Asset markets as an equilibrium selection mechanism

Asset Markets As An Equilibrium Selection Mechanism:
Coordination Failure, Game Form Auctions, and Tacit Communication

John Van Huyck, Raymond Battalio, and Richard Beil

Revised January 1992

[ Introduction | Conclusion | References | Footnotes | John's Web ]

Abstract: In this paper, we explore the possibility that asset markets provide a means of tacit communication, which may allow subjects to coordinate on an efficient product market outcome. We find that the existence of an asset price does communicate information about the equilibrium selection problem in a product market. Specifically, behavior never converged to the efficient product market outcome when subjects where endowed with the right to participate, but always converged to the efficient outcome when subjects purchased the right to participate.

Acknowledgements: The National Science Foundation (SES-8420240; SES-8911032), the Texas Agriculture Extension Service, the Texas Engineering Extension Service, and the Texas A&M Center for Mineral and Energy Research provided financial support.

Introduction

In two recent papers--Van Huyck, Battalio, and Beil (1990; 1991)--we reported experimental treatments in which subjects always coordinated on equilibrium points that where Pareto dominated by other symmetric strict equilibria. Hence, those experiments provide striking examples in which strategic uncertainty leads to coordination failure in the absence of preplay communication. [1] In this paper, we explore the possibility that asset markets provide a means of tacit communication, which may allow subjects to coordinate on an efficient product market outcome.

The influence asset prices can have on the selection of a product market equilibrium is usually ignored in conventional analysis. However, associated with an asset price is an average forecast of the product market outcome that owners are likely to implement. Since owners confront a strategy coordination problem given the existence of multiple product market equilibria, owners may use the asset price, which is observable by all owners, to inform their own beliefs about the likely product market equilibrium and, consequently, implement the equilibrium forecast by the competitive asset market. In this paper, the information about the equilibrium selection problem communicated by the historical asset price leading to the current product market stage game will be called `tacit communication.' [2]

This paper formalizes our intuition that asset prices can select a product market equilibrium and, by so doing, determine the asset's value. In the analysis, the asset is a one period lease on a production opportunity and the product market payoff depends on the strategic interaction with other owners in the product market. Strategic complementarities in the product market produce multiple Pareto ranked equilibria. Because some asset prices reduce the set of profitable product market equilibria, the tacit communication allowed by the existence of an asset price may reinforce the salience of payoff-dominance.

We find that the existence of an asset price does communicate information about the equilibrium selection problem in a product market. The outcome when subjects purchase the right to participate in the product market game is dramatically different from our previous experiments in which subjects were endowed with the right to participate. Specifically, behavior never converged to the efficient product market outcome when subjects where endowed with the right to participate, but always converged to the efficient outcome when subjects purchased the right to participate.

Conclusion

This paper has demonstrated that the existence of an asset market can influence the selection of a product market equilibrium. When the product market exhibits multiple Pareto ranked equilibria, owners are uncertain which equilibrium, if any, will be implemented. Common information that all owners voluntarily paid P informs an owner's reasoning about the equilibrium selection problem by ruling out equilibria supported by strategies that do not pay at least P in equilibrium.

Table seven summarizes the tenth treatment period results of experiments one to fourteen. When endowed with the right to participate in the product market game, subjects never implement the payoff-dominant product market outcome. Without an asset market the precedent established by the historical accident of the initial median appears to select the mutual best response outcome coordinated on in repeated play. Yet, the multiple unit English Clock (EC) auction always induced subjects--regardless of the initial median and after only a few periods of "learning"--to implement the efficient product market outcome. As reported in the contingency table, the efficient outcome in the product market is perfectly correlated with the existence of the asset market institution.

Selling the right to participate in the product market, rather than endowing subjects with the right to participate, has a significant influence on the equilibrium selected in the product market. The asset price influences both initial behavior in the product market and the disequilibrium dynamics. Initially, subjects do not price the asset equal to its payoff in the payoff-dominant equilibrium nor do they implement the payoff-dominant equilibrium in the product market. We consistently observed subject behavior converging to the efficient competitive equilibrium in the repeated two stage game. In these experiments, the existence of an asset market promotes efficient behavior in the product market.

References

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J.B. Van Huyck, R.C. Battalio, and R.O. Beil, "Strategic Uncertainty, Equilibrium Selection Principles, and Coordination Failure in Average Opinion Games," The Quarterly Journal of Economics, 106(3), August 1991, 885-911.

J.B. Van Huyck, R.C. Battalio, and R.O. Beil, "Tacit Coordination Games, Strategic Uncertainty, and Coordination Failure," American Economic Review, 80(1), March 1990.

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Footnotes

[1] Beckman (1989), Cooper, et. al. (1990), and Straub (1991) also report experiments exhibiting coordination failure. Cachon and Camerer (1991) replicate our baseline results with University of Pennsylvania undergraduates.

[2] This sort of tacit communication is often stated as a speech and used to motivate "forward induction." Gale and Hellwig (1989; p.24) and Van Damme (1989; p.484) demonstrate that the logic of forward induction is not equivalent to the equilibrium refinement of strategic stability. We do not apply strategic stability (or the intuitive criterion) in this paper. Following the advice of a wise theorist, we have banned the phrase "forward induction" from this paper.