In experiment 1 we investigated the possibility of an interaction between market structure and market depth. Market depth and the number of transactions that occur are typically tightly correlated, which implied the market is relatively deep in the gain treatment in rounds 1-10 and the loss treatment in rounds 11-20. To be precise, in a deep market an additional large order (either a high bid or a low ask) will not influence price much. To have a deep market the bid and the ask schedules must be relatively flat in the vicinity of the marginal bid and marginal ask. What are bid and ask schedules? They are similar to the demand and supply functions, but rather than being based on values and costs, they are built using the bids and asks of the buyers and sellers.

Why did we manipulate the market structure (market maker gain vs. loss) and market depth? It has to do with how close your bids and asks should be to values and costs. Consider first the “gain” treatment where buyers pay the marginal bid and sellers receive the marginal ask. Suppose that you are the only buyer (this is a very shallow market). Would it make sense to make a bid equal to your value? No, because it would guarantee a profit of zero, regardless of whether or not you end up purchasing. You would be better off bidding less than your value. You would trade off the probability that your bid is too low (lower than the lowest asking price) in which case you would not purchase, receiving a payoff of zero VS getting a higher profit by paying less. The same type of argument applies on the sell side: if the market maker makes a gain and you are the only seller (again, a very shallow market), you would not want to set your asking price equal to your cost: this would guarantee zero profit. Thus, when the market maker makes a gain and the market is relatively shallow we would expect to see buyers bidding less than their value, and sellers asking more than their costs.

Contrast this the treatments where the market maker makes a loss, where buyers pay the marginal ask and sellers receive the marginal bid. In this case there is no chance that you will either pay or receive your bid or ask: your price is determined by the choices made on the other side of the market. Thus, regardless of market depth your bid or ask only influences the probability of trading: i.e. there is no trade-off between the probability of trading and the payoff you receive if you trade. As a result, you should bid (or ask) in such a way that maximizes the probability of trade when the price you pay (or receive) is lower (or higher) than your value (or cost). In this type of situation it can be shown that buyers should bid their value and sellers should ask their cost.

What implications does this have for the volume of trade, relative to the prediction of perfect competition? It should be higher when the market maker makes a loss (a market maker loss is kind of like a per unit subsidy), and lowest when the market maker makes a gain and the market is shallow. Does not appear to have happened… The ratio of subjects in each treatment was \(\approx\) 3:1, next semester I am going to bump it to 7:1.

Figure 1: Buyers in red: Demand (dark), bids (faint), marginal bid (dot). Sellers in blue: Supply (dark), asks (faint), markinal ask (dot). Panels give the 4 treatment combinations: rows marketmaker gain or loss, columns first 10 rounds or second 10 rounds. By hitting the play button above you can see how the markets evolved over the 10 rounds of play. Note that supply and demand shift slightly to the left when players kicked out of experiment for falling behind.

When the market is deep, it should not really matter whether the market maker is making a gain or loss: the gain or loss should be tiny in a deep market. What I was interested in was a potential bidding and asking difference when markets were shallow. In particular when the market maker makes a loss there is no chance that your bid (or ask) will be the price you pay (or receive): Your choice only affects the probability you trade, not the price you pay (or receive). In contrast in the gain treatment your bid (or ask) has a fairly high probability of being the marginal bid (or ask), in which case you would not want to bid your value or ask your cost.

Does not appear to be much of a difference between the gain and loss treatments, regardless of whether the market was deep or shallow.