An Investigation of the Tatonnement Mechanism on Bubbles in Experimental Asset Markets

The existence of price bubbles is one of the most interesting results from the multi-period asset market studies in the experimental literature. Smith, Suchanek, and Williams (1988) were the first to observe price bubbles in long-lived finite horizon asset markets. The typical bubble price pattern is for prices to initially start below the fundamental value and then climb over time to prices that are significantly greater than the fundamental accompanied by excess market activity, and ending with a crash in the last periods of the experiment to the fundamental value. Many studies have followed the pioneering work of Smith et al. in order to test the robustness of the price bubble phenomenon. To date, the only treatment variable that consistently eliminates the existence of the price bubble is experience via participation in two previous asset market sessions of the same. In this study, we test the conjecture that the price bubble phenomenon in multi-period lived asset markets will be significantly reduced or eliminated by the implementation of a Tatonnement market mechanism (TM hereafter) instead of the standard double auction used in all the previous studies. The reason being is that the TM overcomes the two main conjectures from the extensive asset market literature: (1) confusion/mistakes and (2) lack of common knowledge of rationality. The TM overcomes these two issues by virtue of the repetition of the price adjustment process typically required in each period to obtain a market clearing price. This repetition protects the confused/inexperienced from "mistakes" that they may make early in the market, which have the potential of not only being very costly the confused individual, but to the market as a whole. That is, this mistake may reinforce the belief that there is a lack of rationality in the market, and thus fuels speculative behavior for capital gains, which propels the bubble. The fact that TM prohibits purchases that are outside the preferences of the group as a whole not only protects the individual from costly mistakes, but also protects the market as a whole (society) from the potential consequences of these mistakes. The nature of the price adjustment process embodied in TM promotes experience, learning, and common knowledge of rationality from the very first period of the asset market. That is, the knowledge that typically requires participation two to three complete asset markets by all participants is now accomplished in the first period. We find that TM does significantly reduce the decoupling of prices from the fundamental value and produces bubble measures lower than previous studies.