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Individual Rationality and Market Efficiency

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  • Steven Gjerstad
  • Jason M. Shachat

Abstract

The demonstration by Smith [1962] that prices and allocations quickly converge to the competitive equilibrium in the continuous double auction (CDA) was one of the first – and remains one of the most important results in experimental economics. His initial experiment, subsequent market experiments, and models of price adjustment and exchange have added considerably to our knowledge of how markets reach equilibrium, and how they respond to disruptions. Perhaps the best known model of exchange in CDA market experiments is the random behavior in the “zero-intelligence” (ZI) model by Gode and Sunder [1993]. They conclude that even without trader rationality the CDA generates efficient allocations and “convergence of transaction prices to the proximity of the theoretical equilibrium price,” provided only that agents meet their budget constraints. We demonstrate that – by any reasonable measure – prices don’t converge in their simulations. Their budget constraint requires that a buyer’s currency never exceeds her value for the commodity, which is an unnatural restriction. Their conclusion that market efficiency results from the structure of the CDA independent of traders’ profit seeking behavior rests on their claim that the constraints that they impose are a part of the market institution, but this is not so. We show that they in effect impose individual rationality, which is an aspect of agents' behavior. Researchers on learning in markets have been misled by their interpretation of the ZI simulations, with deleterious effects on the debate on market adjustment processes.

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Bibliographic Info

Paper provided by Purdue University, Department of Economics in its series Purdue University Economics Working Papers with number 1204.

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Length: 11 pages
Date of creation: Aug 2007
Date of revision:
Handle: RePEc:pur:prukra:1204

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Related research

Keywords: Bounded rationality; double auction; exchange economy; experimental economics; market experiment; "zero intelligence" model;

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References

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  1. John List, 2004. "Testing neoclassical competitive theory in multi-lateral decentralized markets," Framed Field Experiments 00176, The Field Experiments Website.
  2. Smith, Vernon L, 1982. "Microeconomic Systems as an Experimental Science," American Economic Review, American Economic Association, vol. 72(5), pages 923-55, December.
  3. Antoni Bosch-Domènech & Joaquim Silvestre, 1996. "Credit constraints in general equilibrium: Experimental results," Economics Working Papers 105, Department of Economics and Business, Universitat Pompeu Fabra.
  4. Evans, Dorla A, 1997. "The Role of Markets in Reducing Expected Utility Violations," Journal of Political Economy, University of Chicago Press, vol. 105(3), pages 622-36, June.
  5. Easley, David & Ledyard, John., . "Theories of Price Formation and Exchange in Double Oral Auctions," Working Papers 611, California Institute of Technology, Division of the Humanities and Social Sciences.
  6. Gjerstad, S. & Dickhaut, J., 1995. "Price Formation in Double Auctions," Papers 284, Minnesota - Center for Economic Research.
  7. Hurwicz, Leonid & Radner, Roy & Reiter, Stanley, 1975. "A Stochastic Decentralized Resource Allocation Process: Part I," Econometrica, Econometric Society, vol. 43(2), pages 187-221, March.
  8. Daniel Friedman, 1982. "Price Formation in Double Auction Markets," UCLA Economics Working Papers 278, UCLA Department of Economics.
  9. Vernon L. Smith, 1962. "An Experimental Study of Competitive Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 70, pages 111.
  10. Gjerstad, Steven, 2007. "The competitive market paradox," Journal of Economic Dynamics and Control, Elsevier, vol. 31(5), pages 1753-1780, May.
  11. Markose, Sheri & Arifovic, Jasmina & Sunder, Shyam, 2007. "Advances in experimental and agent-based modelling: Asset markets, economic networks, computational mechanism design and evolutionary game dynamics," Journal of Economic Dynamics and Control, Elsevier, vol. 31(6), pages 1801-1807, June.
  12. Tesfatsion, Leigh S., 2002. "Agent-Based Computational Economics: Growing Economies from the Bottom Up," Staff General Research Papers 5075, Iowa State University, Department of Economics.
  13. John Conlisk, 1996. "Why Bounded Rationality?," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 669-700, June.
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Cited by:
  1. Giuseppe Attanasi & Samuele Centorrino & Ivan Moscati, 2011. "Double Auction Equilibrium and Efficiency in a Classroom Experimental Search Market," LERNA Working Papers 11.03.337, LERNA, University of Toulouse.
  2. Steven Gjerstad, 2007. "Price Dynamics in an Exchange Economy," Purdue University Economics Working Papers 1205, Purdue University, Department of Economics.
  3. Mikhail Anufriev & Jasmina Arifovic & John Ledyard & Valentyn Panchenko, 2013. "Efficiency of continuous double auctions under individual evolutionary learning with full or limited information," Journal of Evolutionary Economics, Springer, vol. 23(3), pages 539-573, July.
  4. Marco LiCalzi & Paolo Pellizzari, 2008. "Zero-Intelligence Trading without Resampling," Working Papers 164, Department of Applied Mathematics, Università Ca' Foscari Venezia.
  5. Grazzini, J., 2011. "Experimental Based, Agent Based Stock Market," CeNDEF Working Papers 11-07, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  6. Jakob Grazzini, 2012. "Analysis of the Emergent Properties: Stationarity and Ergodicity," Journal of Artificial Societies and Social Simulation, Journal of Artificial Societies and Social Simulation, vol. 15(2), pages 7.

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