Abstract
Experimental economists frequently claim that they can contribute to industrial organization (IO) by observing individual behavior in, for example, Cournot or Stackelberg games. In these experiments, they regularly falsify the hypothesis of profit maximization, which is, by and large, retained in applied IO. However, what experimental economists test in the laboratory is, at best, the theory of single-person firms. In contrast, empirical IO studies quite large organizations on the basis of field data, while theoretical IO is concerned with internal organization and its links to market behavior. From a modern theory-testing perspective, many experiments should therefore be considered as irrelevant to modern IO; the focus of experimental IO must change if experimental economists want to contribute to IO.
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Notes
The first problem is often referred to as “the problem of external validity”. External validity is one of the quality criteria for judging experiments that have been proposed originally in psychology (see Campbell 1957; Campbell and Stanley 1963). For a criticism from the theory-testing perspective see, most notably, Gadenne (1976) and further sources discussed by Shadish et al. (Shadish et al. 2002, ch. 14). In experimental economics, the theory-testing view had for a long time been prevalent (see, e.g., Plott 1982); only recently, external validity considerations have become popular (see Schram 2005).
Deductivism means, of course, modern hypothetico-deductivism, where theories are taken to be conjectures and, therefore, in need of tests. Hypothetico-deductivism is opposed to inductivism, see Musgrave (2011). External validity concerns have inspired a “new inductivism” in economics; see Guala (2005), Bardsley et al. (2010), and Gadenne (2013) for a thorough methodological criticism.
The five elements are a generalization from Fudenberg and Tirole (1991, pp. 77–82). Our version also covers behavioral extensions of game theory.
For an early survey, see Cyert and Lave (1965). For a recent survey of the early Cournot oligopoly experiments, see Bosch-Domènech and Vriend (2008). For an overview of the early and recent Cournot oligopoly experiments, see Requate and Waichman (2011, p. 39). For the credit to Holt (1985), see, e.g., Plott (1989).
Holt’s design leads to further, asymmetric Nash equilibria.
One referee suggested the analogy of a map. Representative-agent models, and corresponding experiments, are similar to maps without all the details, good for driving but not for an orienteering competition. Our criticism could then be considered as a request for more detailed maps (maybe because we have come as far as we can go by car). This is a nice picture but we would not like to emphasize it too much because the analogy between theories and maps (and even more between experiments and maps) may not go far.
Perfect consistency with methodological individualism is not a reasonable aim given the complexity of large organizations. Theories connecting organizational structure with market behavior offer a reasonable compromise between representative-agent approaches on the one hand and (infeasible) reductions of economics to psychology on the other hand. This compromise is, for instance, exemplified by Ostrom (1990) approach to governance of a commons.
Thus, the claim of Normann and Ruffle (2011, p. 1) that framing plays no role in IO experiments is rather dubious: it seems that framing is the main difference between many IO experiments and other experiments.
Inductivists do not accept all kinds of analogical reasoning. They try to state conditions under which experiments are externally valid; cf., e.g., Guala’s (2005) “eliminative inductivism”. Jones (2011) rightly argues that Guala’s methodology condemns experimental economics to irrelevance. This should at least motivate experimentalists to consider the deductivist alternative before they buy into eliminative inductivism.
While theories explaining the behavior of individuals in experiments would give rise, via the SRA hypothesis, to theories about the behavior of multi-person firms, it is rather doubtful that these theories would count as explanations. Since the SRA hypothesis does not explain why firms behave like individuals, it would at best support a kind of as-if theorizing about firms as defended by Friedman (1953). This criticism applies also to the heuristic uses of the SRA hypothesis mentioned below.
Here is a simple specification with explicit solutions. Production functions are \( f_{A} \left( {L_{1} ,L_{2} } \right) = L_{1}^{0.5} L_{2}^{0.5} \) and \( f_{B} \left( {L_{3} ,L_{4} } \right) = L_{3}^{0.5} L_{4}^{0.5} \). The inverse demand function is \( p = a - b\left( {x_{A} + x_{B} } \right) \). The material payoff of players \( i = 1, 2 \) is \( \pi_{i} = p x_{A} /2 - c L_{i} \) and the material payoff of players \( i = 3, 4 \) is \( \pi_{i} = p x_{B} /2 - c L_{i} \), where \( 0 < c < a \). With free-riding, the unique Nash equilibrium in which both firms serve the market is \( L_{i} = \frac{a - 4c}{3b}, i = 1, 2, 3, 4 \). Internal cooperation leads to the standard Cournot-Nash equilibrium with \( L_{i} = \frac{a - c}{3b}, i = 1, 2, 3, 4 \). With internal cooperation and collusion between the firms, the solution is \( L_{i} = \frac{2a - 4c}{8b}, i = 1, 2, 3, 4 \). If \( a = 10 c \), free-riding leads to collusion.
Bardsley et al.’s (2010, ch. 2) more complicated account boils down to the account given in the text.
Moreover, it is well known that deviations from profit maximization may lead to behavior that, from the outside (i.e., without direct access to a firm’s technology), still looks like profit maximization. This can easily be seen from the example above, where an observer who just knows the inverse demand function would be unable to say whether the quantity choices of a firm are affected by internal free-riding or not (see also the numerical specification in note 13, where free riding just looks like profit maximization with twice the costs of effort). For some purposes, the hypothesis of apparent profit maximization may suffice. Obviously, this hypothesis can be defended even if the HO model has been falsified.
Obviously, the team production problem, if unsolved, reduces efforts in comparison to the standard model of profit maximization. A reduction in outputs may improve the situation for all players if it brings them closer to the collusive solution. Depending on the specification, the equilibrium outcome achieved by four free-riding homines oeconomici may be higher than, lower than, or equal to the collusive optimum. Situations where players profit from solving their team production problems are possible.
See Sauermann and Selten (1959) and subsequent work by Selten (cf. Engel 2010, pp. 449–450) for early exceptions, and Kirstein and Kirstein (2007) and Raab and Schipper (2009) for recent ones. See also Engel (2010) for a useful but quite terse survey of the empirical literature on the behavioral differences between individuals and corporate actors (or, as we say, groups). Engel refers to many results where groups behave more in line with the HO model than individuals, both cognitively and motivationally. However, there are also many results that point in the opposite direction. Importantly, and as emphasized by Engel, the internal organization of groups matters. However, most of the literature surveyed by Engel bears no immediate relation to applied IO, although almost all of it may have some relevance.
There are, of course, exceptions. If the relevant environment is one of very large teams with a lot of face-to-face interactions (thus ruling out internet experiments), it may become too expensive to test the theory.
For a survey of the new institutional theories of the firm, see Furubotn and Richter (2005, pp. 361–469).
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Acknowledgments
For detailed comments, we are grateful to Siegfried Berninghaus, Björn Kuchinke, Manfred Stadler, and two anonymous referees. For further comments and suggestions, we thank Hartmut Kliemt and participants at the 2011 Karlsruhe Seminar on Behavioral Economics, the 2011 ESA European Conference, the 2011/12 MAGKS Workshop, the 2011/12 Tübingen Economic Workshop, the 2011/12 Hohenheimer Oberseminar, and the 2013 Session of the Economic Theory Group (“Theoretischer Ausschuss”) of the Verein für Socialpolitik.
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Albert, M., Hildenbrand, A. Industrial Organization and Experimental Economics: How to Learn from Laboratory Experiments. Homo Oecon 33, 135–156 (2016). https://doi.org/10.1007/s41412-016-0008-1
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DOI: https://doi.org/10.1007/s41412-016-0008-1