Endogenous Equilibria in Liquid Markets with Frictions and Boundedly Rational Agents
37 Pages Posted: 10 Apr 2012
Date Written: August 5, 2011
In this paper we propose a simple binary mean field game, where N agents may decide whether to trade or not a share of a risky asset in a liquid market. The asset's returns are endogenously determined taking into account demand and transaction costs. Agents' utility depends on the aggregate demand, which is determined by all agents' observed and forecasted actions. Agents are boundedly rational in the sense that they can go wrong choosing their optimal strategy. The explicit dependence on past actions generates endogenous dynamics of the system. We, firstly, study under a rather general setting (risk attitudes, pricing rules and noises) the aggregate demand for the asset, the emerging returns and the structure of the equilibria of the asymptotic game. It is shown that multiple Nash equilibria may arise. Stability conditions are characterized, in particular boom and crash cycles are detected. Then we precisely analyze properties of equilibria under significant examples, performing comparative statics exercises and showing the stabilizing property of exogenous transaction costs.
Keywords: Endogenous dynamics, Nash equilibria, Bounded rationality, Transaction costs, Mean field games, Random utility
JEL Classification: D81, C62, C72
Suggested Citation: Suggested Citation