Dancing to the wrong tune: How rational myopia, belief heterogeneity, and adjustment costs shape financial bubbles

We introduce the Anticipations-Based Production Equilibrium (ABPE) as a minimal extension of the Arrow–Radner Production Equilibrium (ARPE). Whereas ARPE requires optimality and rational expectations, ABPE relies only on local optimization and locally coherent expectations. This mild departure preserves internal consistency, coincides with ARPE in discrete time, while in continuous time allows for speculative bubbles, defined intrinsically as price trajectories that rise explosively before collapsing in finite time. To illustrate the concept, we develop a continuous-time production economy with heterogeneous beliefs and convex adjustment costs, where bubbles emerge endogenously from the interplay of nonlinear price dynamics, and belief-driven momentum. We characterize the precise conditions under which bubbles emerge, and distinguish between financial bubbles, which affect only asset prices, and real bubbles, which also impact production and growth. The ABPE framework is general and accommodates a variety of belief formation mechanisms, which we illustrate with anticipations constructed through backward inference and regret minimization.