Charles R. Plott - US grants

With National Science Foundation support, Dr. Charles Plott will purchase equipment to expand and develop his experimental economics laboratory. This includes 35 pentium 90 16MB, 500MBHD computers, monitors, high speed modems, workstations, a network server and related equipment. He will also hire computer programming staff to develop software which will be distributed to other institutions which teach economics and engage in experimental economics research. In this relatively new branch of economics, researchers create experimental markets in controlled laboratory conditions and allow subjects to participate in them. Money is used as an incentive to evoke responses that accompany meaningful decisions. As Dr. Plott notes, `The logic that supports the use of experimental methods in economics and political science is the same logic that supports the use of experimental methods in any branch of science. The trick is to identify and understand how the study of very simple and special cases can help when the real goal is to understand something that is vastly more complex.` This research, and the NSF grant which partially supports it, serves to accomplish several goals. First, it allows economists to evaluate the validity of widely held economic assumptions such as the laws of supply and demand. Secondly, it permits the application of experimental approaches to the solution of pressing present day problems. Dr. Plott and his group have, for example, conducted studies for the Department of Transportation and several other government agencies. They have provided guidance on issues such as the allocation of airport landing slots, regulation of the pollution permit market and the management of space station resources. Finally, this grant will allow the development of simulation and teaching software which can be used for both education and research.

9730176 Plott This project explores the properties of experimental markets that operate on a time frame, scope and scale substantially beyond market systems that have been studied to date. Advances in technology, coupled with significant scientific progress, have made possible the implementation and control of laboratory experiments that could not be imagined a few years ago. The number of markets will be increased from the two or three market maximum, typical of current studies, to dozens of markets. The time devoted to an experiment will be increased from two or three hours to days and possibly weeks. The number of subjects will be increased from the dozen or so typical of current laboratory experiments to several hundred. The purposed research removes constraints, opens new economic phenomena for study by laboratory experimental methods, develops new methodology and enhances the relevance of laboratory experimental results for applied purposes. The first phase of research involves the creation of large scale/scope experiments that incorporate critical aspects of well researched, small scale experiments. While the purposed large scale experiments are substantially new, the links to previous work will make them "anchors" than can be used for orientation in a variety of different experiments in large environments. This phase concentrates on three areas of laboratory experimentation of interest in their own right: single market equilibration, information aggregation and multiple market (general equilibrium) systems. The second phase depends importantly on the first phase. Completely new research topics and variables will be addressed, once some of the possible influences of limited time, scope and scale are better understood and the anchor experiments have been established. Both classical theory and applied theory involve the interaction of multiple markets, interdependencies and multiple organizations. However, experimentation on such topics has been limited because appropriate environments could not have been created. This next phase creates them. Some of the specific topics to be explored are: multiple moneys and general equilibrium; price controls; information aggregation; local non-convexities in general equilibrium experiments; networked systems and smart markets; and competing organizations. ??

General equilibrium theory underlies our understanding of how complex economies manage risk. It is the basis of the tools used to make investment decisions and to guide policy in applications as diverse as regulated industries (utilities, telecommunications, etc.) and pension funds. In spite of this widespread use, scientific support for such applications has been mixed. The research proposed here seeks to build and test a more robust implementation of general equilibrium theory. Our work integrates theory, experiment, and econometrics in an essential way: experiments suggest the shape the theory should have, the theory suggests which further experiments should be carried out, experiments provide tests of the final theory; econometrics links theory and experiment in a formal way.

We have developed and succesfully conducted laboratory experiments that test the principles of general equilibrium theory in the context of markets with risk. The model that guided our inference is the Capital Asset Pricing Model (CAPM). The experiments confirm the complex pricing relationships predicted by the theory. Since we used the same measurement tools as in the analysis of historical data in the field, our findings suggest that the controversy surrounding historical evidence need not be attributed to a failure of the basic principles of the theory, but to the auxiliary assumptions added to the models to make them testable on field data. Still, we reject the portfolio (allocation) implications of the same theory. The latter finding is particularly perplexing because the traditional theory that explains and supports the prices rests explicitly on the allocational predictions.

Our theory explains the puzzle. It perturbs traditional general equilibrium models in ways that better accomodate the types of behavior of individuals when observed in isolation, away from markets. We provide a unified approach to study the effects of such perturbations. We show, for instance, that random perturbations need not always wash out in large economies; in the case of information aggregation, they cause clearcut biases. Preliminary experiments confirm our predictions. We plan to build on these initial successes, to further our understanding of pricing and allocation of risk in competitive markets. In addition, the theory suggests experiments that will uncover the origin of the perturbations that are needed to make general equilibrium models explain the data. One of these will determine whether risk is like any other commodity and that no special principles must be invoked in order to understand market behavior, a fundamental premise of extant theory. Actual attitudes towards and beliefs about risk may be at odds with this view.

In addition to its scientific and policy implications, this proposal also has an important educational component. Our experiments are web-based and have involved many subjects from more than a dozen undergraduate, graduate, and professional schools across the country. These experiments provide the subjects with a unique educational experience. Our experiments have shown that access to such a large pool of subjects with diverse backgrounds is necessary to achieve results, and the theory explains why. At the same time, it provides exposure to complex financial markets to students who would otherwise not be given the opportunity, for various geographical and socio-economic reasons.

This is a collaborative proposal involving Peter Bossaerts and Charles Plott (both of Caltech) and William Zame (of UCLA).

Considerable information is known to exist in the form of "soft" information such as the hunches, opinions, beliefs and expectations distributed across many individuals. When individuals are differentially located in time and space and receive signals in the form of complex patterns from a common source, such information can aggregate into a reliable statistic. Tools for extracting such information, called Information Aggregation Mechanisms (IAMs), have evolved naturally but the scientific foundation for their successes has not been explored. IAMs involve subtleties because they depend upon incentives and the ability of individuals to update their opinions/beliefs by observing others. Through the application of new laboratory experimental methods, this research will isolate the principles that lead to the successes. Then, using the behavioral principles together with modern communications and computational technology, the research will produce new types of IAMs unlike any that are found occurring naturally. Potential applications range widely across almost any complex system in which the need for information is continuous or reoccurring, the state is not clearly observed from any single vantage point and observation requires human interpretation. Presumably, this would include anything ranging from epidemics, pending systems failures, the outcome of complex decision processes in an organization, or social tendencies.

Prop ID: 0317715
P I: Plott, Charles R.
Organization: California Institute of Technology
Title: Collaborative Research: The Evolution of Prices and Allocations in Markets: Theory and Experiment
CO-PI: Peter Bossaerts/Cal Tech; William Zame/UCLA (Collaborative)

The goal of the proposed research is to understand the dynamics of prices and choices in multi-security/multi-good markets. Do markets get to equilibrium, and how? This research concentrates on a simple environment: trade takes place during some period of time, but information is revealed and consumption takes place only at the end of the period. Within this context, the investigators study price and allocation dynamics experimentally and discover a number of regularities in the data: (i) prices eventually settle close to the theoretical equilibrium; (ii) price changes for a particular good are correlated with excess demand of all goods; (iii) trades are small. Motivated by these empirical findings, the investigators propose a local adjustment model, in the spirit of local models suggested by Smale, to explain these phenomena. The purpose of this project is to study the theoretical properties of the model and to link it to data through a series of experiments.

Because agents in the model make adjustments that are only locally optimal, the model is
in the spirit of much work on limited rationality. However, the end process of the adjustment process is quite rational, and the adjustment process is more robust than most models in the literature. Thus the model illustrates how markets can be smart even though they are populated by human beings of limited capacity. The proposed research is meant to provide a more solid empirical foundation for our theoretical understanding of the evolution of prices and choices in competitive markets for several goods/securities. At the core of the research is a dialogue between theory and data, with econometrics providing the link.

Broader Impacts: The issues studied here are critical for the many important existing markets in which several goods (including services and risky assets) are traded at the same time and in which the supply, demand and price of each of these goods depends in a complicated way on the supply, demand and price of other goods. The proposed work should lead to a better understanding of such interdependencies and therefore to a better understanding of the management of risks in such markets. The experiments proposed here depend on a web-based experimental technology (using unique facilities to which the research team has access) that permits the interaction of many participants in real time. Although technical challenges will continue to arise, there is no doubt that this experimental technology can be adapted to meet them. In addition to its usefulness as a research tool, this experimental technology will be useful as a teaching tool, and for providing broad based demonstrations of the science.