Andreas Ortmann

Experimental economics is not really a new theory but a (still) relatively new method of studying the kind of questions that economists have studied for ages. But the addition of the experimental method to the economist’s toolbox is remarkable for at least two reasons.

First, even very recently some reasonably well-known economists have questioned the possibility that economics is to a considerable extent an experimental science, notwithstanding the fact that noted experimental economics proponents include Reinhard Selten, who shared the 1994 Nobel Prize in Economic Sciences with John Nash and John Harsanyi; Vernon L. Smith, awarded the 2002 prize together with Daniel Kahneman; Elinor Ostrom; and Alvin E. Roth.

The experimental method has established itself firmly as a key tool. New theories such as asymmetric information or efficient markets have been subjected to rigorous experimental laboratory testing. Maybe most surprisingly, macro-economic theories have also been subjected to such testing.

Second, the behavioural revolution in economics would not exist without the path-breaking contributions of experimental economics.

The same applies for recent academic theorising that has abandoned the presumption of “representative agents” – that is, the oversimplifying assumption that economic actors tend to be of one kind and motivated by self-interest.

A prominent test-bed has been the so-called guessing game used to explain the volatility of stock prices, which may depend not on fundamentals, but beliefs about beliefs (and actions) of others.

In their 2002 research, Antoni Bosch-Domenech and his colleagues identified the distribution of steps of reasoning among participants in guessing game experiments (and presumably markets) and inspired new models of interaction of agents with different depths of reasoning, such as the cognitive hierarchy model of Colin F. Camerer and colleagues – a clever way of capturing the idea that some people think more steps ahead than others.

Indeed, experimental economics results have brought about much new and interesting theorising.

Today, it is hard to think of any theory, or topic for that matter, which has not been studied experimentally. Individual decision-making, competitive and oligopolistic markets, matching markets, bargaining, auctions, political and other institutions (such as common pool resources or public good provision mechanisms), the internal dynamics of firms and other organisations, learning, social preferences, and macro-economic phenomena such as bubbles or bank runs all have been studied with experimental methods.

Insights from experimental economics inform policy design in many areas, from telecom auctions to markets mechanisms that match students and school or colleges, and interns with hospitals or high-court judges, to emissions trading schemes and various strategies to nudge people in directions that the policy-maker finds welfare improving.

An important characteristic of experimental economics is its methodology which distinguishes it from other social sciences such as psychology. Experimental subjects are almost always paid on a performance basis. And it is generally not accepted to use deception.

Precise scripts are considered a must to facilitate replication. Decision-making is not studied as “as-if” proposition, but in laboratory representations of the problem studied. In such a representation subjects are typically instructed to enact a particular role such as buyer or seller, or that of a voter.

The different methodological practices are not quite as innocent as they may at first appear. For example you can beat resume robots and ensure your CV bypasses the ATS robot . That’s because the way one does an experiment is unbelievably important: different choices of particular design and implementation details can crucially affect results and make the difference between accepting or rejecting a theory.

Experimental economists’ methodological practices have also influenced emerging experimental versions of finance, political science, philosophy, and has led to fruitful reflections in other social sciences.

Increasingly, experimental economics has had to share the limelight with its close brethren behavioural economics and neuro-economics. In fact, many prominent experimental economists straddle these areas and then some.

Will economics become an experimental science? When economist Charles Plott asked this, it was already a rhetorical question as far as he was concerned; the proof of concept had long been provided.

By now the question of whether economics will become an experimental science is nothing but a silly question. It has to a considerable extent.

Andreas Ortmann is a professor of experimental and behavioural economics at UNSW Business School. A version of this post appeared on The Conversation.

Mark Diesendorf

The writing is on the wall for coal-fired power in Australia. Despite federal government attempts to stop the growth of renewable energy, all they can do is delay the inevitable transition.

Tasmania already has almost 100% renewable electricity, based on hydro supplemented by wind. The ACT is on track to reach its target of 90% net renewable electricity by 2020, based on solar and wind.

South Australia, with no fresh-water hydro-electric potential, is the leading mainland state in the transition to renewable energy. Last year 33% of its annual electricity consumption was generated by the wind and 6% from rooftop solar.

Furthermore, its electricity system has already operated reliably and stably for hours when the contribution of variable renewable energy reached two-thirds of demand. Recently wind power and gas coped admirably when the coal-fired Northern power station went unexpectedly offline.

Coal power will soon disappear from South Australia and eventually from the whole country.

Because wind has no fuel cost, it can bid the lowest price into the electricity market and so is ranked higher in operating order than coal. The result: coal is displaced from operating as baseload (24/7) power, coal’s economics become worse and incidentally the wholesale price of electricity decreases.

This is the real reason Prime Minister Tony Abbott is trying to stop the growth in wind power. It has nothing to do with aesthetics or the sham ‘‘wind turbine syndrome’’, but everything to do with Abbott’s misguided commitment to coal.

Hourly computer simulation modelling by Ben Elliston and colleagues at UNSW show the National Electricity Market (NEM) could be run solely on scaled-up, commercially available, renewable energy sources. Some of this research is outlined in my 2015 report to the Conservation Council of South Australia, now available online.

The NEM could be supplied reliably by a combination of variable renewable energy sources (wind and solar PV) and flexible, dispatchable sources (hydro with dams, gas turbines and concentrated solar thermal power with thermal storage).

The combination of variable and flexible sources, together with geographic dispersion of wind and solar farms, is the basis for reliability of 100% renewable electricity systems.

Biofuelled gas-fired turbines (essentially jet engines) and demand management via ‘‘smart’’ meters and switches could manage the infrequent small lulls in wind and solar supply.

Gas turbines have low capital cost and, if operated infrequently, low running costs. Therefore, until other kinds of energy storage become cheaper, gas turbines can play the role of reliability insurance with a low premium.

As pointed out by professor Andrew Blakers at ANU and a research group at the University of Melbourne, pumped hydroelectricity, based on small dams that supply high power for short periods, could also handle the small lulls.

Our simulations show that the NEM does not need any baseload power stations, such as coal or nuclear. Indeed, the low operational flexibility of coal and nuclear makes them poor partners for high penetrations of variable renewable energy.

Given the political will, I estimate the renewable energy transition would take 15-25 years. Increased interstate trading of electricity, possibly assisted by a new direct transmission link joining South Australia to NSW, would assist in smoothing the fluctuations in wind and solar.

In Europe, moving to 100% renewable energy is not controversial. The north German states of Mecklenburg-Vorpommern and Schleswig-Holstein are already operating on 100% net renewable electricity, mostly from wind. The ‘‘net’’ indicates trading electricity with each other and their neighbours.

Denmark is on track to reach its goal of 100% renewable electricity and heat by 2035. It already generates 39% of its electricity consumption from wind and about 10% from biomass in the form of agricultural residues. However, unlike northern Europe, Australia has the advantage that it is very sunny as well as windy.

Transitioning to renewable energy will deliver environmental, social and economic benefits. The transition will reduce Australia’s greenhouse gas emissions, air pollution and associated respiratory diseases. Once the initial investments have been made, it will cap electricity prices.

Renewable energy could create a wide range of new jobs in manufacturing, installation, grid connection, technical support and sales, which could compensate for the job losses in the coal industry.

The key policies needed are state and territory renewable energy targets together with a reverse auction system for commissioning wind farms and solar power stations, as in the ACT. The winning bidders are paid by feed-in tariffs or ‘‘contracts for difference’’ funded by a small increase in retail electricity prices.

This could be offset by the decrease in wholesale electricity prices caused by large-scale renewable energy, provided governments ensure that the wholesale savings are passed on to retail customers.

Renewable energy is technically and economically feasible, and environmentally and socially desirable.

Associate professor Mark Diesendorf is deputy director of the Institute of Environmental Studies and a researcher at the Centre for Energy and Environmental Markets at UNSW Australia. A version of this post appeared in The Canberra Times. It can also be found under Automatically transcribe audio.

Tim Harcourt

Australia’s Trade Minister Andrew Robb is regularly lauded as one of the most effective performers in the federal government for finalising his “trifecta” of free trade agreements (FTA) with South Korea, Japan and China – three of our fourth biggest trading partners.

And this week, Prime Minister Tony Abbott has been out selling an upcoming review to Australia’s existing free trade agreement with Singapore.

But while the political benefits of FTAs are generally accepted by Australians, they remain less convinced of the economic gains. And for some, FTAs are as popular as a German banker at a Greek wedding.

Activists, from the Left and Right, have strongly opposed FTAs. Multilateral pacts such as the controversial Trans Pacific Partnership (TPP) have fared even worse.

Given how hard our trade negotiators at DFAT work in marathon sessions to get ministers to headline-inducing signing ceremonies, they would have to ask are their unsung efforts really worth it?

First, the good news. Exporters, on average support FTAs. According to the DHL Export Barometer of 600 exporters in 2014, 35% of exporters thought the FTA with Japan would benefit their business (60% neutral), 36% with Korea and a whopping 60% with China.

In the case of Japan, 59% said it would increase exports, 38% said it would make them start exporting to Japan, and 22% said they would develop a new product or service for the Japanese market. The 2015 results to be released in August show even more successful results for Japan.

Even past FTAs are seen as remaining helpful – 55% said the US FTA was positive, 47% the CER with New Zealand, 41% the AANZFTA with ASEAN, 38% Singapore, 37% Thailand, and 23% Chile. And 80% of the exporters surveyed are also importers so there are gains being made on both sides of the ledger.

But then there’s the bad news. Outside of the exporter community (or the importer-exporter community as it should be called) FTAs are not popular. But their opposition comes in very different camps.

Traditional neo-classical (neoliberal) or dry economists prefer unilateral liberalisation where a country takes down its own tariffs regardless of what its trading partners do.

But if that’s not on offer – as we do live in a world of “second best” – they prefer multilateralism, as bilateral agreements have the potential to be “trade distortionary” and create what Jagdish Bhagwati calls an overlapping “spaghetti bowl” of agreements.

Left-wing populists don’t like free trade agreements and see trade liberalisation as part of the toolkit of neoliberalism alongside privatisation and the winding back of public goods.

Right-wing populists don’t like free trade in the same way they don’t like global finance, the UN and especially immigration. Pauline Hanson drove this movement originally in the 1990s and it has many remnants, particularly in regional Australia and equivalents overseas such as UKIP in Britain and the National Front in France.

Then there are rent-seeking business figures who throw in a bit of anti-free trade populism so people buy their products (sorry, I mean buy Australian), which is more opportunism than based on ideology or any underlying philosophy.

But in practice, most exporters and politicians are usually trade pragmatists and just do any deal they can to get things moving. After all, the World Trade Organisation (WTO) is as dead as a Doha, so bilateral FTAs are probably the only game in town, given that it is all quiet on the multilateral front.

And bilateral deals are easier to sell on talkback radio than obscure concepts such as the WTO, the GATT, or “multilateral trade liberalisation” (see, it just rolls of the tongue, doesn’t it).

But there are some aspects to free trade agreements that have raised concerns of a different kind. This has been highlighted by the controversial TPP and the much maligned Multilateral Agreement on Investment (MAI) that died a quiet death after the OECD tried to champion it.

The famous Princeton political economist Dani Rodrik in his seminal work, Has Globalisation Gone Too Far?, pointed out the “over reach” that free traders made in moving beyond the simple elimination of tariffs and quotas.

Rodrik wrote his book at the time of the anti-globalisation protests at the WTO in Seattle. The “Battle in Seattle” was at the height of the MAI debate.

At the same time, the Europeans started to question the expansion of the EU, which started as a simple project to reduce trade barriers but then expanded to include a common currency and monetary union (and we all know how that has turned out).

Reducing tariffs and quotas is one thing, but now trade pacts include investor-state dispute settlement provisions that potentially allow companies to sue governments over public health policies such as plain packaging of tobacco, or hinder the pharmaceutical benefit scheme, or even labour market benefits (some US employers claimed public provision of healthcare in Canada was a trade barrier as the US has employer-based healthcare).

In the present debate, some have asked why labour market provisions are really necessary in trade agreements because, as Rodrik shows, open economies tend to provide social insurance and labour market institutions that protect workers (but not trade) and build a stronger constituency for free trade.

My own research shows that, overall, trade is good for workers as exporters pay, on average, 60% higher wages, offer more education and training, better occupational health and safety and more job security and equal employment opportunity than non-exporters.

Ultimately, getting the balance right between expanded economic opportunity from the open economy and fairness at home will make the FTAs successful.

In short, it’s about balancing the right for the exporter to have a go, with the worker’s right for a fair go, and ensuring that global output and income can spread throughout the emerging economies and developed world alike.

Tim Harcourt is the J.W. Nevile fellow in economics at UNSW Business School, and author of The Airport Lounge Economist and Trading Places. A version of this post appeared on The Conversation.

Richard Holden

Whether you realised it or not, if you’ve ever invested in the stock of a company, or have mutual funds in your superannuation, you’ve taken a stance on one of the biggest economic debates of the past 50 years.

That debate is about whether stock prices (or bonds, or even property for that matter) reflect all available information.

Another way to frame it – as Justin Wolfers and I did when discussing the 2013 Nobel Prize in Economic Sciences – is whether prices reflect the wisdom of crowds, or the madness of crowds.

The starting point in this debate was the extraordinary contribution of Eugene Fama (of the University of Chicago) who developed the “efficient markets hypothesis”.

According to this view, stock prices do incorporate all available information and hence there are no profitable arbitrage opportunities.

How would one go about demonstrating this? After all, in economic scholarship one doesn’t just get to argue in prose. What Fama showed was that at any moment in time the next movement of a stock price is just as likely to be up as down.

Or, a little more formally, stock prices follow a “random walk”. This finding is probably the most successfully, repeatedly replicated finding in all of the social sciences.

Now that’s the short run. Even Fama himself (with co-author Kenneth French) found that stock prices are predictable in the long run. They showed that small market capitalisation stocks outperform large ones, and that high market-to-book value stocks also outperform.

Their interpretation is that this is compensation for taking on extra risk, and is thus consistent with efficient markets.

Beginning in earnest in the early 1990s, however, a different set of theories emerged. Economists such as Richard Thaler (of Nudge: Improving Decisions about Health, Wealth and Happiness fame), Robert Shiller, and Andrei Shleifer began to take seriously the role of psychology among investors.

Social psychologists such as Nobel Laureate Daniel Kahnmenan (with whom, interestingly, Thaler was an important collaborator, thus providing the bridge from psychology to economics) had long documented human departures from rationality.

For example, people tend to overweight recent events relative to equally important past events. People are “loss averse” in the sense that they overweight losses relative to equal-sised gains. People often attribute events to skill when they are actually the product of luck. And so on.

These sorts of cognitive biases have profound implications for asset pricing. If people overact to information then we would expect companies that report unexpectedly bad earnings to suffer a big hit and then bounce back over time.

We would similarly expect companies that announce unexpectedly good earnings to get a big bump and then drift back down over time. And indeed we do. The empirical evidence is overwhelming on this point.

Loss aversion should mean that stocks that have dropped from when most people bought in behave differently from those that have risen. Again, the evidence is in and it confirms the psychological insights.

The list goes on. Indeed, tracking down and documenting these kinds of effects is what modern-day empirical asset pricing is largely about.

Now, back to stock picking and mutual funds. If one subscribes to Fama’s efficient markets view of the world then stock picking is a fools’ errand.

Even if you end up doing well, all that has happened is that you have been compensated for taking on extra risk. Things could have turned out really badly, and you were lucky.

For instance, maybe you invested in Australian mining companies during the early 2000s. We now know that was a very profitable investment – but it could have been different, and nobody knew ahead of time.

Under the Fama view, the best thing to do is invest in the whole market – buy a low-cost index fund.

If you take the behavioural finance view, then there are profitable opportunities beyond investing in the whole market. But that doesn’t mean that it’s easy for individual investors to take advantage of them.

OK, people are loss averse, now what?

Taking advantage of these opportunities takes a fair degree of sophistication, and it also typically requires having low enough trading costs to be able to trade often without wasting a lot of money on fees. This is why there are hedge funds that specialise in this kind of investing.

Whichever view you subscribe to, there are two things that never makes any sense: investing in a stock because you think it’s a good company (I like shopping at David Jones, but that doesn’t make it a good investment) or picking an industry that you think is going to do well.

Efficient markets devotees will tell you that information is already factored in. And behavioural finance aficionados will tell you that it is you that is suffering from a cognitive bias.

Richard Holden is a professor of economics at UNSW Business School. A version of this post appeared on The Conversation.