Vernon Smith:
An Experimental Study of Competitive
Market Behavior
Economics 328
Spring 2005
How to Win a Nobel Prize in 3 Easy Steps . . .
Some papers are important as much for what they
started as for what they are. Smith’s 1962 paper on
markets is an archetypical example of this. It wasn’t
the first paper ever written in experimental economics.
Thurstone had written an influential experimental
paper on indifference curves in 1933 and Chamberlin,
Smith’s advisor, wrote an important experimental
paper on markets in 1948. However, these papers
were largely isolated events. After Smith’s work,
experimental economics became an ongoing line of
research within economics.
“Columbus is viewed as the discoverer of America,
even though every school child knows that the
Americas were inhabited when he arrived, and that he
was not even the first to have made a round trip,
having been preceded by Vikings and perhaps others.
What is important about Columbus’ discovery of
America is not that it was the first, but that it was the
last. After Columbus, America was never lost again.”
– Al Roth
Christopher Columbus
Research Question
Smith’s experiments were designed to study the neo-classical theory of
competitive markets. This is the simple model of supply and demand curves
that every economics student learns in the first few lecture of principles.
In spite of the importance of the competitive model to economics, there was
little direct evidence prior to Smith’s work that the theory actually would
work.
• Field data is too dynamic to see if equilibrium is being achieved.
• Chamberlin’s (1948) earlier work using a decentralized market mechanism found
that generally the prices were too low and the volumes too high as compared to
competitive equilibrium predictions.
• Smith’s experiments were designed to give the theory its best chance to work – this
reflects a desire to establish if there were any cases were the market would
equilibrate as predicted by the theory.
Smith was interested in studying what configurations of supply and demand
were most (or least) likely to lead to equilibrium, and was also interested in the
dynamics that led to equilibrium
Experimental Design and Procedures
Sessions were run in classrooms for hypothetical payoffs.
• The results were later replicated using monetary payoffs.
• In one session the subjects were graduate students in a class on economic
theory.
• In evaluating Smith’s work, it is important to remember that he was first.
Subjects were divided into two groups, buyers and sellers.
• To induce demand and supply curves, each buyer was given a card with
his/her maximum willingness to pay and each seller was given a card with
his/her minimum reservation price.
• Each subject was allowed to buy/sell one unit of the good per trading
period.
• Trading takes place through a double oral auction.
Unlike Chamberlin’s earlier work, this is a highly centralized market.
Buyers and sellers are aware of all bid, asks, and transaction prices.
Summary of Sessions
The sessions focus primarily on the effect of vary the shape of the supply and demand curves. Some
attention is also paid to the effect of changing market institutions and making traders more
experienced..
• Test 1: Basic supply and demand
• Tests 2 and 3: Varies steepness of supply and demand curves without changing equilibrium
price. This allows Smith to study the process that leads to equilibrium.
• Test 4: Flat supply curve. This leaves no surplus for the sellers. It is interesting to think of this
in light of much later experiments on equity in market games.
• Test 5: Studies the effect of an increase in demand. Given that subjects don’t know how
demand has changed, you might expect this to disrupt convergence.
• Test 6: Equilibrium gives a very large surplus to the sellers by using a supply curve that goes
vertical. Once again, this is interesting in light of the later experiments on market games.
• Test 7: Very steep supply curve relative to the demand curve.
• Test 8: Buyers were not allowed to make bids in early periods. This was supposed to simulate
retail markets. The question is whether this prevents convergence to equilibrium.
• Test 9 and 10: Each individual is allowed to make two transactions, doubling the amount of
experience received. This is expected to speed convergence.
Initial Hypotheses
Markets are expected to converge to the competitive equilibrium.
• According to the “Walrasian” hypothesis, this convergence should be faster when
there is larger excess demand (or supply). So, for example, convergence should be
faster in Test 2 than in Test 3.
• The “excess rent” hypothesis focuses on unrealizable profits at a price – the higher
these are, the faster prices should adjust. [Historically, this has not been an
important hypothesis.]
• Allowing more experience should speed up convergence, while changing market
institutions should slow convergence.
Results – Convergence to Equilibrium
The double oral auctions tend to
converge strongly towards
equilibrium and achieve high levels
of efficiency. For example, the
results for Test 1 are shown top right.
This is true even when either demand
or supply shifts over time. See Test
5 results, bottom right.
This is a very basic result, but is the
most important result in the paper.
Competitive market equilibrium is a
central concept in economic theory,
but generally can’t be observed in
the field. These results prove that
competitive equilibrium can work
(but not that it must work).
Results – Uneven Splits of Surplus
Test 4 and Test 7 both feature uneven
(predicted) splits of the total surplus
between buyers and sellers.
These sessions are among the worst in
terms of convergence to equilibrium.
• Test 4 prices were consistently above
equilibrium, giving some surplus to the
sellers.
• Test 7, which isn’t quite as extreme as Test
4, only converges very slowly to
equilibrium. Prices are consistently too
low (compared to competitive equilibrium)
giving some surplus to buyers.
These results can be viewed as a precursor
to the sorts of results on fairness that we
have studied extensively.
Results – Speed of Convergence
Comparing Tests 2 and 3, the supply
and demand curves are flatter in Test 2
than in Test 3. This means that a small
change in prices from the equilibrium
leads to larger excess demand (amount
demanded – amount supplied) in Test 2
then in Test 3. If the speed of
adjustment is related to the size of
excess demand, we should see faster
adjustment in Test 2. This is exactly
what is observed in the data.
Smith finds more support for the excess
rent hypothesis than for the Walrasian
hypothesis. This result is largely of
historical interest – the convergence
results above are the important results.
Results – Inceasing Subjects’ Experience
Tests 9A and 10 replicate Test 7,
but allow traders to use their
values/costs twice in each period.
• By doubling subjects’ experience,
the speed of convergence will be
increased.
• This appears to be true, especially
if you look at Test 10.
This probably isn’t the right way
to test this hypothesis though –
what you really want is subjects
who have already been in one
market experiment to participate
in a second experiment with
different demand and supply
curves.
Conclusions
While Smith draws many conclusions from the data, the most important
conclusion is the most basic one: “The most striking general characteristic of
tests 1 – 3 5 – 7 9, and 10 is the remarkably strong tendency for exchange
prices to approach the predicted equilibrium for each of these markets.”
It must be remembered that Smith designed his experiments to give the theory
its best chance. These experiments don’t establish that in general the theory of
competitive equilibrium will have much predictive power.
On a more general level, this paper played an important role in illustrating how
controlled laboratory experiments let economists understand phenomena and
theories that were hard to observe in the field. In the field, one never knows
what the underlying supply and demand curves are, so you can never truly
know that the competitive equilibrium has been achieved. In the lab, you can
directly observe the emergence of equilibrium.
Further Research on Markets
Smith’s general results on convergence have been replicated many times. DOA markets are
remarkably good at converging to equilibrium under a wide variety of circumstances. This
remains true even if supply and demand curves are shifting (although random shifts do
worsen convergence).
Convergence can be quite sensitive to market institutions. Seemingly small changes in the
rules for queuing can substantially affect the speed of convergence. Larger changes in the
institutions such as using a posted price market can greatly slow convergence, even leading
to non-convergence in some cases.
Market power has mixed effects on convergence to equilibrium. Holt, Langan, and Villamil
(1986) find prices that are significantly above equilibrium when sellers have market power,
but others have found little effect in DOA markets. More generally, the impact of market
power is going to depend on the game being played. When a single individual can easily
manipulate market prices or when institutions reduce competition among sellers, departures
from equilibrium are more likely. Game theory does a fairly good job of predicting when
departures from equilibrium are likely, although it does a poor job of predicting the size of
these departures.
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