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Lessons from Economic Experiments

2007 Capital Campus Texas Retreat

October 23, 2007

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Economists employ controlled experiments in building and testing theory.

In an experiment, one tests for a specific response to a specific stimulus.

In a simulation, one observes a suite of (sometimes unpredicted) auto-generated stimuli and responses.

Economic simulations are useful for gaining intuitions into complex processes.

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The purpose of this simulation is to create a competitive segmented market and to observe the market as it achieves equilibrium.

In this simulation, you will experience real market forces. The same human traits and behaviors that govern real markets exist in the simulation.

What are artificial are your surroundings. The market forces are real.

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The Players and the Goals

In this experiment, there are WORKERS and FIRMS.

WORKERS sell labor to the FIRMS.

FIRMS make and sell stuff.

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The Players and the Goals

Two types of worker

• Red workers

• Blue workers

Each worker’s goal: Maximize income

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The Players and the Goals

One type of firm

• Firms hire Red Labor and Blue Labor to produce their products.

• Firms automatically sell everything they produce for $3 per unit.

Each firm’s goal: Maximize profit

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The Objects

= 1 hour of Blue labor

= 1 hour of Red labor

= 1 dollar

Labor

$

Labor

= 50 cents (each)

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Phases of Play

1. Labor market and production round

2. Calculation round

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Phases of Play

1. Labor market and production round

Red workers and Blue workers sell as much labor as they can to firms for $.

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Phases of Play

1. Labor market and production roundRed labor hired

Blu

e la

bor

hire

d

Units of output produced

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Phases of Play

2. Calculation round

Workers report:

• Income earned• Unsold labor

Firms report:

• Blue labor hired• Red labor hired• Money remaining

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Example: Labor Round

Blue worker 1 Sells 6 to Firm 7 for $5 each.

Red worker 2 Sells 8 to Firm 7 for $5 each.

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0 1 2 3 4 5 6 7 8 9 100 0 35 43 49 53 57 60 63 65 68 70

1 0 39 48 54 59 63 66 70 72 75 77

2 0 41 51 57 63 67 71 74 77 80 82

3 0 43 53 60 65 70 74 77 80 83 86

4 0 45 55 62 68 72 76 80 83 86 89

5 0 46 56 64 69 74 78 82 85 89 91

6 0 47 58 65 71 76 80 84 87 91 94

7 0 48 59 66 72 77 82 86 89 92 95

8 0 49 60 68 74 79 83 87 91 94 97

9 0 49 61 69 75 80 85 89 92 96 99

10 0 50 62 70 76 81 86 90 94 97 100

11 0 51 63 71 77 82 87 91 95 98 101

12 0 51 63 71 78 83 88 92 96 99 103

Units of Red Labor

Example: Labor Round

Firm 7 manufactures 87 units of product.The product will be automatically sold for $3 per unit.

87

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Example: Utility and Profit Round

Worker 1

Ends the experiment with (6)($5) = $30.

Worker 2

Ends the experiment with (8)($5) = $40.

Firm 7

• spent $70 on labor, and

• produced and sold 87 output at a price of $3 each.

Firm 7’s profit is $261 – $70 = $191.

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1. How much are you producing right now?

3 Blue and 1 Red 43 output

2. What happens if you hire 1 more Red worker?

Output increases from 43 to 53 + 10 output

Example: Cost/Benefit of Hiring More Labor

Suppose you can hire 1 Red hour for $6 or 1 Blue hour for $7.

So far, you have hired 1 Red hour and 3 Blue hours.

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3. What does that do to your revenue?

(10 output)($3) = + $30 revenue

4. What does it do to your costs?

Cost of 1 Red worker = $6 + $6 cost

5. What does it do to your profit?

+ $30 revenue & + $6 cost + $24 profit

Example: Cost/Benefit of Hiring More Labor

Suppose you can hire 1 Red hour for $6 or 1 Blue hour for $7.

So far, you have hired 1 Red hour and 3 Blue hours.

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6. What happens if you hire 1 more Blue worker?

Output increases from 43 to 45 + 2 output

7. What does that do to your revenue?

(2 output)($3) = + $6 revenue

8. What does it do to your costs?

Cost of 1 Blue worker = $7 + $7 cost

9. What does it do to your profit?

+ $6 revenue & + $7 cost – $1 profit

Example: Cost/Benefit of Hiring More Labor

Suppose you can hire 1 Red hour for $6 or 1 Blue hour for $7.

So far, you have hired 1 Red hour and 3 Blue hours.

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Trading Rules

Workers must remain in their seats.

Workers display cards indicating their ask prices.

Firms may only purchase 1 unit of labor at a time.

Runner purchases one unit, takes it to manager, goes back and purchase another unit, etc.

Manager calculates cost/benefit of hiring more labor of each type.

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Ready to begin…

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Labor Market and Production Round

Workers: Sell all your labor to firms for $.

Firms: Every unit of output you produce is automatically sold for $3.

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Calculation Round

Workers report:

• Income earned• Unsold labor

Firms report:

• Blue labor hired• Red labor hired• Money remaining

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New Rules

The wage rate that some workers receive is too low. In the interest of assuring a minimum standard of living, we now impose a minimum wage.

LAW:Henceforth, no firm may pay less than per worker.

$6

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Ready to begin…

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Labor Market and Production Round

Workers: Sell all your labor to firms for $.

Firms: Every unit of output you produce is automatically sold for $3.

FIRMS MUST PAY NO LESS THAN PER UNIT LABOR.

$6

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Calculation Round

Workers report:

• Income earned• Unsold labor

Firms report:

• Blue labor hired• Red labor hired• Money remaining

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Results…

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Wage Rate

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

Round 1 Round 2

Blue Labor Red Labor

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Total Profits (all firms combined)

$0

$500

$1,000

$1,500

$2,000

$2,500

Round 1 Round 2

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Unemployment Rate

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Round 1 Round 2

Blue Labor Red Labor

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Units of Output Produced (all firms combined)

860

880

900

920

940

960

980

1,000

1,020

1,040

1,060

Round 1 Round 2

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Red Worker Income

$0

$20

$40

$60

$80

$100

$120

Red 1 Red 2 Red 3 Red 4 Red 5 Red 6 Red 7 Red 8 Red 9

Round 1 Round 2

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Blue Worker Income

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

$100

Blue 1 Blue 2 Blue 3 Blue 4 Blue 5 Blue 6 Blue 7 Blue 8 Blue 9

Round 1 Round 2

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Firm Profits

$0

$50

$100

$150

$200

$250

$300

$350

1 2 3 4 5 6 7 8 9

Round 1 Round 2

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Price Controls

The intent of price controls is to provide relief to buyers (e.g., college tuition caps, credit card interest rate caps) or support to sellers (e.g., minimum wage, ethanol subsidies).

How do you cure a fever?

Prices are not levers that set value, they are metrics that respond to value.

Price controls fail on two counts: (1) legislating price does not legislate value, (2) legislating price prevents price from signaling value.

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Price Controls

All things are scarce.

Scarce resources will be rationed.

The question is, by what mechanism?

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Price Controls

In a free market, scarce resources are rationed by prices.

Price controls cause scarce resources to be rationed by non-price factors.

Capping interest rates rations credit toward less risky borrowers.

Capping tuition rations college toward smarter students.

A floor on wages rations jobs toward more productive workers.

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Minimum Wage

When we force an employer to pay a worker more than the job is worth, the job disappears.

40 years ago: Telephone operators

30 years ago: Gas station attendants

10 years ago: Fast food servers

Last year: Pizza deliverers

What happens to workers whose jobs are eliminated?

Those whose labor is worth more than minimum wage find new jobs.

Those whose labor is worth less than minimum wage remain unemployed.

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How does the simulation compare to reality?

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Source: Statistical Abstract of the United States, and Bureau of Labor Statistics

3%

4%

5%

6%

7%

8%

9%

$0.30 $1.30 $2.30 $3.30 $4.30 $5.30 $6.30

Un

emp

loym

ent

Rat

e

Minimum Wage

All Workers (1970-2004)

40

3%

4%

5%

6%

7%

8%

9%

0.3 0.32 0.34 0.36 0.38 0.4 0.42 0.44 0.46 0.48

Un

emp

loym

ent

Rat

e

Minimum Wage as Fraction of Average Hourly Wage

All Workers (1970-2004)

Source: Statistical Abstract of the United States, and Bureau of Labor Statistics

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0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

0.3 0.32 0.34 0.36 0.38 0.4 0.42

Un

emp

loym

ent

Rat

e

Minimum Wage as Fraction of Average Hourly Wage

Workers with a College Education (1984-2004)

Source: Statistical Abstract of the United States, and Bureau of Labor Statistics

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0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0.3 0.32 0.34 0.36 0.38 0.4 0.42

Un

emp

loym

ent

Rat

e

Minimum Wage as Fraction of Average Hourly Wage

Workers with a High School Education (1984-2004)

Source: Statistical Abstract of the United States, and Bureau of Labor Statistics

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0%

2%

4%

6%

8%

10%

12%

14%

16%

0.3 0.32 0.34 0.36 0.38 0.4 0.42

Un

emp

loym

ent

Rat

e

Minimum Wage as Fraction of Average Hourly Wage

Workers with Less than a High School Education (1984-2004)

Source: Statistical Abstract of the United States, and Bureau of Labor Statistics

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Effects of minimum wage on immigration

• Supply effect: Increase in the minimum wage increases the attractiveness of U.S. jobs to potential immigrants.

• Demand effect: Increase in the minimum wage increases the attractiveness of undocumented workers to U.S. firms.

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0.00%

0.10%

0.20%

0.30%

0.40%

0.50%

0.60%

0.70%

$0.00 $1.00 $2.00 $3.00 $4.00 $5.00 $6.00

Minimum Wage (1970-2004)

Alie

ns

Ex

pe

lled

(v

olu

nta

ry d

ep

art

ure

s a

s %

of

US

po

pu

lati

on

)

Source: Department of Homeland Security and Bureau of Labor Statistics

Increases in the minimum wage make US jobs more attractive to foreigners and undocumented workers more attractive to US firms.

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Lessons from Economic Experiments

2007 Capital Campus Texas Retreat

October 23, 2007