The Creation and Control of Speculative Bubbles in a Laboratory Setting

Abstract

Persistent divergence of an asset price from its fundamental value has been a subject of much theoretical and empirical discussion. This paper takes an alternative approach of inquiry – that of using laboratory experiments – to study the creation and control of speculative bubbles. The following three factors are chosen for analysis: the compensation scheme of portfolio managers, wealth and supply constraints, and the relative risk aversion of traders. Under a short investment horizon induced by a tournament compensation scheme, speculative bubbles are observed in markets of speculative traders and in mixed markets of conservative and speculative traders. These results maintain with super-experienced traders who are aware of the presence of a bubble. A binding wealth constraint dampens the bubbles as does an increased supply of securities. These results are unchanged when traders risk their own money in lieu of initial endowments provided by the experimenter.