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Heterogeneous Expectations, Volatility and Welfare

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    Abstract

    This paper explores the extent to which the lack of rationality of economic agents has affected the economic fluctuations of the U.S. hog market. The dynamic model of this paper adopts the framework of conventional rational expectations models and nests heterogeneity in expectations in the framework. In particular, the model assumes two types of economic agents. One (rational agent) has rational expectations and the other (boundedly rational agent) has static expectations. A log-likelihood function is constructed based on the model and the fraction of boundedly rational agents is estimated by the function. Subsequently, simulation experiments are performed to investigate the extent to which the presence of boundedly rational economic agents has affected the volatility of the economic variables of the market. In particular, two sets of artificial data are generated by the model, one set with the estimated fraction of boundedly rational agents and the other with their zero fraction. Next, the standard deviations of the quantity and price variables are computed using the simulated data and then compared. The welfare quantified as consumer surplus minus production costs is measured and compared in the same way. Empirical test results indicate that the presence of boundedly rational economic agents has increased the price and quantity volatility by 14 and 25 percent respectively, in the U.S. hog market for the period from 1945 to 1990. However, welfare turns out to be rarely affected by their presence as far as rational economic agents dominate the market.

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    File URL: http://www.iuj.ac.jp/workingpapers/index.cfm?File=EMS_2000_01.pdf
    File Function: First version, 2000
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    Bibliographic Info

    Paper provided by Research Institute, International University of Japan in its series Working Papers with number EMS_2000_01.

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    Length: 32 pages
    Date of creation: Jun 2000
    Date of revision:
    Handle: RePEc:iuj:wpaper:ems_2000_01

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    Keywords: Heterogeneous expectations; Bounded rationality; Optimal control problem; Economic fluctuations; Consumer surplus;

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    1. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, . "Noise Trader Risk in Financial Markets," J. Bradford De Long's Working Papers _124, University of California at Berkeley, Economics Department.
    2. Hayes, Dermot J. & Schmitz, Andrew, 1987. "Hog Cycles and Countercyclical Production Response," Staff General Research Papers 597, Iowa State University, Department of Economics.
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    14. John Conlisk, 1996. "Why Bounded Rationality?," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 669-700, June.
    15. J. Barkley Rosser, 1999. "On the Complexities of Complex Economic Dynamics," Journal of Economic Perspectives, American Economic Association, vol. 13(4), pages 169-192, Fall.
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