Bubbles and Experience: An Experiment

History contains many colorful examples where speculative trade in some commodity or financial asset generated a phase of rapidly increasing prices, followed by a sudden collapse (see, e.g., Edward Chancellor, 1999, or Charles Kindleberger, 2001). One famous case cited by many economists (see Peter Garber, 2000, pp. 127–31, for references) is the Dutch “tulipmania” of the 1630s. The prices of certain tulip bulbs reached peaks in excess of several times a normal person’s yearly income, and then suddenly lost almost all value in early 1637 (see Mike Dash, 1999). In more recent times, we have the development of the NASDAQ share index up until March 2000, and the subsequent price fall in that market. Can such pricing developments be understood in terms of market fundamentals (changes in expected values of future dividends, say), or are they “bubbles,” indicative of systematic deviations from fundamental pricing? The outlook varies among scholars, but it is hard to determine the truth because fundamental values are usually not observable. In this connection, experiments may be useful. In laboratory markets, fundamental values may be induced and compared to actual prices. One may hope to get insights about the “real” world by analogy. In this vein, starting with a classic contribution by Vernon L. Smith et al. (1988), laboratory experiments have shown (inter alia) that bubbles tend to occur with inexperienced traders and not with experienced traders who have participated many times in the same type of market. It is not quite clear which result applies, however, because in the nonlaboratory world markets include both experienced and inexperienced traders. There is perhaps reason to think that most trading reflects decisions of experienced traders, but conceivably there are enough inexperienced traders to sustain bubbles. Indeed, an informal survey we ran indicates that most experimental economists think that a small fraction of inexperienced traders is sufficient to create bubbles, at least in the laboratory. This paper reports results from laboratory financial markets with a mixture of experienced and inexperienced traders. We find that even with as small a fraction of experienced traders * Dufwenberg: Department of Economics and Economic Science Laboratory, University of Arizona, Tucson, AZ 85721 (e-mail: [email protected]); Lindqvist: Research Institute of Industrial Economics (IUI), Box 55665, 102 14 Stockholm, Sweden (e-mail: [email protected]); Moore: Department of Economics, Auburn University Montgomery, P.O. Box 244023, Montgomery, AL 361244023 (e-mail: [email protected]). We thank Dan Friedman, Steve Gjerstad, Uri Gneezy, Henrik Horn, Steffen Huck, Kai Konrad, Wieland Müller, Rosemarie Nagel, Charles Noussair, Bob Slonim, Hans Wijkander, and participants at CEEL’01 in Trento, ESA’01 in Tucson, the Workshop on Experimental Economics in Siena, MERSS’02 in Mannheim, ESA’02 in Boston, METU’02 in Ankara, ESA’02 in Strasbourg, and seminars at IUI, Stockholm School of Economics, Stockholm University, and Universidad de San Andrés in Buenos Aires for helpful comments. We are grateful to Urs Fischbacher for permission to use the z-Tree software; the Laboratory for the Study of Human Thought and Action at Virginia Tech where the experiment was run in October 2001; and the Swedish Competition Authority for financial support. 1 Believers in the latter perspective often invoke terms suggestive of folly or hysteria, like “mania,” “panic,” or (Alan Greenspan’s) “irrational exuberance,” as in the titles of Kindleberger’s (2001) and Robert Shiller’s (2000) books on the topic. The opposing fundamental view is advocated, e.g., by Garber (1989, 2000). 2 See Ronald R. King et al. (1993), Steven Peterson (1993), Van Boening et al. (1993), David P. Porter and Smith (1995), Eric O’N. Fisher and Frank S. Kelly (2000), Vivian Lei et al. (2001), Ernan Haruvy and Charles N. Noussair (forthcoming), and Noussair and Steven Tucker (2003). Van Boening et al., in particular, focus on the impact of experience. 3 At the 2002 meeting of the Economic Science Association in Tucson, Arizona, we invited guesses on what would happen in a design with a mixture of experienced and inexperienced traders. The vast majority guessed that bubble-crash pricing patterns would occur with only a few inexperienced subjects. 4 Smith et al. (1988) and Peterson (1993) ran a few mixed-experience markets, but the issue of heterogeneity of experience levels was neither the main focus nor systematically explored. King et al. (1993) performed a related test, but instead of using a mixed-experience population, they let some “insiders” read Smith et al. (1988) before the experiment. Bubbles remained, except in a market that allowed for short-selling.