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Can Markets Learn to Avoid Bubbles?

  • Ross M. Miller

    (Miller Risk Advisors)

One of the most striking results in experimental economics is the ease with which market bubbles form in a laboratory setting and the difficulty of preventing them. This article re-examines bubble experiments in light of the results of an earlier series of market experiments that examine how learning occurs in markets characterized by an asymmetry of information between buyers and sellers, such as found in Akerlof’s lemons model and Spence’s signaling model and extends the arguments put forth in the author’s book, Paving Wall Street: Experimental Economics and the Quest for the Perfect Market. Markets with asymmetric information are incomplete because they lack markets for specific levels of product quality. Such markets either lump all qualities together (lemons) or using external indications of quality to separate them (signaling). Similarly, the markets used in bubble experiments are incomplete in that they are lacking a complete set of forward or futures markets, depriving traders of the information supplied by the prices in those markets. Preliminary experimental results suggest that the addition of a single forward market can sometimes mitigate bubble formation and this article suggests more extensive research in this direction is warranted. Market bubbles outside of the laboratory usually are found in markets in with forward and futures markets that are either legally restricted or otherwise limited. Experimentation in markets with asymmetric information also indicates that the ability of subjects to learn how to send and receive signals can be enhanced by changing the way that market information is presented to them. We explore how this result might be used to help asset markets learn to avoid bubbles.

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File URL: http://128.118.178.162/eps/exp/papers/0201/0201001.pdf
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Paper provided by EconWPA in its series Experimental with number 0201001.

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Length: 18 pages
Date of creation: 07 Jan 2002
Date of revision: 07 Jan 2002
Handle: RePEc:wpa:wuwpex:0201001
Note: Type of Document - PDF/Acrobat; prepared on Windows 98SE; to print on PDF compatible; pages: 18 ; figures: None. Forthcoming in the Journal of Psychology and Financial Markets
Contact details of provider: Web page: http://128.118.178.162

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  1. Miller, Ross M & Plott, Charles R, 1985. "Product Quality Signaling in Experimental Markets," Econometrica, Econometric Society, vol. 53(4), pages 837-72, July.
  2. Tversky, Amos & Kahneman, Daniel, 1986. "Rational Choice and the Framing of Decisions," The Journal of Business, University of Chicago Press, vol. 59(4), pages S251-78, October.
  3. Forsythe, Robert & Palfrey, Thomas R & Plott, Charles R, 1982. "Asset Valuation in an Experimental Market," Econometrica, Econometric Society, vol. 50(3), pages 537-67, May.
  4. Miller, R. M. & Plott, Charles R. & Smith, Vernon L., . "Intertemporal Competitive Equilibrium: An Empirical Study of Speculation," Working Papers 87, California Institute of Technology, Division of the Humanities and Social Sciences.
  5. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  6. Porter, David P & Smith, Vernon L, 1995. "Futures Contracting and Dividend Uncertainty in Experimental Asset Markets," The Journal of Business, University of Chicago Press, vol. 68(4), pages 509-41, October.
  7. Vernon L. Smith, 1962. "An Experimental Study of Competitive Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 70, pages 322.
  8. Akerlof, George A, 1970. "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, MIT Press, vol. 84(3), pages 488-500, August.
  9. Rothschild, Michael & Stiglitz, Joseph E, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 630-49, November.
  10. Andrei Shleifer & Robert W. Vishny, 1995. "The Limits of Arbitrage," NBER Working Papers 5167, National Bureau of Economic Research, Inc.
  11. Garber, Peter M, 1990. "Famous First Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 35-54, Spring.
  12. Wilson, Charles, 1977. "A model of insurance markets with incomplete information," Journal of Economic Theory, Elsevier, vol. 16(2), pages 167-207, December.
  13. Caginalp, Gunduz & Porter, David & Smith, Vernon, 2000. "Momentum and overreaction in experimental asset markets," International Journal of Industrial Organization, Elsevier, vol. 18(1), pages 187-204, January.
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