Nonspeculative Bubbles in Experimental Asset Market Lei, Noussair and Plott (2001) Presented by Huanren(Warren) Zhang

Outlines  Introduction to Bubbles  Research Questions: Why do bubbles occur?  Speculative Hypothesis  Active Participation Hypothesis  Experimental Design  Results  Conclusions

Introduction to Bubbles  Bubbles – trade in high volumes at prices that are considerably at variance from intrinsic values  It has been argued that bubbles are a feature of security markets.  It is hoped that if we can understand how bubbles form in the laboratory, we can also understand how they form (and can be prevented) in financial markets.

Tulipmania (Holland, 1634 – 1637)  Speculation in tulip bulbs infected with the mosaic virus, ran rampant.  In January of 1637, prices of bulbs increased by more than 1000%. The price of one special, rare type of tulip bulb called Semper Augustus was 1000 guilders in 1623, 1200 guilders in 1624, 2000 guilders in 1625, and 5500 guilders in 1637 (equal to about $50,000).  Prices collapsed in February, setting off a prolonged depression.

Black Tuesday (U.S., 1928 – 1929)

Bubbles in the Lab  One of the most remarkable results from research on experimental asset markets is the discovery of Smith, Suchanek, and Williams (1988)  Smith, Suchanek, and Williams (1988) ran 28 sessions of 15 rounds using a DOA design with a risky asset. They find that prices typically start well below expected value, bubble up in the middle rounds, and then collapse at the end of the experiment. This has been replicated many times, although there have been exceptions (Camerer and Weigelt, 1990).

Bubbles in the Lab

 Changes in institutions that might be expected to eliminate bubbles do not appear to have the expected effect.  King, Smith, Williams, and Van Boening (1993) allow for short selling, buying on margin, brokerage fees, and limits on price changes (circuit breakers). None of these institutional changes has much impact on the formation of bubbles.  Porter and Smith (1995) find that neither allowing a futures market nor eliminating dividend uncertainty eliminates bubbles.

Bubbles in the Lab  Van Boening (1993) used sealed bid auctions and still observed bubbles.  Fisher and Kelly (1998) have two markets operating simultaneously, and still observe bubbles forming and crashing.  Experience has some impact.  Subjects who have previous experience with bubble experiments produce fewer (and smaller) bubbles (King et al, 1993; Peterson, 1991).  However, sessions with business professionals are just as likely to produce bubbles (Smith et al, 1988; King et al, 1991).

Lei, Noussair, and Plott – Research Question  Why do bubbles occur?  Speculative Hypothesis  Traders are hoping to take advantage of irrational individuals or other speculators to make a large profit through capital gains.  As the end of the market approaches, the bubble inevitably collapses.  This hypothesis does not require the presence of irrational traders to generate a bubble. All that is needed is a failure of common knowledge of rationality.  Active Participation Hypothesis  Focus on methodology of experiments  In most bubble experiments, the only activity available to subjects is trading. Subjects make unprofitable trades just to be doing something.  In other words, bubbles are a subtle type of demand induced effect.  Lei et al aim to test these two hypotheses, separately and in conjunction.

Experimental Design and Procedures  Experiments were conducted using a standard continuous double oral auction program. A total of 16 sessions were run. Each session had between 12 and 18 periods, with the number of periods pre-determined and known by the subjects.  There were four main treatments:  One-Market: These were control sessions analogous to a standard bubble experiment. (4 sessions)  No-Spec: This treatment was designed to eliminate speculation as a possible cause for bubbles. Subjects were assigned a role as a buyer or a seller and were not allowed to resell units, eliminating any possibility of capital gains. (3 sessions)

Experimental Design and Procedures  There were four main treatments:  Two-Market: A second market was added to the design. This market was for a non-durable good (service) that only lasted for one period. Subjects were assigned a role as a buyer or a seller in this market; supply and demand curves were induced in the standard fashion. This second market gives subjects something to do other than participate in the risky asset market. (6 sessions)  Two-Market/No Spec: This was the natural combination of the preceding two treatments – subjects in the risky asset market could no longer resell assets. (3 sessions)

Experimental Design and Procedures

Results for the Nospec Sessions  RESULT 1: The speculative hypothesis is not supported in our data. The pursuit of capital gains is not the only cause of experimental asset market bubbles.

Results for the Nospec Sessions

Results for TwoMkt Sessions

 The volume of trading is significantly reduced in the two- market treatment. The volume of trades falls by about 35% when a second market is introduced (Table IV).  However, bubbles are still observed and median prices are not significantly affected by the introduction of a second market.  Thus, the data supports the Active Participation Hypotheses, but this hypothesis cannot explain the pricing patterns in bubbles.

Results for TwoMkt/NoSpec Sessions

 RESULT 5: The existence of a second market reduces the incidence of dominated transactions in markets in which speculation is not possible. There is no evidence of excess trade in TwoMarket/NoSpec.

Results for TwoMkt/NoSpec Sessions  The authors conjecture that adding the second market reduces the chance that a bubble occurs, but they cannot confirm this without more data.

Results for TwoMkt/NoSpec Sessions  RESULT 6: In TwoMarket and TwoMarket/NoSpec, departures of prices from fundamental values are a specific characteristic of the asset markets that does not extend to the service markets.

Conclusions  The experimental results indicate that speculation is not necessary to create bubbles. Models of “rational” bubbles which rely on a failure of common knowledge of rationality receive little support here – at least some subjects are clearly making errors that are inconsistent with rationality.  The standard methodology drives some of the apparently irrational behavior. However, bubbles are not eliminated by using a methodology that gives subjects an option other than trading in the asset market.

Presenter’s Comments  From the illustration of the experiment design, it seems that the subjects are not informed explicitly what the fundamental value is at a certain period.  The subjects may not know what the fundamental value is. Because there is cost of calculating the value, they may not bother doing it. Hence they are not certain about the fundamental value  Herd behavior happens when traders are not sure about the fundamental value  Experienced professionals (without speculative nature) may help eliminate the bubble

Additional Studies  Dufwenberg, Lindqvist, and Moore (2003) study markets in which experienced and inexperienced traders are mixed. They find that even a fairly small proportion of experienced traders (1/3 of the population) is sufficient to largely extinguish the occurrence of bubbles.  Haruvy and Noussair (2003) substantially increase subjects’ short selling capacity beyond that allowed in earlier experiments. Short selling significantly depresses asset prices, but does not induce prices to track fundamentals.  Noussair and Tucker (2003) study bubbles in the presence of multiple futures markets. The presence of these futures markets induces prices to follow fundamentals, presumably by inducing greater backward induction.

Additional Studies  The authors speculate that bubbles are driven by an interaction between naïve traders and speculators. This raises some intriguing possibilities for how bubbles occur in real financial markets.