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Dr. Chen next to the whiteboard with instructions for student test subjects.
Photo Credit: Anjali Vaidya
Experimental Economics:
Testing Business Ideas
in the Lab By Anjali Vaidya
How a Former Physicist is Changing the Way Business Decisions are Made,
One Simulation at a Time
R
onald Reagan famously called economics “the The Founding of Experimental Economics
dismal science”, alluding to a title bestowed on the Dr. Kay-Yut Chen, principal scientist at Hewlett
field after economist Thomas Malthus grimly linked Packard (HP) Labs, is a Physics major from Cal Tech. As
population growth to inevitable global starvation. But an undergraduate, he fully intended to pursue graduate
to many scientists and engineers, the field of economics research in experimental physics until the innovative work
can hardly be considered a science at all. Unlike physics of a particularly famous professor put him on a different
or chemistry, economics relies heavily on unverifiable path to scientific fame. The professor was Dr. Charles Plott,
assumptions. Most of the few “laws” that exist in the field pioneering researcher in the world of experimental economics
are not confirmed through the rigors of experimentation, whose work has contributed to the recent explosion of
but are mere interpretations of real world phenomena. And experimental methods in the economics profession. Plott
unlike, say, classical mechanics, a field built entirely upon himself had worked with the researcher largely considered
Newton’s universally accepted and authenticated Laws of to be the “father” of experimental economics: Vernon Smith,
Motion, economics is a field with many schools of thought in awarded the Nobel Prize in 2002. It was Smith who conducted
which conflicting and even contradictory ideas are allowed seminal experiments on the convergence of price and quantity
to coexist. Of course contradiction and uncertainty are to their theoretically-predicted market equilibrium. In these
anathema to scientific purists, and for this reason economics experiments, Smith assigned his students to the category of
has been relegated to the fuzzier world of social sciences. But “buyer” or “seller” of a particular good, each buyer with his
economics as a field of study is evolving, as evidenced by a own particular valuation of how much the good is worth,
former physicist in Palo Alto who is using Stanford students each seller with his own cost of production. Each student
as economic test subjects and in doing so, changing the way thus came to represent a point on the downward sloping
business decisions are made one computerized simulation demand and upward sloping supply curves. When students
at a time. were allowed to competitively “bid” or “ask” on their
54 stanford scientific
engineering
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commodities, the price and technology
quantity transacted quickly
and inevitably converged to
an equilibrium theoretically
predicted by perfect
competition. And so was born
the field of experimental
economics, in Smith’s
small classroom at Purdue
University, autumn semester
1955. His experiments
consistently showed that
abstract economic principles
could accurately predict
the real-world behavior of
autonomous human beings.
During the past half century,
economic experimentation
has grown to validate several
theories on economic issues
such as auctions, bargaining,
finance, learning, games and
decision making. Photo Credit: Anjali Vaidya
In 1994, Hewlett Packard
made quite possibly the HP Labs in Palo Alto, where Chen’s simulations take place.
largest investment in experimental economics to date by engineering approach. I am more interested in knowing
establishing the first economics lab inside a corporation and what works and what doesn’t: If I have to structure a supply
hiring Chen to lab-test their business ideas. It is here where chain or write a retail contract, what’s the most profitable
Chen has worked for the past twelve years, hiring Stanford way to do it?”
students to take part in computerized simulations that help In one example of Chen’s experiments, he researched
HP structure its decision making in the most strategic way how retailers get around HP’s minimum advertised price
possible. (MAP) policy. Common among large companies, such
policies dictate the minimum price that each product can
Gaming the System be advertised to ensure all retailers have decent margins.
So how exactly do Dr. Chen’s experiments work, and what Because HP has hundreds of products advertised every week,
has he discovered? Over the years, Chen has worked on the company has neither the time nor resources to litigate if
numerous projects for HP and his standard approach is the retailers violate the policy. So a penalty is instituted instead
same: observe the economic behavior of human players in (often fines, or restrictions on what products can be sold
“The moral of the story is that if you are going to lose that much
money, it’s better to do so in the lab than in the real world.”
-Chen
games with different payouts. “Just like I’d model the behavior in the future). The question is: how do you write the most
of atoms in a physics experiment,” he notes, “except now the effective penalty protocol? In simulation with an early draft
atoms can think.” Stanford students are incentivized with of the protocol, Stanford students quickly discovered a way
monetary payoffs depending on how strategically they play to “game the system” by playing upon the end of a product’s
the game – payments range from $25 for participation to as lifecycle. Each product that HP sells has a lifecycle (around
high as $100. Chen deliberately avoids introducing a concrete 18 months for a printer, for example) after which the MAP
context for the game in order to see how gut intuition guides penalty has no teeth. Stanford students exploited this fact to
his players. And his goals? Chen is chiefly concerned with skirt the minimum price policy but avoid the penalty fines.
issues directly related to HP’s business strategy. He is, after After Chen discovered this, he recommended the penalty
all, a scientist for an $80 billion company, where scientific protocol be revised to reflect a different time structure.
research is chartered with the explicit goal of improving the He redid the simulation and found that even the cleverest
bottom line. As such, according to Chen, “I take more of an Stanford Student could no longer game the system to get
To Learn More
56 stanford scientific