The Effect of Short Selling on Bubbles and Crashes in Experimental Spot Asset Markets

We study the effect of allowing short selling on the efficiency of the pricing mechanism and the incidence of price bubbles in laboratory asset markets. We report an experiment that illustrates that allowing a sufficiently large short selling capacity results in a substantial reduction in the magnitude and duration of bubbles, but also leads to sustained episodes of busts, during which prices are consistently below fundamental values. Increasing short-selling capacity lowers prices but does not induce prices to track fundamentals. We argue that prices in our markets are influenced by constraints on consumer demand and supply. Specifically, restrictions on short selling capacity serve to increase prices and limits on the cash available for purchases serve to decrease prices. Restrictions on short sales in the forms of cash reserve requirements and of quantity limits on short positions behave in a similar manner. A flexible cash reserve requirement that is tightened when prices are low leads to prices closer to fundamentals. A simulation model, based on a model proposed by DeLong et al (1999), generates price patterns that are similar to the data we observe.