Individual expectations, limited rationality and aggregate outcomes

by Cars H. Hommes, Jan Tuinstra, Joep Sonnemans and Te Bao

Journal of Economic Dynamics and Control (2012), Volume 36, Issue 8, Pages 1101–1120.

Abstract

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 underreaction in the short run and overreaction in the long run. A simple evolutionary selection model of individual learning explains these differences in aggregate outcomes.