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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 ...

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