Asset Bubbles and Rationality: Additional Evidence from Capital Gains Tax Experiments

Abstract

[Introduction] The remarkable phenomenon of bubbles and crashes in laboratory asset markets was first discovered and reported in Smith et al (1988). Subsequent research inquired about the robustness of the phenomenon and how it might be explained. One interpretation of the data is that public knowledge of rationality is lacking in the subjects, which leads to a type of individually rational, bubble creating speculation as part of an attempt to acquire capital gains. A different interpretation is that subjects begin with a type of confusion or mistaken understanding about this particular environment and that such "irrationality" at the individual level initiates the bubble, which could be sustained by a lack of common knowledge of rationality even after all confusion becomes removed during the process of participating in the market. This paper explores these two ideas through the study of experiments in which a capital gains tax is imposed that makes speculation for capital gains unprofitable except under extreme circumstances.

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