Vernon L. Smith, Economist
"I think it's different kinds of minds, and the recognition that certain mental deficiencies may actually have some selective advantages in terms of activities. We've lost a lot of the barriers that have to do with skin color and with various other characteristics. But there's still not sufficient recognition of mental diversities. And we don't all have to think alike to be communal and to live in a productive and satisfying world."
"I think we're born traders. 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."
Vernon L. Smith
Markets in no way need destroy the foundation upon which they probably emerged -- social exchange between family, friends and associates. Thus, individuals can be habitual social exchangers and vigorous market traders as well. Consequently, there is the ever-present flat-earth danger that the rules of 'personal exchange' will be applied inappropriately to govern or modify the extended order of markets. Equally dangerous, the rules of impersonal market exchange may be applied inappropriately to our cohesive social networks.
This presentation was a version of the address delivered by Professor Smith in Stockholm in December 2002 on the occasion of his receipt of the Nobel Prize. The presentation draws upon Professor Smith's lifetime contributions to the field of experimental economics, contributions that culminated in his achieving this highest level of recognition.
Every laboratory experiment is defined by an environment, specifying the initial endowments, preferences and costs that motivate exchange. This environment is controlled using monetary rewards to induce the desired specific value/cost configuration.
Static price theory predicts that nonbinding price ceilings and floors will have no effect on price determination in double auction markets. In fact they have substantial effects on price dynamics. Ceilings limit the negotiation strategies of sellers, while floors limit the strategies of buyers. The buyer side of the market responds with lower bids (in the ceiling case), and the sellers with higher offers (in the floor case) than would otherwise prevail, slowing convergence.Sellers have to learn to begin negotiation at the ceiling and concede only slightly, and similarly, buyers must learn to start at the floor and resist price concessions.
Over the past 50 years, Smith has overseen thousands of experiments, including 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 electric power.
Traditionally, economists have not had an analogous body of tested behavioural principles that have survived controlled experimental tests, and which can be assumed to apply with insignificant error to the microeconomic behaviour that underpins the observable operations of the economy. Analogously, one might have supposed that there would have arisen an important area of common interest between economics and, say, experimental psychology, similar to that between astronomy and physics, but this has only started to develop in recent years.
Cooperation between individuals requires the ability to infer each other's mental states to form shared expectations over mutual gains and make cooperative choices that realize these gains. From evidence that the ability for mental state attribution involves the use of prefrontal cortex, we hypothesize that this area is involved in integrating theory-of-mind processing with cooperative actions. We report data from a functional MRI experiment designed to test this hypothesis.
The experimental literature contains only a few attempts to articulate a "theory" of laboratory experiments in economic. It is appropriate for this effort to have been modest, since it has been more important for experimentalists to present a rich variety of examples of their work than abstract explanations of why one might perform experiments.
"I can switch out and go into a concentrated mode and the world is completely shut out.. If I'm writing something, nothing else exists. Perhaps even more importantly, I don't have any trouble thinking outside the box... I don't feel any social pressure to do things the way other people are doing them, professionally. And so I have been more open to different ways of looking at a lot of the problems in economics."
The deep structure of human behavior falls into three interdependent categories: the internal order of mind; the external order of social exchange; and the extended order of markets. Each forms a complex self ordering system governed by endogenous rules reflecting individual and species experience, and biological/cultural evolution.
Smith's father, a machinist, had instilled in him a desire to understand how things work. Taking his first economics course his senior year, Smith recalls, "I guess I realized that economics was not that different from physics." But unlike physics, "economics didn't have a foundation in empirical work. It was not clear that the way it was taught was how things actually worked." Theories were just accepted without proof. Smith would eventually challenge that notion.
"My work has to do with rationality in the markets or the efficiency of markets in capturing the gains of trade, specifically the production and consumption markets, markets where the settlements are daily. Going back to Adam Smith, these markets are seen as engines for creating wealth by allowing specialization. My work shows that these markets are incredibly efficient in reaching equilibrium. [It] establishes how efficiently the various types of markets can function."
First, the default mode for economic behavior is personal exchange. This mode of behavior is supported by innate mental capacities such as mentalizing others, delay of gratification, and goodwill accounting, within an environment where historic and future interactions play an important role.,, Second, economic progress can be seen in part as the development of social 'tools' that extend personal exchange to allow for the reduction of uncertainty and an increase in the scope of economic activity.
"So there I was, wide-awake at 3 am, thinking about Chamberlin's silly experiment... The thought occurred to me that the idea of doing an experiment was right, but what was wrong was that if you were going to show that competitive equilibrium was not realizable -- you should choose an institution of exchange that might be more favorable to yielding competitive equilibrium. Then when such an equilibrium failed to be approached, you would have a powerful result. This led to two ideas: (1) why not use the double oral auction procedure? (2) why not conduct the experiment in a sequence of trading `days' in which supply and demand were renewed? The following January, I carried through my insomniacal plan...
The market structure at the retail level, which is where the system is rigid and unresponsive, has not changed in 15 years. Essentially from the neighborhood substation to the end use customer, we are talking about 1930's technology... The retail energy supply sector is not now close to being highly competitive. When it is, the supplying firms will have all the incentive they need to innovate and profit thereby.
At the end of grade 1, Mr. Hemburger gave me a note to take home to my mother, stating unceremoniously, that 'Vernon can read the second grade reader and therefore next year he will be in the third grade.' There were of course only three subjects - reading, writing and arithmetic. Reading was the litmus test; if you were less strong in arithmetic, or writing, the next year you could participate along with those in the row on your left, before Mr. Hemberger got to your row. The whole purpose of this management style was to move each person along at her own pace of accomplishment, get her through school and into farm work where she could be useful. I understand that the earliest achievement tests showed high performance in Kansas and Nebraska because of these rural schools.
Research Interests: Experimental Economics, Industrial Organization, Property Rights Economics, Neuroeconomics
Smith pioneered the field of experimental economics nearly 50 years ago and currently leads a team of economists at George Mason's Interdisciplinary Center for Economic Science, in which students across related disciplines learn "by doing" through direct experience with market performance. He is a faculty member in the School of Law and Department of Economics and a fellow of the Mercatus Center.
Few utilities understood then that they could make more money selling less power—a situation you get when you lose money on every kwh you sell. "PG&E and SoCalEd had $15 billion sucked out of their pockets," Smith noted, by not heeding his advice. "Not a power system in the world... isn't vulnerable" to the kind of crisis that happened in California, he added, and that's because everybody uses 1930s substation technology.
If asked to produce a list of current economists whose work will most influence the development of economics over the next 50 years, I would put Vernon Smith's name close to the top. As Smith once remarked, economics has been traditionally considered an "observational" science like astronomy or meteorology, rather than an experimental science like physics or chemistry. The great accomplishment of Smith and his fellow experimentalists has been to convince the economics profession that economics can be an experimental science.
Understanding decision requires knowledge beyond the traditional bounds of economics, a challenge to which Hume and Smith were not strangers. This is manifest in recent studies of the neural correlates of strategic interaction using fMRI and other brain imaging technologies. This research explores intentions or "mind reading," and other hypotheses about information, choice, and own versus other payoffs in determining behavior.
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