We especially thank our discussants Thomas Langer and Marc Willinger for their helpful comments. The paper improved significantly from comments by an anonymous referee and the editor. Financial support under a NWO-Pionier grant is gratefully acknowledged

Abstract:The evolution of many economic variables is affected by expectations that economic agents have with respect to the future development of these variables. Here we show, by means of laboratory experiments, that market behavior depends to a large extent on how the realized market price responds to an increase in average price expectations. If it responds by decreasing, as in commodity markets, prices converge quickly to their equilibrium value, confirming the rational expectations hypothesis. If the realized price increases after an increase of average expectations, as is typical for financial markets, large fluctuations in realized prices are likely.

We present results on expectation formation in a controlled experimental environment. In each period subjects are asked to predict the next price of a risky asset. The realized market price is derived from an unknown market equilibrium equation with feedback from individual forecasts. In most experiments prices deviate from the benchmark fundamental and bubbles emerge endogenously. These bubbles are inconsistent with rational expectations and seem to be driven by trend chasing behavior or "positive feedback expectations" of the participants. We also analyze individual predictions of participants and find that participants within a group tend to coordinate on a common prediction strategy.

We investigate expectation formation in a controlled experimental environment. Subjects are asked to predict the price in a standard asset pricing model. They do not have knowledge of the underlying market equilibrium equations, but they know all past realized prices and their own predictions. Aggregate demand of the risky asset depends upon the forecasts of the participants. The realized price is then obtained from market equilibrium with feedback from individual expectations. Each market is populated by six subjects and a small fraction of fundamentalist traders. Realized prices differ significantly from fundamental values. In some groups the asset price converges slowly to the fundamental price, in other groups there are regular oscillations around the fundamental price. In all groups participants * We benefitted from comments by seminar participants at the Universities of Amsterdam, Dortmund, Groningen, Maastricht, Strasbourg and participants of the Review of Financial Studies Conference on Experimental and Behavioral Finance, Mannheim, December 12-13, 2002 and the "Marchés Boursiers" conference, Paris, May 27-28, 2003. We especially thank our discussants Thomas Langer and Marc Willinger for their helpful comments. The paper improved significantly from comments by an anonymous referee and the editor. Financial support under a NWO-Pionier grant is gratefully acknowledged.