In twelve sessions conducted in a typical bubble-generating experimental environment, we design a pair of assets that can detect both irrationality and speculative behavior. The specific form of irrationality we investigate is probability judgment error associated with low-probability, high-payoff outcomes. Independently, we test for speculation by comparing prices of identically paying assets in multiperiod versus single-period markets. When these tests indicate the presence of probability judgment error and speculation, bubbles are more likely to occur. This finding suggests that both factors are important bubble drivers.
JEL classification: C91, C92
Key words: bubbles, asset markets, judgment error
The authors are grateful to Bryan Church, Charles Noussair, Chuck Schnitzlein, and David Stolin as well as seminar participants at Groupe ESC Toulouse and the Cass Business School for helpful suggestions. Financial support provided by the Federal Reserve Bank of Atlanta and Social Sciences and Humanities Research Council of Canada is gratefully acknowledged. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
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