Experimental economics and market institutions: using the lab to design trading mechanisms

1. Experimental economics and market institutions: using the lab to design trading mechanisms Stéphane Robin GATE-CNRS Cargèse – May 2008

2. Introduction: Aims of the workshop • The workshop topics: • Market institutions as an important issue for economists • Experimental economics as an appropriate methodology to study market institution • Aims of the workshop • Introduction to experimental economics • How to run market experiment • Present experiment use for market design

3. Structure • About experimental economics • What is it ? • Ingredients of an experiment • What are the purposes of experiments ? • Market experiment: the institution issue • Markets in the lab. • 1 - How to create a market in a lab? • 2 - Various market institutions • 3 - A simple double auction experiment • 4 - Good and bad news from the lab about market • Experiments for market design • Two illustrations

4. Part 1: About experimental economics What is it ? Ingredients of an experiment What are experiment motivations ? Market experiment: the institution issue

5. Experimental economics: What is it? Create a manageable "microeconomic environment in the laboratory where adequate control can be maintained and accurate measurement of relevant variables guaranteed" Wilde, 1980 as quoted in Smith, 1982

6. Experimental economicsIngredients of an experiment • Environment • Initial endowments, preferences and costs that motivate exchange. • Environment is controlled (most often through monetary rewards) • Institutions • Market communication offer, acceptance…, rules of exchange of information and rules for binding a contracts • Behavior • Human action observed given the control on environment and institution

7. Experimental laboratory Cirano, Montréal GATE, Lyon

8. Controlled economic environments • Induced-value theory (Smith, AER, 1976) • Monotonicity, subject must prefer more reward than less and not become satiated • Saliency, reward depends on subject actions • Dominance, rewards outclass other influence of subject action • Most often, experimentalists use monetary reward. At the moment, in Lyon the average payment subjects receive is 15€ (but with an important variance)

9. What are the purposes of experiment ? • Test a theory, or discriminate between theories • Explore the causes of a theory's failure • Establish empirical regularities as a basis for new theory • Compare environments • Compare institutions • Evaluate policy proposals • The lab as a testing ground for institutional design Smith, 1994, JEL

10. Increasing use of experiment methodology • 1994 : Reinhart Selten nobel price • 2002 : Joint nobel price for Vernon Smith and Daniel Kahneman

11. Learning Decision bias Public goods Trust Consumption Coordination Believes Demography Market design Economic Development Auction Environment Collective decision Donations et charity Finance Pricing Incentive Labour economy Financial market Bargaining Neuro-economy Industrial organization Health economy Social preference Loan Bounded rationality Social network Risk preference Temporal preference Voting procedure Expanded topics

12. An experiment

13. Instructions (control and replicability) Welcome to this experiment about decision making in a market. The experiment is expected to last for about 10 minutes. You will be paid a minimum of 0 for your participation. On top of that you can earn more than 1 bottle of Corsican wine if you make good decisions. We will read the instructions aloud. Then you will have time to read them on your own. If you then have questions, raise your hand and you will be helped publicly. • You will choose a whole number between 0 and 100 (0 and 100 included). You have to write this number on a piece of paper with your name. • The papers of the audience will be collected and the average of the numbers chosen will be computed. • We shall compute the target which is 70% of the average of the numbers chosen by the participants. • The one who will give the number which is the most close to the target will win a bottle of Corsican wine. • Tie will be solve with a throw of a dice Please do not communicate during the experiment

14. Beauty contest (Nagel, AER, 1995) • The game is dominance solvable. • The process of iterated elimination of weakly dominated strategies leads to the game's unique equilibrium in which everybody chooses 0. • Very few people choose 0… • Are people irrational?

15. Market institution “Institutions define the language –the messages – of the market, such as bids, offers and acceptances, the rules that govern the exchange of messages, and the rules that define the conditions under which messages lead to allocations and prices.” Smith, 2001.

16. Market experiment: the institution issue • Chamberlin 1948 first market experiment • Decentralized negotiation as a "souk" • Inefficient outcomes compare to partial equilibrium prediction • Smith 1962 answer • Market institution matter • Continuous oral double auction as centralized stock exchange • Efficient outcome with a quick convergence to the partial equilibrium even with small number of traders

17. Market experiment: the institution issue • From the study of well-known institution… • Test, comparison of well-known institutions • Robustness to environment modification market structure, asymmetric information, externalities… • … to the design of new institution • The lab as a test bed for new institution • Emerging discipline of design economics: design and maintenance of markets and other economic institutions.

18. Efficient allocation Partial equilibrium of Alfred Marshall Price Competitive equilibrium «…every position of equilibrium of demand and supply may fairly be regarded as a position of maximum satisfaction… » A. Marshall Quantity

19. Market as a coordination mechanism with private informationHayek hypothesis • Market is a mechanism which allows a decentralized coordination of agents with private information. • Market reacts rapidly to environment change • Market informs agents about their environment « We must look at the price system as such a mechanism for communicating information if we want to understand its real function. »

20. Looking for good market institution • Allocative efficiency • Market extracts the maximum surplus from exchange • Information • Market aggregates and diffuses information • Transaction cost • Market saves transaction cost

21. Part 2: Markets in the lab. How to create a market in a lab? Good and bad news from the lab about market

22. How to create a market in the lab. Let's start with a bilateral exchange Two individuals, one unit exchange Supply « Induced value » for the seller: €100 « Cost » controlled by the experimenter No cost without sale Demand « Induced value » for the buyer: €300 « Preference » controlled by the experimenter

23. The exchange • A potential surplus of ECU 200 • Price 100<p<300 • Price indeterminate • Institutions matter: ultimatum, dictator,...

24. Exchange, surplus and subjects' payment • Let's suppose we have a deal at 150. • Seller surplus: 150 – 100 = 50i.e contract price minus seller's limit price • Buyer surplus: 300 – 150 = 150i.e. buyer's limit price minus contract price • Subjects' payment depend on the exchange surplus

25. Competitive equilibrium Equilibrium price between €172 and €190 Maximum surplus: €426

26. 11 buyers: 300 € 280 € 220 € 200 € 190 € 176 € 172 € 160 € 155 € 120 € 110 € 10 sellers: 230 € 220 € 210 € 195 € 185 € 172 € 170 € 150 € 142 € 130 € Competitive market and partial equilibrium

27. Creating a market • Each seller : • Has only one unit of good to sell, with a fixed cost value • Each buyer : • Has value for only one unit fixed redemption value

28. Bilateral Bargaining Walrasian tâtonnement Posted offers Unilateral Auctions Sealed-Offers Oral Bilateral Auctions Clearing House Continuous Oral Auctions Market Institutions

29. Continuous Oral Auction: Ask Auction • Ask auction: • Any seller who makes an ask proposition to sell raises his hand. • This ask is publicly announced to the market, other sellers may propose lower prices. • Only the most attractive ask “stands” and can be accepted. • Prices are high, but competition among sellers pushes them down. • At any time, a buyer can buy by accepting the current ask.

30. Continuous Oral Auction: Bid Auction • Bid auction: • Any buyer who makes a bid proposition to buy raises his hand. • This bid is publicly announced to the market, other buyers may propose higher prices. • Only the most attractive bid “stands” and can be accepted. • Prices are low, but competition among buyers pushes them up. • At any time, a seller can sell by accepting the current bid.

31. Double auction • Double auction: The two previous auctions are open in parallel for the same product market. • The improvement rule is so that bids are going up and asks are going down. Therefore, prices on the two auctions tend to converge. • Oral auction: offers and transaction are publicly announced • The DA institution was largely used in stock auction markets e.g. New-York SE.

32. Good news about market from the lab Market for final goods

33. Market ingredients • 5 buyers and 5 sellers • Institution: continuous oral double auction • Private information about value • Competitive price between 780 and 790

34. Noussair, Robin, Ruffieux, JEBO, 1998)(30/03/95a) Efficiency: maximum surplus is rapidly generated by the market. Information: rapid price convergence to the equilibrium price

35. Smith, JPE, 1962.Market with shock on demand

36. Market with random shocks on offer and demand (Jamisson et Plott, JEBO, 1997)

37. Marché avec chocs aléatoires sur l’offre et sur la demande (Jamisson et Plott, JEBO, 1997)

38. Experimental results regarding the market with DA for goods • Quick convergence towards equilibrium • Efficient allocation

39. Looking for the limits of competitive outcomes • Regular or cyclical demand or/and demand shifts • Random supply or/and demand shifts • Insiders • Multiple, Interrelated Markets

40. 3 - Studying market failures • Monopoly, oligopoly and collusion • Externalities and Public goods • Information asymmetries • Speculation on asset markets, and “bubbles”

41. Bad news about market from the lab Market for assets

42. Efficiency for asset market « In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production-investment decisions, and investors can choose among the securities that represent ownership of firms' activities under the assumption that security prices at any time "fully reflect" all available information. A market in which prices always "fully reflect" available information is called "efficient". » Eugene F. Fama, TJEF, 1970.

43. Asset markets and Speculation • Design: • Traders initially possess cash and units of asset that they can buy and sell during the session. • At the end of each trading period, the experimenter monitor draws and announce a common dividend for all asset units. • The expected value is $.24 equally like alternatives: $.6, $.28, $.08, $.00

44. Asset Market: fundamental values $3,36=14*0,24 $0,24=1*0,24 $3,60=15*0,24

45. Asset market: results expected • Few transactions • Market price should be stuck to fundamental values Smith, Vernon L., Gerry L. Suchanek, and Arlington W. Williams. “Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets.” Econometrica 56, no. September 1988: 1119-1151.

48. Asset market in the lab • These results are robust. • Nobody can infer fundamental value from market price observation • Inefficient regarding information and at the end regarding allocation.

49. Part 3: Experiments for market design

50. Market design «This branch of experimental economics uses the lab as a test bed to examine the performance of proposed new institutions, and modifies their rules and implementation features in the light of the test results » Vernon Smith, Nobel Prize Lecture, December 2003