An experimental analysis of the IPO pricing mechanism: The case of Book-building

This study conducts the first laboratory experiment using a direct mechanism to investigate the efficiency of the Book-building (BB) method in Initial Public Offering (IPO) pricing. Contrary to the global empirical regularity of IPO underpricing, our experiment frequently observes overpricing relative to the fundamental value. This phenomenon is caused by overstated offers and particularly pronounced when investors are unsophisticated, suggesting that overpricing arises from insufficient compensation on information elicitation, belief-action mismatches, and sentimental behavior as explained by investor active participant bias. Our findings offer two main contributions. First, we demonstrate that, in the absence of ex ante screening and ex post adjustments, the theoretical model of the BB method results in severe IPO overpricing, necessitating the setting of filing range and issuer’s strategic underpricing adjustment. Second, investor sentiment can be seen as the cause of price increases in both IPOs and first-day closing prices, the extent is determined by the proportion of unsophisticated investors. These results highlight the effect of behavioral distortions in IPO pricing and point to the importance of institutional sophistication and investor screening in improving the efficiency and transparency of BB method.