Individual Expectations, Limited Rationality and Aggregate Outcomes
Tinbergen Institute Discussion Paper No. 12-016/1
45 Pages Posted: 18 Feb 2012 Last revised: 8 Oct 2012
Date Written: February 16, 2012
Recent studies suggest that the type of strategic environment or expectation feedback can have a large impact on whether the market can learn the rational fundamental price. We present an experiment where the fundamental price experiences large unexpected shocks. Markets with negative expectation feedback (strategic substitutes) quickly converge to the new fundamental, while markets with positive expectation feedback (strategic complements) do not converge, but show under-reaction in the short run and over-reaction in the long run. A simple evolutionary selection model of individual learning explains these differences in aggregate outcomes.
Keywords: Expectation feedback, under- and over-reaction, strategic substitutes and strategic complements, heuristic switching model, experimental economics
JEL Classification: C92, G14, D84, D83, E37
Suggested Citation: Suggested Citation