The Rationality of Prices and Volume in Experimental Markets

Market experiments designed to test whether individual errors are reduced by markets generally indicate that errors do make prices or trading volume irrational. For example, in markets for assets of uncertain value a "representativeness"- based theory predicts deviations of prices from Bayesian predictions. Endowment effects and optimism about relative trading ability lead to trading volumes which are too low or too high. Forecasts of future prices in markets violate rational expectations restrictions. And subjects do not ignore their own information when making forecasts of the forecasts of others. These data suggest that individual errors are often reduced, but not eliminated, in experimental markets under ideal learning conditions. They cast doubt on the optimistic presumption that prices negotiated in competitive market settings will reflect true values. The markets are unusually competitive, but the results suggest that errors are likely to be important in two-party negotiations and other settings too.