Small Deviations from Maximizing Behavior in a Simple Dynamic Model

The basic intuition that motivates this paper is that the presence of non-maximizing agents creates incentives for maximizing agents to take advantage of them, and when "frictions" are sufficiently small, these incentives might translate seemingly small deviations from maximizing behavior into non-negligible effects. This paper explores this intuition by looking at a simple dynamic model, which in reduced form can be described by the elementary demand-supply paradigm. The dynamic model allows to caputre explicitly the special efforts that the maximizing agnets devote to gain at the expense of the non-maximizing ones. In a mdoel with inflexible entry process, it is shown that, when market frictions are relatively insignificant, small deviations from maximizing behavior have substatntial impact on market outcomes. In a model with flexible entry process, the price effect of deviations from rationality is dampened by adjustments in entry. Yet these deviations result in forst order effieciency loss, in contrast to the second order loss that one would expect from looking at standard static models.