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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
dismal science”, alluding to a title bestowed on the
field after economist Thomas Malthus grimly linked
population growth to inevitable global starvation. But
to many scientists and engineers, the field of economics
can hardly be considered a science at all. Unlike physics
or chemistry, economics relies heavily on unverifiable
assumptions. Most of the few “laws” that exist in the field
are not confirmed through the rigors of experimentation,
but are mere interpretations of real world phenomena. And
unlike, say, classical mechanics, a field built entirely upon
Newton’s universally accepted and authenticated Laws of
Motion, economics is a field with many schools of thought in
which conflicting and even contradictory ideas are allowed
to coexist. Of course contradiction and uncertainty are
anathema to scientific purists, and for this reason economics
has been relegated to the fuzzier world of social sciences. But
economics as a field of study is evolving, as evidenced by a
former physicist in Palo Alto who is using Stanford students
as economic test subjects and in doing so, changing the way
business decisions are made one computerized simulation
at a time.
54 stanford scientific
The Founding of Experimental Economics
Dr. Kay-Yut Chen, principal scientist at Hewlett
Packard (HP) Labs, is a Physics major from Cal Tech. As
an undergraduate, he fully intended to pursue graduate
research in experimental physics until the innovative work
of a particularly famous professor put him on a different
path to scientific fame. The professor was Dr. Charles Plott,
pioneering researcher in the world of experimental economics
whose work has contributed to the recent explosion of
experimental methods in the economics profession. Plott
himself had worked with the researcher largely considered
to be the “father” of experimental economics: Vernon Smith,
awarded the Nobel Prize in 2002. It was Smith who conducted
seminal experiments on the convergence of price and quantity
to their theoretically-predicted market equilibrium. In these
experiments, Smith assigned his students to the category of
“buyer” or “seller” of a particular good, each buyer with his
own particular valuation of how much the good is worth,
each seller with his own cost of production. Each student
thus came to represent a point on the downward sloping
demand and upward sloping supply curves. When students
were allowed to competitively “bid” or “ask” on their
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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
of atoms in a physics experiment,” he notes, “except now the
atoms can think.” Stanford students are incentivized with
monetary payoffs depending on how strategically they play
the game – payments range from $25 for participation to as
high as $100. Chen deliberately avoids introducing a concrete
context for the game in order to see how gut intuition guides
his players. And his goals? Chen is chiefly concerned with
issues directly related to HP’s business strategy. He is, after
all, a scientist for an $80 billion company, where scientific
research is chartered with the explicit goal of improving the
bottom line. As such, according to Chen, “I take more of an
in the future). The question is: how do you write the most
effective penalty protocol? In simulation with an early draft
of the protocol, Stanford students quickly discovered a way
to “game the system” by playing upon the end of a product’s
lifecycle. Each product that HP sells has a lifecycle (around
18 months for a printer, for example) after which the MAP
penalty has no teeth. Stanford students exploited this fact to
skirt the minimum price policy but avoid the penalty fines.
After Chen discovered this, he recommended the penalty
protocol be revised to reflect a different time structure.
He redid the simulation and found that even the cleverest
Stanford Student could no longer game the system to get

layout design: Jessie Tao and Stephanie Le volume v 55

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technology around the fines. In doing so, Chen prevented
millions of dollars in lost revenue for HP. “The
moral of the story,” as he says, “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.”
Economics as a Science?
One of the primary criticisms of Chen’s field is that humans
are too complex for experimental treatment. We act according
to free will and our economic decisions could never be as
accurately predicted as, say, Newton’s laws predict motion.
In response, Chen asserts that it was precisely this complexity
of human decision-making that first intrigued him, luring
him from experimental physics to experimental economics.
Further, Chen argues that “Human economic behavior is
no more complex than other scientifically-researched areas
like protein folding. In fact I’d argue it’s less so. Besides, it is
precisely because
humans are so
complex that they His experiments consistently showed that abstract
are scientifically
interesting!” economic principles could accurately predict the
When asked about
economic laws real-world behavior of autonomous human beings.
versus the laws
of physics, most
notably those famous Laws of Motion, Chen is quick
to concede that all scientific theories have their limitations.
Because economics is about human behavior, we may never
get to a point where we can predict with 100% certainty what
a human will do. “But we can get pretty close,” says Chen.
“Say I give you a choice between $5 and $10. I’d say I can
predict with 99% certainty which one you will choose.”
Perhaps most controversially, Chen also contends that
human beings have less free will than we may think. Time
and time again in his simulations, students have proven
to react in the same way to given incentive schemes. Most
of us will choose the $10 over $5. The interesting question
Photo Credit: http://www.cdc.gov/ncidod/eid/vol7no2/scottG1.htm
The classic supply and demand curves, intersecting at the theoretically predicted
and experimentally observed market equilibrium.
56 stanford scientific
becomes: how does our greed change/manifest itself
when things get complicated? When you start to deal with
uncertainty and strategic considerations, the predictability
of human behavior declines. But it still exists. Chen’s
experiments show that while you may not always understand
the fundamental principles driving economic behavior, you
can often identify statistical patterns that will predict what
people do. “And that’s a lot better than even physics can
do in certain areas,” Chen asserts. “Physics may be great at
predicting how the planets move around the sun. But when it
comes to predicting the weather, for example… well, physics
is as bad as economics!”
The Future
While Chen is one of very few experimental economists
and even fewer in the corporate world, he is quick to give
credit to others when asked how his field is changing the way
business is done. He cites a growing research trend where
not only economists are using behavior in their experimental
methodology, but also researchers in management science,
supply chain management, and business operations.
Entirely new areas like experimental finance, for example,
have grown from the same incentivized payoff experiments
and computational tools that allowed experimental
economics to take off. Chen claims that he is merely one
of many researchers putting the science and engineering
into business process designs – reducing the guesswork in
corporate decision-making.
As for any regrets about switching from physics to
economics, Chen is sure he has none. He believes that
research in experimental economics has at least as much
potential to change the world as did the proverbial apple
that fell on Newton’s head. After all, “When you look at the
history of physics, it’s a long one – Sir Isaac Newton lived
more than 3 hundred years ago. The only real difference
between physics and economics really is that the physicists
have had a much larger head start.” S
ANJALI VAIDYA is a junior majoring in Materials Science and
Engineering and minoring in Economics. Her interests include
nanotechnology, Agatha Christie mysteries, and the latest
happenings on Grey’s Anatomy.
To Learn More
Visit the website of Dr. Kay-Yut Chen at http://www.hpl.
hp.com/personal/Kay-Yut_Chen/research.htm