Is Free Market Free? Vernon Smith’s Nobel Winning Experiment and Behavioral Economics
In this article, the exploration of experiments in behavioral economics and the inherent self-regulation of the free market will be undertaken. Before delving into these topics, a mention of behavioral economics is deemed necessary.
Until recently, economics was a discipline that analyzed current and past situations. Then, starting in the early 2000s, interdisciplinary studies resembling, and economics extended into a completely different field, delving into psychology, and experiments were initiated. This shift, intertwining experiments with economics, led to the Nobel Prize in Economics in 2002 for Economics and Law Professor Vernon Smith. Smith shared this joy first with the other Nobel laureate in Economics of that year, Daniel Kahneman, a psychology professor at Princeton. After that point in the competitive environment of experimental studies on decision-making under risk, revolutionized various aspects of life, from IMF decisions to political decisions.
Smith created an experiment aiming to demonstrate the behavioral aspects of economics, forming a market with 10 undergraduate students. The market consists of 5 buyers and 5 sellers. Sellers know their product costs, and they can keep the profit from the selling prices for themselves. Buyers, regardless of the seller, know that they can resell the product to the experimenter at the prices shown on the card below, and they can keep the profit for themselves. Negotiations are allowed if necessary. The experiment assumes that each seller can make only one sale, and buyers can make only one purchase in parallel.
In this case, Smith decided to place the quantity of products on one axis and the prices determined by the sellers on the other axis. As a result, the graph provided below emerges.
As evident from the graph, the equilibrium point is established towards the sellers selling at $10. This enables both buyers and sellers to maximize their profits. Smith’s experimental results largely confirm this thesis. During that period, there was an expectation that an infinite sample and unlimited information would be provided for the market to establish and regulate itself. However, Smith realized through his simple experiment that the market could self-regulate with both limited information and a very small sample.
Smith conducted various derivatives of this experiment and demonstrated that the results indicate that the free market is not truly free; instead, it reaches equilibrium through competition and communication within.
While the focus of this text is predominantly on Vernon Smith’s experiment, it would be remiss not to mention Daniel Kahneman and Amos Tversky who are also pioneers of behavioral economics recognized by bounded rationality when addressing this topic.
Although individuals may have the potential to perceive the truth during competition, as exemplified in the following quote, Kahneman and Tversky observed how people can be blind to see it.
As an example according to findings of Kahneman and Tversky after observing a long run of red on the roulette wheel, for example, most people erroneously believe that black is now due.
“We can be blind to the obvious, and we are also blind to out blindness.” -Daniel Kahneman
References:
- Smith, Vernon L. (1962), “An Experimental Study of Competitive Market Behavior”,Journal of Political Economy, Vol. 70, №2, pp.111–37.
- Tversky, A., & Kahneman, D. (1971). “Belief in the law of small numbers” in “Psychological Bulletin”, 76(2), 105–110.
- (2003) Vernon L. Smith https://www.imf.org/external/pubs/ft/fandd/2003/03/clif.htm
- (2002) Don Coursey https://www.econlib.org/library/Columns/CourseyVSmith.html
For further reading:
“Thinking Fast And Slow” by Daniel Kahneman
“Nudge” by Richard Thaler
Kahneman D., J. Knetsch, and R. Thaler (1990), “Experimental tests of the endowment effect and the Coase theorem”, Journal of Political Economy 98, 1325–1348.
Kahneman D. and A. Tversky (1972), “Subjective probability: A judgment of representativeness”, Cognitive Psychology 3, 430–454.
Kahneman D. and A. Tversky (1973), “On the psychology of prediction”, Psychological Review 80, 237–251.
Kahneman, D, and A. Tversky, eds. (2000), Choices, values and frames, Cambridge University Press, Cambridge.
Plott C. and V.L. Smith (1978), “An experimental examination of two exchange institutions”, Review of Economic Studies 45, 133–153.
Smith, V.L. (2000), Bargaining and Market Behavior : Essays in Experimental Economics, Cambridge University Press, Cambridge.
