Competitive financial markets play an absolutely central role in the economy. They provide the means by which society shares risk and allocates capital. Existing theoretical models of such markets are elegant and beautiful, but fare badly when confronted with actual data. The work proposed uses laboratory experiments to explore several possible explanations for the disconnection between theory and fact: (a) that some agents are better informed than others, (b) that some agents do not use available information as well as others, and (c) that some agents suffer from cognitive biases.
This work shows that experiments can play a role in finance entirely analogous to the role they play in the physical sciences, making it possible to create and study complicated systems in a controlled setting, eliminating "frictions" and noise, studying the effect of changing a few variables while holding others constant, and exploring counterfactuals. The insights to be gained from this research have implications for investment and for government policy and regulation, including social security.
