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John Dickhaut
Accounting
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On the surface, it's obvious that trust makes the economic world
go round. A worker trusts that he or she will get paid at the end
of the week. Investors trust that earnings reports are based on
fact, not fiction. Back in the mid-1700s, Adam Smith-the father
of economics-built portions of his theories on this principle, which
he termed "sympathy." In the years since then, economists and other
thinkers have developed hundreds of further insights into the ways
that people and economies function. But what if Adam Smith was wrong
about sympathy?
Professor John Dickhaut of the Carlson School of Management's accounting
department is one of a growing number of researchers who uses verifiable
laboratory techniques to put principles like this one to the test.
"I'm interested in how people make choices and how these choices
affect the economy," says Dickhaut. A decade ago, he and his colleagues
developed the trust game, an experiment that tracks trust levels
in financial situations between strangers. "The trust game mimics
real-world situations," he says.
Luckily for modern economics-and for anyone planning an investment-Dickhaut's
modern-day scientific methods verify Adam Smith's insight. People
tend to err on the side of trust than mistrust-are more likely to
be a little generous than a little bit stingy. In fact, a basic
tendency to be trusting and to reward trustworthy behavior may be
a norm of human behavior, upon which the laws of society are built.
And that's just the beginning of what the trust game and the field
of experimental economics can teach us.
Trust around the world
Since Dickhaut and his co-authors first published the results of
their research, the trust game has traveled from the Carlson School
at the University of Minnesota all the way to Russia, China, and
France. It's tested gender differences and other variations.
"It's an experiment that bred a cottage industry," says Dickhaut.
Because the trust game has proved so reliable, researchers now use
it to explore new areas. George Mason University's Vernon Smith,
2002 Nobel Laureate for his work in experimental economics, used
the trust game in some of his path-breaking work. University of
Minnesota researcher and Dickhaut co-author Aldo Rustichini is discovering
that people's moods can be altered in the trust games so that participants
become increasingly organized in their behavior, as if this can
impact the outcome. This happens after the participants are repeatedly
put in situations where their trust has been violated.
Although it's too soon to be certain, such research could reveal
why people respond to troubled times by tightening up regulations
or imposing new ones, such as Sarbanes-Oxley. This new research
suggests that calls for tighter rules may reveal more about the
brain than reduce chaos in the world of finance.
Researchers who study the brain during economic transactions, or
neuroeconomists, scanned the brains of trust game players in labs
across the country to discover the parts of the brain that "light
up" during decision-making. Already, neuroeconomists have discovered
that the section of the brain investors use when making a risky
investment, like in the New York Stock Exchange, is different than
the one used when they invest in a less risky alternative, like
a U.S. Treasury bill.
"People don't lay out a complete decision tree every time they make
a choice," Dickhaut says. Understanding the part of the brain accessed
during various situations may help to uncover the regulatory structures
that would be most effective-since people think of different types
of investments so differently, they might react to rules in different
ways as well. Such knowledge might also point to why behaviors differ
when faced with long- or short-term gains.
Dickhaut's original paper, "Trust, Reciprocity, and Social History,"
is still a hit. Despite an original publication date of 1995, the
paper recently ranked first in ScienceDirect's top 25 downloads
from the journal Games and Economic Behavior.
Risky business
Dickhaut hasn't spent the past 10 years resting on his laurels.
Instead, he's challenged long-held beliefs with startling new data.
In his latest research, Dickhaut and his coauthors create lab tests
that mimic E-Bay style auctions, bidding contests for major public
works projects, and others types of auctions. The results may be
surprising.
"People don't appear to take risks based on some general assessment
of whether they're risk-seeking or risk-averse," says Dickhaut.
In other words, it's easy to make faulty assumptions about how a
person will respond to risk. Even people who test as risk-averse
might be willing to make a risky gamble in a certain type of auction.
This research could turn the evaluation of risk aversion upside
down. Insurance company questionnaires are meant to evaluate how
risky a prospective client's behavior might be. In fact, the questionnaires
could simply reveal how a person answers a certain kind of question,
not how he or she would behave when faced with a risky proposition.
Bubble and bust, laboratory style
In related research, Dickhaut and his students seek that most elusive
of explanations: what produces a stock-market collapse? His students
have successfully created models that explain market crash situations
in the lab. In these crashes, brokers try to hold off selling until
the last possible moment, hoping that they'll get out at the peak.
Buyers try to wait until the prices are the lowest they're going
to get. It's a complicated setting that happens every day-and infrequently
leads to a bubble and a crash.
"It must be more than price alone," says Dickhaut. "Traditional
economics tells us that people are price takers who don't see that
their actions influence prices. Stock buyers don't expect their
purchases to impact a stock's prices. Instead, they think of themselves
as taking advantages of outcomes."
He urges thinkers to take into account that people are always trying
to manipulate the market. "This is almost always going to happen,"
he says. "One person will always think he knows more than the other."
Transparency-giving a buyer all of the information about a company-is
often suggested as the answer to avoiding inflated prices that can
lead to a crash. Common sense says that the more knowledge a buyer
has, the less likely he or she is to pay more than a stock is worth.
Surprisingly, Dickhaut's findings refute this seemingly logical
answer. His lab tests prove that transparency can cause worse outcomes
than in a market with poorer information. In other words, transparent
doesn't equal clearly understood. "People fail to coordinate understanding,"
explains Dickhaut. "They don't communicate their expectations, and
they might think that they understand more than they do about a
company."
Do stock prices balloon and crash because of genuine misunderstandings?
Can better communication about a stock's value really be the key
to avoiding future market crashes? "I wish you could say for sure,"
says Dickhaut. "That's one of the things we want to find out."
Experimental economics is still a young discipline, and it seems
to raise new questions even as it answers old ones. Even so, the
contributions are real. In 2005 John Dickhaut was awarded the Carlson
School's first career research award, a signal that his research
has been of significant value in his field. "It's fun," he says
with a grin. "There's a lot out there to learn."
Reprinted with permission from the July 2005 edition of Insights@Carlson
School, a publication of the Carlson School of Management.
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