1. Experimental Economics: Bubbles and Crashes Revisited Dean L. Johnson & B. Patrick Joyce Professors of Finance and Economics Michigan Technological University University of Split (Joyce) Croatian Economic Research Institute Zagreb, Croatia March 2013

2. Edward H. Chamberlin First recorded experiment JPE 1948 Chamberlin tested the model of ˝perfect competition˝ and found no ˝tendency to the market clearing price of a perfect market.˝ Chamberlin and J. Robinson were independently working on what we now refer to as Monopolistic (Imperfect) Competition

3. Chamberlin’s Experiment Subects given a buyer card or a seller card (induced supply and demand are step functions) Each had one unit to buy or sell Searched in the room (pit) for someone on the other side of the market Tried to negotiate a contract Reported all contracts to Market Manager sometimes written on the blackboard-Ticker Tape One shot market – no learning possible

4. Results 46 trials Quantity: more than predicted – never less 42 times> EQ, 4 times = EQ Average Price: generally lower than predicted Lower 39 times Higher 7 times Pure Competitive equilibrium is IMPOSSIBLE!

5. Vernon Smith’s Insomnia Had participated in Chamberlin’s experiments at Harvard At Purdue University in late 1950s: what if? Instead of searching organize the market as a Double Oral Auction (DOA)? Does the market converge to equilibrium as modeled in the textbooks without many of the usual assumptions of pure competition? (frictionless, price taking environment)

8. DOA: Supply and Demand Results Convergence is robust to: 1. shape of curves (schedules) 2. distribution of profits 3. number of traders (6 to 8 sufficient) 4. ……..

9. Bubbles, Crashes and Endogenous Expectations in Experimental Spot Asset Markets Smith, Suchanek, and Williams Econometrica 56 (5), September 1988 Structure of the experiments Each subject received an initial endowment of cash (experimental francs) and certificates (assets) – three kinds Trading periods 4 minutes duration Open book double auction – bids and offers long lived (period) Finite number of trading periods Subjects paid sum of dividends plus capital gains from buying and selling certificates Subjects experienced in markets but inexperienced in trading assets (later trials with 1x and 2x experience) Some trials had positive salvage value

10. Results? Bubbles and Crashes Asset price bubbles up far above the (declining) fundamental value and then crashes through fundamental value, sometimes bouncing “Hard and soft landings”

11. Typical result found in Smith, Suchanek and Williams

14. Common knowledge of subjects – SSW Number of periods (15) Dividend dynamics How the experiment ends No knowledge of others’ endowments (cash or certificates) Price determination dynamics (Double Auction) Trading prices this period (Ticker Tape) Time remaining in period Current highest bid (offer to buy) & lowest ask (offer to sell in book)

15. Common Results 1.Asset prices bubble up and then crash as the experiment approaches the final period 2.Price controls (upper and lower limits around the fundamental value) influence price dynamics – smaller bubbles 3.Trading volume decreases preceding the crash 4.Price “tracks” fundamental value after the crash 5.Experience does not eliminate the bubble-crash phenomena until subjects are at least 2x experienced and only reduces the bubble

16. Robustness of SSW’s results? King, Smith, Williams and van Boening (1993) 1. short selling 2. margin buying 3. limit price-change rules 4. insider trading 5. experience in the institution Van Boening, Williams and LaMaster (1993) Closed book call market Only with 2x experience does price “track” fundamental value

17. Longer duration, open communication, more traders? Williams (2007) 300+ traders, open communication, 8 weeks, open book call market Results - bubbles and crashes even a “double bubble” Lahav (2006) 200+ rounds, open book call market Results – multiple bubbles and crashes routine

18. Johnson and Joyce Structure of experiments 1.Inexperienced subjects 2.10 trading periods 3.Random final period 4.Two kinds of endowments: high cash - low certificates, low cash – high certificates 5.Period duration – 4 minutes 6.Subjects paid dividends plus capital gains from trading certificates 7.Double oral auction 8.Ticker tape 9.Bids and offers erased after a transaction (book cleared) 10.Two dividend states: high (100 francs) low (20) francs, E(d) = 60 francs 11. Fundamental value – three states: falling, constant and rising

19. Fundamental Value Determination Certificate pays dividend + salvage value in each period e.g. rising fundamental value because salvage value rises more rapidly than the sum of expected dividends fall

20. 1.Original hypothesis was that circuit breakers would mitigate the bubble crash behavior 2. Our modified hypothesis is the original plus traders are interested in trading profits alone so their expectations are that Pt = Pt+1 = Pt+i.., until something happens whatever that might be (pulling the rug out from the traders or changing the circuit breakers- imposing or eliminating them) End-of-game effect reduced by probabilistic end point? Bubble and crash behavior eliminated by not pulling the rug out from underneath the traders? I.e. not having a rapidly declining fundamental value? Rational behavior leads to price converging to fundamental value in all experiments [constant, falling, rising fundamental value] or prices exhibit typical bubble and crash in all experiments or some converge to fundamental value and some don’t or what?

21. Results? No routine bubbles & crashes Market 1: Replication of SSW’s parameters- no salvage value

23. Market 2: Declining Fundamental Value- Positive Salvage Value

24. Market 2: Relative Value (FV = 1)

25. In the front of the room will be ten envelopes. At the end of each decision period we will open an envelope. In one envelope will be a piece of paper on which the word STOP is written. When that envelope is chosen, the experiment will immediately terminate and all certificates will be redeemed according to the following schedule: PeriodRedemption value for each certificate if the experiment ends this period 10 2100 3200 4300 5400 6500 7600 8700 9800 10900 If the envelope that is opened at the end of a decision period contains a blank piece of paper the decision sessions will continue as before. Before we begin one of you will have the opportunity to verify that one of the envelopes contains a piece of paper with the word STOP on it.

37. Mispricing of Assets If the experimental markets are diverging from FV or are not converging rapidly then in some sense the “market” is mispricing the asset Stockl, T., J. Huber, and M. Kirchler (2010) `Bubble Measures in Experimental Asset Markets’, Experimental Economics, 13, 284- 298.

38. Relative absolute deviation (RAD) measures the amount of mispricing Relative deviation (RD) measures the direction of mispricing independent of the: number of periods and absolute level of fundamental value which is important given our experiments incorporate random number of periods and changing fundamental values

39. Mispricing Measures 1 p represents the period, N is the total number of periods is the mean price during period is the fundamental value during period p represents the mean fundamental value in the market.

40. Mispricing Measures 2 While large RAD values indicate large mispricing in the market, RAD measures this mispricing without regard to the sign/direction of the mispricing. The RD measure indicates the direction of the mispricing. That is, positive RD values indicate overpricing, while negative RD values indicate underpricing.

41. Mispricing Measures 3 Taken together, the RAD and RD measures provide a more accurate picture of markets and allow comparison across experiments with changing fundamental values and changing ending periods. In particular, if one finds a large RAD and an equally large positive value for RD, this is an indication of a market that experienced a bubble. However, if one finds a positive RAD and a RD near zero, this indicates prices fluctuating around fundamental value.

42. Mispricing Test Following KHS, the Mann Whitney U test was used to test the null hypothesis that there is no difference in the population based on the RAD and RD samples for markets with decreasing fundamental value versus markets with constant or increasing fundamental value.

43. Mean Relative Absolute Deviation and Mean Relative Deviation by Fundamental Value Path Fundamental ValueRADRD Rapidly Decreasing0.7550.674 Moderately Decreasing 0.2970.224 Constant0.232-0.063 Increasing0.310-0.016

44. Statistical Results Mann Whitney U test was used to test the null hypothesis that there is no difference in the population based on the RAD and RD samples Based on the Mann Whitney U test, we are: 1. able to reject for RD 2. unable to reject for RAD, the null hypothesis for the measures at the 5% significance level That is, while all the markets experienced mispricing (RAD), the markets with decreasing fundamental values experienced overpricing (RD) not found in the other markets.

45. Interpretation Consistent with our “pulling the rug” hypothesis, markets with rapidly decreasing fundamental value experience large positive RD values that, while reduced, continue to persist in moderately rapid decreasing fundamental value markets. In markets with constant or increasing fundamental value, the RD measures display near zero values. Overall these results strongly support our hypothesis.

46. Conclusions? 1. What causes the bubble – crash phenomena? When the FV t falls “too rapidly” even if the subjects are “rational” it takes them a long time to realize the value of FV t and the adjustment process causes the crash. The crash is the way market rationality becomes common knowledge. (Lei, Noussair, Plott) But, even if FV t falls “too rapidly” a positive salvage value does not seem to cause a crash. In other words, SSW’s design structure (choice of parameters) seems to lead to crashes unless substantial experience with the institution is present and then the bubble-crash is early and muted followed by P t “tracking” FV t. Rising or constant fundamental values also do not seem to be associated with crashes or anti-crashes.

47. References Ackert, L., and B. Church (2001) ‘The Effects of Subject Pool and Design Experience on Rationality in Experimental Asset Markets’, The Journal of Psychology and Financial Markets (2)1 6-28. Ackert, L., B. Church, and N. Jayaraman (2001) ‘An Experimental Study of Circuit Breakers: The Effects of Mandated Market Closures and Temporary Halts on Market Behavior’, Journal of Financial Markets (4) 185-208. Ackert, L., B. Church, and N. Jayaraman (2002) ‘Circuit Breakers With Uncertainty About the Presence of Informed Agents: I Know What You Know … I Think’ Federal Reserve Bank of Atlanta Working Paper 2002-25. Dufwenberg, M., T. Lindqvist, and E. Moore (2005) `Bubbles and Experience: An Experiment', American Economic Review, 95, 1731-1737. Hirota, S. and S. Sunder (2006) ‘Price Bubbles sans Dividend Anchors: Evidence from Laboratory Stock Markets’, Working Paper. Kirchler, M., J. Huber, and T. Stöckl (Forthcoming) ‘Thar She Bursts - Reducing Confusion Reduces Bubbles’, American Economic Review. King, R., V. Smith, A. Williams, and M. van Boening (1993) ‘The Robustness of Bubbles and Crashes in Experimental Stock Markets’, in Nonlinear Dynamics and Evolutionary Economics, ed. by I. Prigogine, R. Day, and P. Chen. Oxford: Oxford University Press. Noussair, C., S. Robin and B. Ruffieux (2001) ‘Price Bubbles in Laboratory Asset Markets with Constant Fundamental Values’, Experimental Economics, 4(1), 87-105. Porter, D. and V. Smith (1995) ‘Futures Contracting and Dividend Uncertainty in Experimental Asset Markets’, Journal of Business, 68, 509-541. Smith, V., G. Suchanek, and A. Williams (1988) `Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets’, Econometrica (56), 1119-1151. Smith, V., van Boening, M., and C. Wellford (2000) `Dividend Timing and Behavior in Laboratory Asset Markets', Economic Theory, 16, 567-583. Stockl, T., J. Huber, and M. Kirchler (2010) `Bubble Measures in Experimental Asset Markets’, Experimental Economics, 13, 284-298.

48. Market 3: Declining FV – Positive Salvage Value

49. Market 3: Relative Values

53. Preliminary analysis Pricing errors Let ∆P (t) = change in market price in period t ∆FV (t) = change in fundamental value in period t, then if market prices are always correct, we would have and for all periods P(t=0) = FV (t=0) and ∆P (t) = ∆FV (t), t = 1, …, T. That is, we expect alpha to be zero and beta to be equal to one below But if P (t) ≠ FV (t), that equation no longer provides an adequate description of market behavior. A weaker hypothesis would simply say price “tracks” fundamental value across periods. Or:

54. Regression Analysis