We use game theory and the Santa Fe Artificial Stock Market, an agent-based model of an evolving stock market, to study the properties of strategic Nash equilibria in financial markets. We discover two things: there is a unique strategic equilibrium in the market, and this equilibrium in sub-optimal since traders' earnings are not maximized and the market is inefficient. The inevitability of this strategic equilibrium is due to an analogue of the prisoner's dilemma; the optimal global state is unstable because each individual has too much incentive to ``defect'' and use forecasting rules that pull the market into the sub-optimal equilibrium.
Submitted to Computational Economics (special issue on Evolutionary Processes in Economics).
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Paper provided by Santa Fe Institute in its series Working Papers with number
99-03-023.