Bubble Game (Monikas & Pouget, 2013)

Question 1

What is a speculative bubble?

Answer 1

Speculative bubbles represent a significant deviation from the fundamental value o assets, characterized by a sharp increase in asset prices, driven by exuberant market behavior, followed by a sudden crash.

Question 2

What challenge is there in real-world observations?

Answer 2

The fundamental values of assets cannot be directly observed, which makes it hard to decompose price increases into “fundamental” and “bubble” components.

Question 3

theoretical concepts to make predictions and rationalize behavior of economic agents

Answer 3

Nash equilibrium
Cognitive hierarchy model
Quantal response requilibrium

Question 4

theoretical concepts - nash equilibrium

Answer 4

state where no player can improve their situation by unilaterally changing their strategy, assuming the other players keep their strategies unchanged

Question 5

theoretical concepts - cognitive hirarchy model

Answer 5

assumes that players have different levels of “strategic” thinking

Question 6

theoretical concepts - quantal response equlibrium

Answer 6

assumes that players make mistakes in systematic ways

Question 7

experimental design

Answer 7

sequential trading game involving a worthless asset, where traders are financed externally. Players can decide every round whether or not they want to buy an asset at a given price and players do not know at what position in the sequence they are.

Question 8

treatment variations

Answer 8

no cap on prices, a cap at 10 000, 100 and.1.

Question 9

What is the rational action for the scenarios with and without a price cap?

Answer 9

No cap: bubbles, i.e. buying the asset can be rational
Finite cap: bubbles, i.e. buying the asset, are irrational

Question 10

Takeaways

Answer 10

1. Bubbles form with and without a price cap
2. The propensity to enter a bubble increase with the distance between offered price and maximum price.

Question 11

prediction from theory: situation without cap

Answer 11

given the probabilities for being at a given position in the sequence, the predicted probability to buy is 24%.

Question 12

prediction from theory: situation with cap:

Answer 12

knowing that the last person in the sequence, i.e. that person being offered the maximum price, will not buy, by backward induction, all previous players should also not buy -> predicted probability to buy 0%.

Question 13

mechanisms: bounded rationality

Answer 13

players’ behaviors are rational within their limited cognitive abilities, i.e. they just make mistakes and/or use simple heuristics -> good fit with the data

Question 14

mechanisms: cognitive hirarchhies

Answer 14

players underestimate others’ sophistication -> poor fit with the data

Question 15

mechanisms: quantal response equilibrium

Answer 15

players correctly anticipate other players’ mistake -> good fit with the data

Question 16

mechanisms: heterogeneity in payoff responses

Answer 16

players have different attitudes toward risk and reward, e.g. some might derive utility from gambling and speculating -> increases empirical fit of all models.

Question 17

strengths and limitations

Answer 17

clean and controlled setting with interesting treatments, however, maybe simplifies reality too much (e.g. in real life traders do not have perfect information about the fundamental value of the asset).

Question 18

policy relevance

Answer 18

• understanding the mechanisms behind bubble formation can inform policy decision related to financial market regulation and stability
• the findings from the Bubble Game experiment can help policymakers design interventions to prevent or mitigate the impact of speculative bubbles