0 An Experimental Study of Bubble Formation in Asset Markets Using the Tâtonnement Trading Institution Volodymyr Lugovskyy a, Daniela Puzzello b, and Steven Tucker c,* a Department of Economics, Georgia Institute of Technology, USA b Department of Economics, University of Illinois at Urbana-Champaign, USA c Department of Economics, University of Canterbury, New Zealand September, 2010 Abstract We report the results of an experiment designed to study the role of institutional structure in the formation of bubbles and crashes in laboratory asset markets. In a setting employing double auctions and call markets as trading institutions, bubbles and crashes are a quite robust phenomenon. The only factor appearing to reduce bubbles is experience across markets. In this study, we employ the tâtonnement trading institution, which has not been previously explored in laboratory asset markets, despite its historical and contemporary relevance. The results show that bubbles are significantly reduced, suggesting that the trading institution plays a crucial role in the formation of bubbles. Keywords : Experimental Asset Markets, Price Bubbles, Trading Institutions, Tâtonnement * Corresponding author. Address: Department of Economics, University of Canterbury, Private Bag 4800, Christchurch, New Zealand, 8015; phone: 64-3-3642521; fax: 64-3-3642635; e-mail: [email protected]. Acknowledgements: We thank the participants at the 4th Australian Workshop on Experimental Economics and MODSIM09 International Congress on Modelling and Simulation, and seminar participants at the Purdue University and University of Pittsburgh, for helpful comments and suggestions. The research was conducted at the New Zealand Experimental Economics Laboratory (NZEEL) and supported by the University of Canterbury, College of Business and Economics.1 1. Introduction Price bubbles are not a rare phenomenon. Indeed, there are many historical examples of commodity or financial asset markets that have experienced a period of sharp rising prices followed by an abrupt crash. One of the earliest recorded and most famous examples is the Tulip mania (Holland, 1637) in which prices reached a peak of over ten times greater than a skilled craftsman’s annual income and then suddenly crashed to a fraction of its value. More recently, the real estate bubble of 2007 plagued many of the major economies of the world from which most are still reeling today (Akerlof and Shiller, 2009). As price bubbles represent a phenomenon with substantive economic implications, they are widely studied in finance and economics. Smith, Suchanek, and Williams (1988) were the first to observe price bubbles in long-lived finite horizon experimental asset markets. Many studies have followed the pioneering work of Smith et al. in order to test the robustness of the price bubble phenomenon. To date, the only treatment variable that appears to consistently eliminate the existence of price bubbles is experience of all or some of the markets participants via participation in previous asset market sessions with identical environments (Smith et al., 1988; Van Boening, Williams, and LaMaster, 1993; Dufwenberg, Lindqvist, and Moore, 2005; Haruvy, Lahav, and Noussair, 2007).1 1 Hussam, Porter and Smith (2008) show that if the environment is subject to changes in liquidity and uncertainty, then even experience is not sufficient to eliminate bubbles. Noussair and Tucker (2006) seem to eliminate the spot market bubble via a stylized experimental design of a futures market for every spot market period. Crockett and Duffy (2009) show that intertemporal consumption smoothing inhibits the formation of bubbles.2 Asset market experience addresses what we believe to be two leading explanations for the existence of price bubbles. The first is the lack of common expectations due to the rationality of subjects not being common knowledge (Smith et al., 1988; Smith, 1994). Even though the experimenter can make every effort to explain the dividend process to all subjects, they may still be skeptical about the rationality of other traders. That is, some subjects may believe that other traders may be willing to make a purchase at a price greater than the fundamental value, and thus provide opportunities for capital gains via speculation. This speculative demand can build upon itself, and thus endogenously push the prices higher and higher above the fundamental value creating a price bubble. Note that with the lack of common knowledge of rationality, speculative bubbles may exist even if all subjects understand the dividend process perfectly. The second explanation, as argued by Lei, Noussair, and Plott (2002) and Lei and Vesely (2009), is that the difficulty in assessing the dynamic asset valuation may generate confusion and decision errors leading to bubble formation. More specifically, subjects may struggle with backward induction in order to correctly calculate the fundamental value, and thus a rational price, in a given period. Accumulating experience by participating in multiple asset markets allows subjects to gain confidence in the rationality of other traders as well as to learn the dynamic asset valuation process, and thus eliminate confusion and decision errors. The main innovation of our paper is that we consider a tâtonnement trading institution, as opposed to double auctions or call markets, typically used in experimental asset markets. We are interested in the tâtonnement trading institution for two reasons. Firstly, we believe that the tâtonnement addresses both of the driving forces for bubble3 formation described above, and thus conjecture that price bubbles will be significantly reduced by the implementation of a tâtonnement trading institution instead of the standard call market or double auction institutions. Furthermore, tâtonnement is a trading institution of historical and contemporary relevance. Indeed, the tâtonnement is one of the earliest classical theories which is explicit about market price dynamics and adjustment to equilibrium (see Duffie and Sonnenschein, 1989). Also, the tâtonnement trading institution is not just an abstract theoretical construct as it is employed in some actual markets, e.g., the Tokyo grain exchange (Eaves and Williams, 2007). A characteristic of the double auction market mechanism is that buyers and sellers tender bids/asks publicly. Typically the