Bubbles in Experimental Asset Markets

One can define a bubble as a persistent increase in the price of an asset over and above its fundamental value with an abrupt fall in prices when no buyers are available to make purchases. The occurrence of market bubbles has a long history, starting with the Dutch Tulip Mania (1624-1637) to the South Sea and Mississippi Bubble (1716-1720), the British Railway Mania (1840´s) to the crash of 1929. Recent events have been the crash of 1987, the dot-com bubble (1990s) to the most recent housing crisis in early 2000. Even though bubbles, and a subsequent crash, may reallocate resources to more efficient activities, the economic costs of bubbles are large and sometimes felt for long periods of time. It is important to emphasize that markets perform an important role in that they aggregate information (Hayek, 1945) for its participants. The aggregation of information occurs through the price discovery process. In the real world markets are seldom efficient and mispricing is common. Due to this, information aggregation seldom happens and consequently one observes deviations of prices from their fundamentals on a regular basis. Market bubbles are an elusive phenomenon and it is due to this that the prior knowledge of the occurrence of a bubble is difficult. In most cases we only know of their occurrence when we observe a crash, but by then it’s too late. Simply stated, bubbles reflect mis-pricing of an asset from its fundamental value. Clearly, knowing the fundamental value in the real world is a challenge. The use of economic experiments is important to study the nature of bubbles for this very reason. Bubbles are hard to detect. The institutional environment is easily controlled in a laboratory setting and one can study the reasons behind the deviation of prices from their fundamental value by carefully varying the experimental parameters. Information that is not easily available in real world settings, such as the fundamental value, is observed and can be controlled in a laboratory setting (declining, constant, ambiguous etc.). Typically, experimental studies on asset market bubbles utilize the continuous Double Auction institution where a participant can be on either side of the market acting as a buyer or seller. This may depend upon the underlying market conditions or their choice of the role based upon their expectations. The good in a typical asset market is durable and lasts till the end of the experiment. For our purpose we will limit ourselves to studies that use perfectly durable goods in asset markets. A good purchased in any period earns a dividend at the end of that period and can be resold at any point of time till the last period and is not perishable. The knowledge of the last period is common to all subjects.