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From zero-intelligence to Bayesian learning: the effect of rationality on market efficiency

Author

Listed:
  • Daniele Giachini

    (Institute of Economics & Department L’EMbeDS, Scuola Superiore Sant’Anna)

  • Shabnam Mousavi

    (Max Planck Institute for Human Development)

  • Matteo Ottaviani

    (Scuola Normale Superiore
    German Centre for Higher Education Research and Science Studies (DZHW))

Abstract

In this paper, we investigate the relationship between individual rationality and price informative efficiency studying a prediction market model where agents repeatedly bet on the occurrence of a binary event following their subjective beliefs. We define individual rationality in terms of the amount of past observations used to update beliefs. In this way, a wide spectrum of rationality levels emerges, ranging from zero-intelligence to Bayesian learning. We show that the relationship between individual rationality and price informative efficiency is nonlinear and U-shaped. We argue that the results emerge from the particular interaction of two evolutionary forces operating at different levels: the market selection mechanism that moves wealth toward more accurate agents and the individual learning process that moves posterior probabilities over models depending on observed realizations.

Suggested Citation

  • Daniele Giachini & Shabnam Mousavi & Matteo Ottaviani, 2025. "From zero-intelligence to Bayesian learning: the effect of rationality on market efficiency," Journal of Economic Interaction and Coordination, Springer;Society for Economic Science with Heterogeneous Interacting Agents, vol. 20(3), pages 659-676, July.
    • Handle: RePEc:spr:jeicoo:v:20:y:2025:i:3:d:10.1007_s11403-024-00424-0
    DOI: 10.1007/s11403-024-00424-0
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    Keywords

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    JEL classification:

    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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