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  1. Chris Starmer Experimental Markets TSU Short Course in Experimental and Behavioural Economics, 5-9 November 2012

  2. Background • In 2002, Vernon L. Smith Shared Nobel prize in Economic Science • For work developing experimental approaches to study of markets • Discovery of remarkable properties • This (more-or-less) started of one of the major research programmes in experimental econ. • I talk about this today Visit -

  3. Route Map The approach Smith pioneered uses an experimental technique called Induced Value Methodology A technique for setting up experimental markets Today I will Introduce the method Show some classic – often replicated - results (performance of competitive equilibrium) Extension to asset markets

  4. What is an Experimental Market? • Experiment in which: • Some experimental subjects assigned roles of buyers and/or sellers • There are ‘goods’ that can be traded • Often ‘induced value’ tokens (See later) • Markets (usually) set up so that: • there are potential gains from trade • Experimenter controls rules of trade • Observes what happens

  5. V.Smith 1989, J.EconPerspectives • Market experiment is conjunction of: • Environment • Participants, endowments, preferences… • Institution • Rules of trade, who can do what, when ….. • Behaviour • Experiments often involve • Creation/manipulation of Environ/Institution • With view to observing consequent behaviour

  6. A Classic Market Experiment Vernon Smith (1962) J. Pol. Econ. “An Experimental Study of Competitive Market Behaviour”

  7. Environment (Smith 1962) • Subjects divided at random into (Buyers, Sellers) • Each buyer Bi given a ‘value’: • MAX PRICE (vi) they can pay for unit of (fictitious) commodity • Each seller Sj given a ‘cost’: • MIN PRICE (cj) at which they can sell a unit of commodity • vi and cj - private information for individuals • If trade takes place between i and j at price p: Bi = vi – p sj = p – cj • Smith asked participants to try to max profit • Note: hypothetical in this early experiment

  8. Interpretation of Payoffs • In the aggregate: • the values given to buyers define a demand function • so, for any potential price, the values determine the maximum quantity that can could be purchased Illustration........

  9. Buyer ‘Values’ and Demand Suppose there were 6 buyers with max prices: v1 = 1 v2 = 2 v3= 3 v4 = 4 v5 = 5 v6 = 6 Price Price 7 Price 6 Price 5 Price 4 Price 3 Price 2 Price 1 Demand 1 2 3 4 5 6

  10. Seller ‘costs’ and market supply Suppose there were 6 sellers with min prices: c1= 2 c2 =3 . . . c6=7 Price Price 7 Price 6 Price 5 Price 4 Price 3 Price 2 1 Supply 1 2 3 4 5 6

  11. Supply and Demand Buyer values and seller costs used in this way INDUCE demand and supply schedules in an experimental market Price 7 Supply 6 5 4 3 2 Demand 1 1 2 3 4 5 6

  12. Equilibrium Applying standard competitive equilibrium theory, we can identify the equilibirum (range) for Price and Quantity Price 7 Supply 6 5 Equil. Price 4 3 2 Demand 1 1 2 3 4 5 6

  13. Back to Smith 1962…..

  14. Supply and Demand conditions in Smith 1962 • Smith reports results of running several market sessions • Demand and Supply conditions vary • Here are D and S schedules from one market

  15. Demand and Supply induced in ‘Test 1’ (Source: Smith, 1962, p 113)

  16. Question Should we expect equilibrium in this experimental market?

  17. Not Necessarily • “The mere fact that […] supply and demand schedules exist in the background of a market does not guarantee that any meaningful relationship exists between those schedules and what is observed in the market they are presumed to represent. All the supply and demand schedules can do is set broad limits on the behaviour of the market. • (Vernon Smith, 1962, p.115) • In other words, D and S determine the set of feasible trades • What will arise as the actual pattern of trading is an open question

  18. Institutions Matter • Simple thought experiment demonstrates that institutions matter…. • Consider an extreme case where the rules of the experiment are • Everyone sits in isolation • No possibility to communicate with other potential traders • In this case, the institutional arrangements inhibit/prevent trade: • No prices formed • Zero quantity traded

  19. Smith’s 1962: uses a ‘Double Auction’ • Sequence of trading periods (5–10 mins) • Experimenter opens/closes trading periods • At any time during trading period B (or S) are free to make verbal offers (hence DA) • These must respect max values (min costs) • Improvement rule for new offers • Higher bid/lower offer than current best • Any S ( or B) can accept an existing offer to buy (or sell) s.t. cost (value) constraints • Acceptances result in binding contracts • B/S pair drop out of market once party to a contract • Trading period continues until no further contracts are being made

  20. Features like world Traders ignorant of each others values Learn about other’s values by observing others’ willingness to trade Small numbers of traders Features unlike world S and D held constant over trading periods in experiment Realisticness Smith’s marketssee Smith 1962 pp.115- 116

  21. Smith’s (1962) Results: “Test 1” (Source: Smith, 1962, p 113) Deviation from eq. Price In early periods ‘Convergence’ toward Equilibrium in later periods

  22. Variation in S and D Schedules 1. Changing slopes of Demand and Supply functions

  23. Smith 1962: Changing slopes of D and S

  24. Double-Auction Markets: Experimental Results (Source: Smith, 1962) Rapid convergence for (relatively) flat supply and demand functions

  25. Double-Auction Markets: Experimental Results (Source: Smith, 1962) Convergence is more erratic for steeper schedules (note (relatively) higher α values for this market)

  26. Impact of Surplus Distribution

  27. Producer’s Surplus > Consumer’s Surplus (Source: Smith, 1962) Notice that there is convergence from below CE This pattern is typical of markets where producers’ surplus is greater The pattern tends to be reversed when the dist. of surplus is reversed

  28. Variation in S and D Schedules Demand Expansion

  29. Demand Expansion Baseline demand condition for 4 periods In period 4, buyers get new private max prices inducing demand expansion Note different equilibrium predictions (Source: Smith, 1962)

  30. Results of demand shift – upwards sloping supply (Source: Smith, 1962) Rapid convergence – Periods 1 –4 Rapid (overshooting) reaction to shift in demand ‘Quick’ (2 period) adjustment to new equilibrium

  31. Surprised by convergence in Smith’s experiment?

  32. Consider some of key assumptions of CE models Many Buyers Many Sellers Price Taking Perfect Info Compare with Smith’s markets Handful of traders Price Making Imperfect info Perhaps you should be? Each trader knows only their own value. Individuals do not know the general supply and demand conditions

  33. Commenting, years later on accumulated evidence from experiments using DA markets, Smith argues…. • “There are no experimental results more important or more significant than that the information specifications of traditional competitive price theory are grossly overstated. The experimental facts are that no double auction trader needs to know anything about the valuation conditions of other traders, or have any understanding or knowledge of market supply and demand conditions, or have any trading experience (although experience may speed convergence) or satisfy the quaint and irrelevant requirement of being a price ‘taker’ (every trader is a price maker in a double auction).” • Vernon Smith (Quote reproduced in Holt, p370)

  34. Session 5 – Part II Asset Market Experiments

  35. Asset Markets I discuss application of induced value to study asset markets. I discuss a landmark study Plott, C and S. Sunder (1982) • “Efficiency of Experimental Security Markets with Insider Information…..”, J. Political Econ. • And some subsequent literature

  36. Characteristics of Asset Markets • ‘Assets’ • Value may depend on uncertain state of nature • May deliver multi-period returns (dividends) • Experimental assets typically have one or both of these features • Traders • buy and sell with view to profit • potential for ‘speculation’ • Often asymmetric information • ‘Insiders’ know more about value of asset (or state of nature)

  37. Two (caricatured) views on efficiency of asset markets Label these loosely as: The efficient market hypothesis The speculation hypothesis

  38. Efficient Market Hypothesis • Asset prices tend to reflect all relevant information • determined by ‘fundamentals’ • (correspond with discounted present values) • respond rapidly (if not instantaneously) to new information • Various Rational Expectations models in this spirit

  39. Speculation Hypothesis • Roughly: • Pursuit of speculative profits can lead prices to deviate from fundamentals • May create potential for ‘bubbles’ and ‘crashes’ in stock prices

  40. One rationale for asset market experiments • EMH is difficult to test with field data: • Researchers don’t know discounted PVs • Researchers don’t know what relevant info is • Researchers can observe if responses to good and bad news have right sign, but don’t know if price levels reflect fundamentals

  41. Advantage of Experiments In principle, Experimenter can: • control fundamentals • e.g. implement asset with PV known to experimenter • implement markets with Rational Expectations Equilibria known to experimenter • manipulate information structures • E.g. create insider information and observe impact

  42. Issues • Two what extent, and under what conditions, do markets: • disseminate and aggregate dispersed information? • achieve rational expectations equilibria? • To what extent, and under what conditions, do we see out of equilibrium phenomena? • e.g. speculative bubbles and crashes

  43. A Classic Asset Market Experiment Plott and Sunder 1982

  44. Plott and Sunder - Basics • Run 5 multi-period markets in which: • At start of each period ‘investors’ endowed with assets (2 units each) • Holder at end of period is paid dividend • Dividend value varies for three sets of investors (I,II,III) • Hence potential gains from trade • For every investor, dividend D(S) also depends on state of nature S in {X,Y} • State of nature, varies randomly across market periods

  45. (induced) payoff function • Investors can hold, buy or sell assets • Payoff (individual i) in each period (t) determined as: $it = Ci + Rit + nitD(S)it – Eit $it= dollar earnings Ci = cash endowment Rit= revenue from sales nit = holdings of assets (end of period t) D(S)it= dividend Eit=i’s expenditure on purchase of assets in period t

  46. state of nature • Determined randomly in each period (‘year’) • All agents knew: • State probabilities (via training

  47. Insiders (and outsiders) • In some periods, a subset of agents (usually half of each group I, II, III) were informed about state (‘insiders’) • achieved by experimenter randomly selecting state of nature from {X,Y} • then distributing cards to all investors • ‘Insiders’ received card specifying S (= X or Y) • Uniformed investors received blank cards

  48. P+S: Predictions Consider two theoretical models Private Information (PI) Rational Expectations (RE) Common assumptions: Agents are risk neutral & follow simple decision rule: • Buy assets if P < E(dividend) • Sell assets if P > E(dividend) PI: E(.) based on private information Hence different E(.) for Insiders/Outsiders RE: E(.) based on full information Market behaves as if all agents know realised state

  49. PI and RE Lead to different predictions re: Market prices Pattern of asset holdings Illustrate with P + S: “Market 3”

  50. Dividends by trader groupMarket 3