Collaborative Research: Perfect Rational Markets, Imperfectly Rational Traders: Theory and Experiment

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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).