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Edited* by Douglas S. Massey, Princeton University, Princeton, NJ, and approved October 21, 2014 (received for review April 22, 2014)
Significance
Markets are central to modern society, so their failures can have devastating effects. Here, we examine a prominent failure: price bubbles. We propose that bubbles are affected by ethnic homogeneity in the market and can be thwarted by diversity. Using experimental markets in Southeast Asia and North America, we find a marked difference: Market prices fit true values 58% better in diverse markets. In homogenous markets, overpricing is higher and traders’ errors are more correlated than in diverse markets. The findings suggest that price bubbles arise not only from individual errors or financial conditions, but also from the social context of decision making. Informing public discussion, our findings suggest that diversity facilitates friction that enhances deliberation and upends conformity.
Abstract
Markets are central to modern society, so their failures can be devastating. Here, we examine a prominent failure: price bubbles. Bubbles emerge when traders err collectively in pricing, causing misfit between market prices and the true values of assets. The causes of such collective errors remain elusive. We propose that bubbles are affected by ethnic homogeneity in the market and can be thwarted by diversity. In homogenous markets, traders place undue confidence in the decisions of others. Less likely to scrutinize others’ decisions, traders are more likely to accept prices that deviate from true values. To test this, we constructed experimental markets in Southeast Asia and North America, where participants traded stocks to earn money. We randomly assigned participants to ethnically homogeneous or diverse markets. We find a marked difference: Across markets and locations, market prices fit true values 58% better in diverse markets. The effect is similar across sites, despite sizeable differences in culture and ethnic composition. Specifically, in homogenous markets, overpricing is higher as traders are more likely to accept speculative prices. Their pricing errors are more correlated than in diverse markets. In addition, when bubbles burst, homogenous markets crash more severely. The findings suggest that price bubbles arise not only from individual errors or financial conditions, but also from the social context of decision making. The evidence may inform public discussion on ethnic diversity: it may be beneficial not only for providing variety in perspectives and skills, but also because diversity facilitates friction that enhances deliberation and upends conformity.
Footnotes
- ↵1To whom correspondence should be addressed. Email: sslevine{at}sslevine.com.
Author contributions: S.S.L., E.P.A., M.B., E.J.Z., and D.S. designed research; S.S.L. and V.L.B. performed research; S.S.L. and M.B. analyzed data; and S.S.L., E.P.A., M.B., V.L.B., E.J.Z., and D.S. wrote the paper.
The authors declare no conflict of interest.
↵*This Direct Submission article had a prearranged editor.
See Commentary on page 18407.
This article contains supporting information online at www.pnas.org/lookup/suppl/doi:10.1073/pnas.1407301111/-/DCSupplemental.
Freely available online through the PNAS open access option.
References
Ethnic diversity deflates price bubbles
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