Market Experiments & Price Discovery
• The traditional approach for studying the markets relies on
several curicial assumptions
– Agents maximize their own well-being
– Many agents
– No barriers to entry
– Everyone is a price-taker
• The expected outcome is competitive equilibrium price and
quantity
– Efficiency
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Market Experiments & Price Discovery
• In market experiments, we often induce the following
preferences:
• Reservation values for buyers
– Maximum willingness to pay
• Marginal costs for sellers
– Minimum willingness to accept
• This provides:
• Demand curves
– Order reservation values - Highest to lowest
• Supply curves
– Order marginal costs - Lowest to highest
• Allows direct construction of theoretical demand and supply
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Pit Market
• One of the earliest examples of economic experiments was
Chamberlin (1948)
– buyers and sellers in a pit market.
– Seller is given a card with the cost on it (c).
– Buyer is given a card with the value on it (v)
• A bilateral bargaining takes place between the buyer and
the seller.
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Pit Market
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Pit Market
• Chamberlin’s trading institution is symmetric and less
structured.
• When the trading prices are not announced, the institution
can also be considered as very much decentralized.
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Pit Market
• 46 trials, random assignment of valuations to subjects in
each
• Average price
– Lower than predicted – 39 instances
– Higher than predicted - 7 instances
• Average volume greater than predicted
• In terms of prices what we observe is nonconvergence.
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A sample trial
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Pit Market
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Pit Market
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Double Auction
• Smith (1962) offers a modified design.
• Available bids, asks and transaction prices were centrally
announced.
• Buyers could raise the current best bid at any time, and
sellers could undercut the current best ask at any time.
• A trade occurs when these processes meet
• This is called Double Auction.
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Double Auction
• Much more centralized compared to the Pit market of
Chamberlin.
• Efficiency is very high.
• Convergence to the equilibrium price is very easy to obtain.
– Robust to flat demand/supply schedules, changes in demand &
supply, etc.
• Note that both efficiency and convergence occur even tough
subjects do not have any information regarding the
distribution of other subjects’ valuations.
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Double Auction
• Vernon Smith: I am still recovering from the
shock of the experimental results. The
outcome was unbelievably consistent with
competitive price theory. ... But the result
canʼt be believed, I thought. It must be an
accident, so I will take another class and do a
new experiment with different supply and
demand schedule
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Market Experiments
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Double Auction
• Why was the Smith (1962) experiment so
powerful?
– Not exactly perfect competition
– Only private information
– Profit motivated, but hardly optimizers
– Showed the model to be far more robust than
even the most ardent supporters had claimed (or
even imagined).
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Posted-Offer Market
• An alternative setup to Double auction would be Posted-Offer
Market
– Most developed markets use posted-offer institution
• Posted-offer markets
– Buyers inspect sellers' price offers
– Decide whether to accept
• Double-auction markets
– Both buyers and sellers can make offers
– Bids and asks are openly announced
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Posted-Offer Market
• Ketcham, Smith & Williams (1984) compare Posted-offer
markets and Double-auction markets:
– prices tend to be higher and efficiency lower in posted-
offer markets relative to double-auction markets»
– «Price signaling, indicating attempts at tacit collusion, is
rather common among sellers in posted-offer market»
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Call Market
• Another alternative setup would be Call Market
– Used for the sale of fixed quantities of licences or permits
• A simple two-sided uniform price double auction
– Bids are ranked from high to low
– Asks are ranked from low to high
– Together, these make up ‘revealed’ demand and supply and the
corossing is used to determine market-clearing price
– Bids and asks can be changed until the market is officially closed
("called")
• Past studies compared the efficiency of this setup to
continuous double auction (the setup in previous slides) 18
Call Market
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Asset Markets
• Asset markets have particular characteristics
– Most of an asset’s value depends on its future price
– Errors in beliefs play a crucial role
– Potential for speculation
• We need to know fundemental values so study speculation
• This is hard in real markets
• So, we use an experiment and an asset with a commonly known
expected value.
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Asset Markets
• A typical experimental asset market
– Sell and buy shares of an asset with a commonly-known
expected value and no private values or costs
– Dividends per share are distributed at the end of each
period ▪ Example: $10 with p = 0.25, $25 with p = 0.5, and
$40 with p = 0.25
– Shares carry over from one period to the next
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Asset Markets
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Asset Markets
• Typical result: Price bubble (deviation from fundamentals)
emerges and then crashes
• Occurs even with
– Large number of buyers
– Players observing previous crashes
– Sophisticated subjects
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Asset Markets
• Why does this happen?
• Trend followers (feedback traders): Demand more if prices have
been increasing and less if they have been decreasing:
Qt = −𝛿 + 𝛽 𝑝𝑡−1 − 𝑝𝑡−2
• Speculators: Demand more if they think the bubble is growing and
less if they think it will crash (demand more as the difference between
the expected price in the next period and the current spot price gets higher
versus demand less when it gets lower)
Qs = 𝛾 𝐸[𝑝𝑡+1 ] − 𝑝𝑡
• Value investors: Demand more if prices are below the fundamental
value and less if above:
Qs = −𝛼 𝑝𝑡 − 𝑓𝑣𝑡 24