An Introduction to Market Experiments Catherine Eckel University of Texas at Dallas

Introduction Market experiments = laboratory for policy testing and development Hard to visualize what experiments are like without seeing one This auction is an example of one of the earliest and most powerful experiments

Overview of Experiment Each table is a trading team in the experiment - buyer or seller Make decisions about your trading strategy as a group between rounds Designate one person as the “trader” to act for your group during the trading periods

Sellers Each seller receives a cost of production Your cost is the number on your record sheet Costs are reallocated each round Sellers make money by selling above their cost Remember: Your objective is to earn as much profit as you can If your unit sells, you earn price – cost. Otherwise you earn 0. If you do not sell you do not incur production cost

Buyers Each buyer has a reservation value Your value is the number on your record sheet Values are reallocated each round Buyers make money by buying below their value Remember: Your objective is to earn as much profit as you can If you buy a unit, you earn Your Value – Price. Otherwise you earn 0. You do not make a profit on unbought units

The Market All buyers and sellers receive values, costs At any time, a buyer can raise his bidding card and when recognized say “Buyer X bids ___” At any time, a seller can raise her bidding card and when recognized say, “Seller Y offers ___” Bids and offers are recorded by the recorder Bids have to improve on previous bids, and offers have to be lower than the previous offer.

The Market, cont’d. At any time, any buyer can accept the outstanding offer (raise your card!) At any time, any seller can accept the outstanding bid (raise your card!) When a buyer and seller agree a sale is made. Write down on your record sheet your price and profit. Then all bids and offers are automatically withdrawn. The market ends when there are no more trades, or 4 minutes, whichever comes first.

Your record sheet: Sellers Record: whether your unit sold, the price you sold it for, and your profit (price - cost). In the bottom of the form record information for the round, including any comments

Your record sheet: Buyers Record: whether you bought a unit, the price you bought it for, and your profit (value - price). In the bottom of the form record information for the round, including any comments

Fill out your record sheet Use one box for each round Notice your cost or value (it will change each round) When your unit sells, fill out price Record whether your unit sold and calculate profit Record market information High and low price Units sold Comments space lets you record particular things about this round.

How the experiment will go The floor will open Bids must go up, offers must come down When a bid and offer agree (or a bid or offer are accepted) a trade is made All outstanding bids and offers are withdrawn, and the floor reopened. If you traded your unit, you are done for this round If you did not trade your unit, you may still trade When there are no more trades the market closes We will do several rounds of the market Costs and values are “reshuffled” each round to give everyone a chance to earn money.

Remember Buy low and Sell high Try to make as much money as you can Envelope contains the “prediction”

What did we do? Reproduced a market in the lab! Sellers had induced costs Buyers had induced values Implemented a specific trading institution Oral Double Auction When we collect data people are paid what they earn.

What Else Can You Do With this Market? Examine the effects of policy changes Taxes Quotas Tariffs Price Ceilings and Floors Examine the results of changes in supply and/or demand by changing seller costs and buyer values

Results of a Double Auction Market Experiment

What else can you do? Compare trading “institutions” Differences in the rules for trading Example: What is the effect of rules that prohibit insider trading? Design new markets Economic engineering: wind tunnel design Example: Markets for pollution permits “Smart” market for wholesale electricity

“Take home” message: Markets can be reproduced in the lab Double auction lab markets converge quickly to competitive equilibrium Lab markets can be used to test theories or examine policies Lab markets can be used for “wind tunnel” design of new markets