we can redefine what markets mean as surely as did the invention of money.
“These newly designed processes might not resemble classic markets,” says Caltech’s Plott. By testing these market concepts in advance, “We can eliminate the multibillion-regulatory-dollar faux pas. “ Instead of just being the point where supply and demand intersect, price can become something else.
The ability to engineer and test market mechanisms will change how goods are bought and sold; how the Pentagon procures weapons systems; how state and federal regulations are promulgated, and how companies are managed.
“This approach combines the coordination advantages of centralization with the information advantages of decentralization,” asserts Arizona’s Smith. In other words, markets can be engineered to be both responsible and responsive.
The government has already taken a cut at injecting market mechanisms into regulatory practices. Airlines can now bid for airport slots. The Environmental Protection Agency wants to auction off pollution rights to industry.
“There’s definitely a trend in that,” says Michael E. Levine, dean of Yale University’s School of Management, who worked with former Civil Aeronautics Board Chairman Alfred E. Kahn during airline deregulation. “Regulators are increasingly using games and markets as a substitute for regulatory edict.”
But these are crude first efforts. If experimental economics lives up to its promise, we are going to see pretested, carefully designed market mechanisms injected into all manner of economic systems. Arizona’s Smith is exploring how to design regulations that might make stock trading less volatile. Caltech’s Plott is working with natural gas pipeline companies to optimize scheduling over their huge networks. Scientists at Xerox’s Palo Alto Research Center are using software “agents” to bid for and allocate scarce computer time. Wherever flexibility in resource allocation is desirable, market design is inevitable.
“Optimization requires an exchange of information,” says William S. Perrell, a senior vice president at Marketel International. “Efficient markets require two-way information flows. The change from mono-directional information (posted price) markets to bi-directional information markets will be as fundamental as the change from the telegraph to the telephone.”
Using sophisticated software, Marketel wants to redesign the travel market. The San Francisco-based company plans to create an “electronic auction” for airline seats. Instead of relying on posted airline ticket prices, Marketel would encourage passengers to bid for their seats and similarly encourage the airlines to bid for passengers. The idea is to use the electronic market to strike a better balance between the airlines’s desire to fill planes and the customer’s desire for reasonable fares at reasonable times.
“Current mono-directional systems don’t capture consumer preferences,” says Perrell. “We make markets that are driven by transactions that could not occur in a mono-directional information society.”
Similarly, unwieldy corporate bureaucracies are destined to be re-engineered by market mechanisms that touch everything from the budgeting process to compensation structure. Instead of simply submitting budgets and salaries for review, resources may increasingly be allocated by auction and Marketel-like systems software.
“Most organizations have an internal suspicion of market mechanisms,” says Yale’s Levine. But he believes that carefully crafted market mechanisms could eventually have a major impact on corporate governance. The managers of the Exxons and General Electrics will increasingly find themselves competing in internal as well as external markets.
The raw material for market engineering will likely come from experimental economics. “Experimental economics offers an extremely important source of new information,” asserts Stanford’s Kenneth Arrow, a Nobel laureate in economics. “It provides insights into the way markets work that we just can’t get through theory. But this still hasn’t penetrated the mainstream.”
But as government and industry struggle to cope with increased complexity and diminishing resources, it’s inevitable that this next decade will see a bull market in the design and engineering of markets.
