On Nonbinding Price Controls in a Competitive Market

Interest in the effect of nonbinding price controls on double auction markets stems from two primary considerations. The double auction institution converges to a competitive allocation more rapidly, and with fewer participating agents than any other institution with which it has been compared (see Smith et al.). One way to improve our understanding of this important property is to determine what conditions, if any, can interfere with or retard this convergence process. Nonbinding price controls represent a condition that may affect this convergence process. Hence, if such effects can be documented, they will provide a body of data that any future proposed model of the double auction process should be able to explain. A second reason for studying the effect of nonbinding controls on the double auction is practical: The organized commodity exchanges ". often set limits on price fluctuations during any single day. When prices at any point during a day rise above Qr fall below the closing prices of the preceding day by more than the amount of the limit, no further trading for that day is permitted" (Walter Labys, p. 162). Consequently, commodity trading frequently occurs at prices near the level of nonbinding price floors or ceilings. Mark Issac and Charles Plott report the results of twelve exploratory experiments in which various price control constraints are imposed on double auction markets. Their two principal conclusions can be summarized as follows: 1) The hypothesis is rejected that nonbinding price controls, that is, price ceilings above or price floors below the competitive equilibrium (CE), will serve as a focal point or signalling price on which sellers and buyers will key their contracts. 2) Inconclusive evidence is presented in support of the hypothesis that nonbinding controls near the CE will bias prices below CE when there is a price ceiling and above CE when there is a price floor. Support for this second hypothesis is not conclusive because some experimental markets show a tendency to converge from below and others from above depending upon the relative bargaining strength of buyers as against sellers. Thus sampling variation among subjects can yield a group in which buyers (sellers) are able to make contracts at an average price below (above) CE for several periods of trading. Consequently, in an experiment in which there is a price ceiling (floor) five cents above (below) CE and in which contract prices are observed to occur below (above) CE, one cannot determine conclusively whether the observed effect was due to the nonbinding price control or to the bargaining characteristics of the market participants. We report below an experimental design developed for the purpose of separating these confounding factors and allowing the effect of nonbinding controls to be isolated. The results of sixteen experiments strongly support the hypothesis that markets with a nonbinding price ceiling (floor) near CE will converge from below (above) relative to any otherwise identifiable tendency to converge from below (above). An analysis of the effect of a nonbinding price ceiling (floor) on the distributions of bids and offers reveals the cause of this bias: ceilings limit the bargaining strategies of sellers especially, but also that of buyers, while floors have the opposite effect. Thus, in the absence of price controls, double auction trading is characterized by a process in which sellers typically make concessions from offer prices well above CE while buyers most often concede from bid prices well below CE. A price ceiling truncates seller offer prices at the ceiling, requir*University of Arizona and Indiana University, respectively. Research support by the National Science Foundation is gratefully acknowledged.