Boundaries of the Tournament Pricing Effect in Asset Markets: Evidence from Experimental Markets

1. Introduction When traders in experimental asset markets are compensated according to a tournament contract (a "salary-plus-bonus" scheme in which a trader's bonus is proportional to the amount by which that trader exceeds the average performance in that market), we observe violation of convergence results obtained in experiments that did not use such compensation schemes. This effect of tournament incentives has been documented by James and Isaac (2000). In this paper, we search for what Smith and Williams (1990) have termed "the boundaries of falsification" for the proposition that tournament contracts affect asset market prices. Specifically, we examine the robustness of the tournament pricing effect on market prices on several fronts. First, we ask whether the pricing effect survives when not all traders are being compensated according to the beat-the-market contract. Second, we ask whether the tournament pricing effect is robust with respect to perturbations in the trader's compensation contract. Third, we ask whether the pricing effect is observed in two-period asset-life markets (hereafter 2 p.a.l. markets) as it is in 15-period asset-life markets (hereafter 15 p.a.l. markets).1 Section 2 presents the background of the current experiments, the research conjectures, and the experimental design. The experimental results are contained in section 3. Section 4 discusses a phenomenon that we had not encountered until these experiments. Section 5 offers the conclusions and thoughts for further reflection. 2. Conjectures and Experimental Design Background James and Isaac (2000) was the first paper to assess the effect on asset market prices of tournament contracts imposed at the individual level. This is distinct from an earlier paper by Brown, Harlow, and Starks (1996) that examines how individual portfolio managers' allocation decisions change in response to such contracts but that does not address the issue of any effects on prices of the assets the portfolio managers are trading. Brown, Harlow, and Starks is itself a specific application of a wider literature on using tournament contracts to address principal-agent conflicts (see also Nalebuff and Stiglitz 1983; Bull, Schotter, and Weigelt 1987; and Ehrenburg and Bognanno 1990). The issue of the effect on market prices is arguably the most important one surrounding the imposition of tournament contracts on portfolio managers because it is these capital market prices that help allocate savings to different forms of investment. Naturally, misleading capital market prices can potentially lead to catastrophically misdirected capital spending.2 This key aspect of James and Isaac-that it addresses the effect at the market level of using tournament incentives at the individual level-is also present in this paper. The research objective of this paper is to document the eventual market level ramifications of varying the use of tournament contracts. The nature of those variations will be discussed here. The Effect of Tournament Incentives on Asset Market Prices Prior to this paper, it has been established that the way in which traders in experimental asset markets are compensated on an individual basis can significantly change the prices that eventuate at the market level. In a seminal paper on experimental asset markets, Smith, Suchanek, and Williams (1988; hereafter SSW) find that as groups of traders were called back for repeat sessions of a 15 p.a.l. market (which can be viewed as an experimental implementation of the theoretical market analyzed by Tirole 1982), the market price of the asset bubbled less in each successive 15-period asset market. This suggests that the no-trading, common expectations equilibrium derived by Tirole might be reached eventually but requires experience on the part of the pool of traders. Of note, in SSW, the traders are compensated such that an experimental dollar corresponds to a U.S. dollar; that is, the traders' respective experimental dollar holdings, deriving variously from cash endowments, dividend payments, and capital gains, are translated one for one into U. …