Following the Actions of Others: The Simple Average of Strategies in a Rational Expectations Economy

Abstract

We study an alternative mechanism of social learning in a rational expectations equilibrium economy where agents learn from the actions of others by adopting the simple average of ex ante optimal strategies of their social network. When information is exogenous, large social networks benefit all agents if and only if agents are relatively homogeneous in terms of information precision. In contrast, a setting where both information acquisition and network formation are endogenous leads to small social networks in equilibrium. Both solitary action and large social networks are unstable as agents have an incentive to form, respectively disintegrate into, small social networks of just two or three agents. However, each agent would benefit if larger networks were imposed on the entire economy by a central agent. We further show that imposing large social networks on the economy reduces information acquisition, market efficiency, market liquidity, and trading volume, while increasing return volatility.

Keywords: Simple Average of Strategies, Rational Expectations Equilibrium, Information Acquisition, Social Networks

JEL Classification: D82, G14