Silly bubbles and the insensitivity of rationality testing: An experimental illustration

Conventional economic and financial theory often requires that market price reflect the 'rational' assessment of the intrinsic value of an asset. Yet, gradual booms in security markets and their rapid crash make it clear that prices do not always mirror fundamental values. An experimental market reveals that prices in a double oral auction need not converge to a 'rational' value. In fact for this experiment, prices and fundamental values are highly inversely related. More problematic still is the fact that conventional statistical tests of market rationality are unable to detect the irrational bubbles generated by this experiment. This paper illustrates how difficult it is to empirically identify irrationality in simple self-fulfilling behavior and thus how easy it is to label 'silly' economic behavior 'rational'.