General Equilibrium Theory with Incomplete Information: The Wisdom of Crowds and Efficient Markets

17 Pages Posted: 12 Dec 2016 Last revised: 29 Sep 2019

Date Written: September 19, 2017

Abstract

I study general equilibrium theory with incomplete information. When agents are not fully informed, they can end up purchasing a bundle of goods that is far from optimal. General equilibrium theory falls short of providing a satisfactory explanation of the ability of real markets to deliver good outcomes under these circumstances.

I introduce the wisdom of crowds as a corrective for suboptimal individual behaviour. The wisdom of crowds refers to the empirically observed ability of crowds to show collective intelligence even when their constituent individuals do not. I show that when crowds are wise, aggregate demand, aggregate production and prices all approach their ex-post Pareto efficient levels. In a neighbourhood of equilibrium, prices follow a martingale process, providing a general equilibrium derivation of the efficient market hypothesis. A spot market that opens after the resolution of uncertainty delivers an outcome that is ex-post Pareto efficient. This is achieved without any contingent commodities or securities, and agents who act `naively' and needn't have any ability to predict future prices.

Keywords: General equilibrium theory, incomplete information, bounded rationality

JEL Classification: D52, D83

Suggested Citation

Kerr, Steven, General Equilibrium Theory with Incomplete Information: The Wisdom of Crowds and Efficient Markets (September 19, 2017). Available at SSRN: https://ssrn.com/abstract=2883351 or http://dx.doi.org/10.2139/ssrn.2883351

Steven Kerr (Contact Author)

University of Edinburgh ( email )

31 Buccleuch Place
Edinburgh, EH8 9JT
United Kingdom

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