Economics 328 Spring 2005

1. Lei, Noussair, and Plott: Non-Speculative Bubbles in Experimental Asset Markets: Lack of Common Knowledge of Rationality vs. Actual Irrationality Economics 328 Spring 2005

2. Prices from Tuesday’s Experiment

3. An Introduction to Bubbles • The experiment we ran in class on Tuesday closely resembles many previous experiments run by researchers. A single DOA market is run for a known finite number of rounds. Traders are allowed to buy and sell, raising the possibility of speculation. The asset being sold is typically a risky security that pays a dividend in each round. If individuals are risk neutral, the price should be linearly decreasing over time. If individuals are risk adverse, prices should be bounded above by the expected value line. • Ex ante, most economists would expect to see little trading in a market like this. However, in fact we typically see frenzied trading. Economists also would expect to see prices at or below the expected value. In fact, we often observe large bubbles – persistent pricing of the security above its fundamental value. • It has been argued that such bubbles are also a feature of real world 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 real world financial markets.

4. Tulipmania (Holland, 1634 – 1637) • There have been a number of dramatic examples of bubbles observed in financial markets, often with dire consequences. • Speculation in "bizarres," tulip bulbs infected with the mosaic virus, runs rampant, fueled in part by use of call options to leverage investments. In January of 1637, prices of bulbs increase 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). Another bulb was sold in February 1637 for 6700 guilders. Prices collapsed in February, setting off a prolonged depression.

5. The South Sea Bubble (England, 1720) • The South Sea Company was formed in 1711. Given a monopoly over trade with South America in exchange for taking on some government debt, the company was never profitable. Peace with Spain in 1719 and an ongoing stock bubble on the continent spurred interest in the South Sea Company. In January of 1720, the stock price stood at slightly more than £125/share. New stock was issued at £300/share in April of 1720. Spurred by speculative interest and easy credit, prices soon soared over £1000/share. The stock price collapsed in fall of 1720, spurred by a liquidity crisis caused by passage of the Bubble Act and sale of shares by the firm's directors.

6. Black Tuesday (U.S., 1928 – 1929) • The 1920s were a period of strong economic growth, spurred in part by changes in production technology. For a variety of reasons, interest in stocks grew in this period as well. In March 1928, stock prices began a sharp upwards climb. While originally based on good economic news, this rapid increase was spurred on by the presence of speculators and easy credit. Stock prices had almost doubled by the summer of 1929. In late summer and early fall of 1929, signs began to accumulate of an oncoming recession. As stock prices began to drift lower, investors began to face margin calls. Unable to meet these margin calls, they were forced to liquidate their holdings. The stock market's fall snowballed, culminating in Black Thursday (October 24, 1929) and Black Tuesday (October 29, 1929) when the markets were in free fall. Stock prices eventually fell by over 50% from their high point. While the 1929 crash was probably not the cause of the Great Depression, it was certainly a harbinger.

7. Another Historical Bubble? • Prices for tech stocks in the U.S. markets (largely NASDAQ), became hugely overvalued in the late 1990s. Stock for firms that had never shown any profit and showed little prospect for future profits sold at the sorts of prices usually reserved for blue chip stocks. Eventually, the financial law of gravity kicked in and prices crashed. The long term implications of this bubble are still not clear.

8. Bubbles in the Lab • Economists have run a number of experiments exploring this phenomenon. Generally, it isn’t hard to produce bubbles in the lab. • Smith, Suchanek, and Williams (1988) ran 28 sessions of 15 rounds using a DOA design with a risky asset like we’ve used in class. 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).

9. 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. 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).

10. Lei, Noussair, and Plott – Research Question • Two possible explanations for the occurrence of bubbles are the “speculative hypothesis” and the “active participation hypothesis.” In the first, traders are hoping to take advantage of irrational individuals or other speculators to make a large profit through capital gains. In other words, they are market timing. 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. Think about the relationship between this and Nagel’s guessing game that we studied earlier this semester.) The second hypothesis focuses on the methodology. In most bubble experiments, the only activity available to subjects is trading. To the extent that the protocols encourage participation, 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.

11. 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: • 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) • 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 and 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) • One-Market: These were control sessions analogous to a standard bubble experiment. (4 sessions)

12. Results • Substantial bubbles are observed in the no-spec treatment, indicating that speculators are not needed for bubbles to form. The presence of sales that could not possibly be profitable (buying above the maximum possible dividend payoff or selling below the minimum possible dividend payoff) as well as excess volume indicate systematic errors in decision making.

13. 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. 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

14. Results • The two-market/no-spec treatment brings the results even closer the “rational” outcome. There are fewer dominated trades and the excess volume is cut even more. However, one of the three sessions still shows a bubble. The authors speculate that bubbles will be less frequent in the two-market/no-spec treatment, but there aren’t enough sessions to test this hypothesis. • In the two market experiments, the departure of prices from fundamentals observed in the assets markets does not extend to the service markets. In the service markets, prices converge to the competitive equilibrium. This suggests that any irrationality being observed in these experiments cannot be attributed solely to the subjects, but must instead rely on an interaction between the subjects and the asset markets

15. Conclusions • The experimental results indicate that speculation is not necessary to create bubbles. This doesn’t mean that speculation can’t occur in bubbles, but instead that bubbles could still occur even without speculators. 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 used in bubble experiments drives some of the apparently irrational behavior – particularly the high volume of trading and the prevalence of dominated trades. However, the most striking feature of bubbles, the boom and then crash in prices, is not eliminated by using a methodology that gives subjects an option other than trading in the asset market. • 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. One interesting feature of the U.S. stock markets in the late 1990’s is how broad participation. It may be this influx of novice investors that created the conditions for the apparent stock market bubble observed in NASDAQ.

16. Additional Studies • Haruvy and Noussair (2003) reexamine the effect of short selling on the occurrence of bubbles. Their primary innovation is to 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. This is an intriguing result although the structure of the futures markets is quite stylized. • 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. This provides some explanation for why bubbles are rare occurrences.