Randomness and the Madness of Crowds

Chapter in "The Challenge of Chance", eds. Klaas Landsman & Ellen van Wolde (Springer-Verlag, Heidelberg, 2016). Written for a general audience.

25 Pages Posted: 27 Nov 2015

See all articles by Utz Weitzel

Utz Weitzel

VU University Amsterdam; Tinbergen Institute; Radboud University

Stephanie Rosenkranz

Utrecht University - School of Economics

Date Written: November 22, 2015

Abstract

Human interaction often appears to be random and at times even chaotic. We use game theory, the mathematical study of interactive decision making, to explain the role of rationality and randomness in strategic behavior. In many of these situations, humans deliberately create randomness as a best response and equilibrium strategy. Moreover, once out of equilibrium, individual beliefs about the real intentions of others introduce significant randomness into otherwise quite simple and deterministic situations of interaction. In a second step we discuss the role of randomness on financial markets, which are prototypical institutions for the aggregation of individual behavior. As in certain simple games, financial markets can produce outcomes that are close to perfect randomness. In fact, random walks in financial returns are considered by most scholars to be efficient and desirable. Finally, we apply game theoretical insights to behavior on financial markets and show how strategic speculation on 'greater fools' can create a 'madness of crowds' that often ends in chaotic swings, bubbles and crashes.

Suggested Citation

Weitzel, Utz and Rosenkranz, Stephanie, Randomness and the Madness of Crowds (November 22, 2015). Chapter in "The Challenge of Chance", eds. Klaas Landsman & Ellen van Wolde (Springer-Verlag, Heidelberg, 2016). Written for a general audience.. Available at SSRN: https://ssrn.com/abstract=2694249

Utz Weitzel (Contact Author)

VU University Amsterdam ( email )

De Boelelaan 1105
Amsterdam
Netherlands

Tinbergen Institute ( email )

Gustav Mahlerplein 117
Amsterdam, 1082 MS
Netherlands

Radboud University ( email )

Heyendaalseweg 141
Nijmegen, 6525 AJ
Netherlands

Stephanie Rosenkranz

Utrecht University - School of Economics ( email )

Kriekenpitplein 21-22
Adam Smith Building
Utrecht, 3584 EC
Netherlands
+31 30 253 9806 (Phone)
+31 30 253 7373 (Fax)

HOME PAGE: http://www.uu.nl/uupublish/defaculteit/persoonlijkepagi/rosenkranz/

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