Collaborative Research: Sunspots in the Laboratory

University Of Pittsburgh, Pittsburgh PA

Investigators

Abstract

Economists have developed a theory of "sunspot" equilibrium to describe situations where economic fluctuations are not driven by changes in market fundamentals, but are instead due to extrinsic, non-fundamental factors. This project involves the design of an experiment that will explore whether and how such extrinsic factors can result in market fluctuations, and whether the particular market institution also plays a role. The experiment consists of two main treatments. In the first, human subjects participate as buyers or sellers in a computerized "double auction", where goods can be bought and sold continuously over a fixed trading period at mutually agreed upon prices that are observable as they occur to all participants. In the second "call market" treatment, subjects submit private bids and offers, and a centralized mechanism determines the single, market clearing price, as well as the quantities that each participant can buy or sell. Thus, the only information subjects receive in this environment is the resulting market price and the quantity they were able to buy or sell at this price. In both treatments, subjects face uncertainty in that they are given two sets of values or costs for the goods they can buy or sell; these two sets correspond to the"state" of the economy, and are referred to as "high" or "low" in reference to the equilibrium price in the two states. (the equilibrium quantity is the same in both states). Initially, subjects are told the state of the economy in advance, so that they become familiar with the two states for prices. After several rounds, subjects are informed that the true state of the economy, will henceforth be determined expost, after all trading is completed. Furthermore, the rule for the determination of the state will depend on the median trade price in the double auction environment or on the analogous market clearing price in the call market environment. If this price lies within a proscribed domain of the equilibrium low price, then the state is declared to be low and if it lies outside this domain, in that of the equilibrium high price, then the state is declared to be high. Subjects are provided with a potential coordination device (or sunspot realization) which takes the form of a random announcement by the experimenter of the forecast for the state of prices in the current period. Subjects are instructed that this announcement has no binding consequences. Preliminary findings suggest that subjects coordinate perfectly on the announcement in the highly centralized call market environment but fail to do the same in the more decentralized double auction environment. These experimental findings if replicated, have significant implications for the architecture of real financial markets.